A great rotation is underway in FX markets

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While we wait for a “great rotation” from fixed income into equities, there is another rotation already at work in the currency markets.

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Residents of the United States, please read this important information before proceeding

The main FX story of 2013 has not been the survival of the euro (EUR), but the procyclicality of the US dollar

Foreign exchange (FX) markets are undergoing a fundamental shift. Relationships between currencies and the economic and financial backdrop have started to change. Here, we discuss two of the main changes. First, the US dollar is taking on the properties of a procyclical currency. Second, there is a shift from the risk-on/risk-off environment to a world where investors differentiate currencies based on idiosyncratic factors.

Welcome the new US dollar

The main FX story of 2013 has not been the survival of the euro (EUR), but the procyclicality of the US dollar (USD). In the February edition of Compass, we detailed why we believe that USD may turn pro-cyclical again and, therefore, benefit from the economic recovery and rising markets. Indeed, such a view has now become consensus.

The key to our call on the pro-cyclicality of USD is our view that the US economy is in better shape than many think and is likely to outperform other major economies. The buoyant US economy should benefit USD via two channels:

the monetary channel: markets should not expect further easing on top of what has been announced, and may, in fact, start entertaining the idea of some policy normalization
the asset-price channel: the growing economy makes domestic investment opportunities attractive, and will positively affect asset prices.

The implication of the above is that USD is likely to “rotate” away from being considered a funding currency to being seen as investment currency. Not only should this increase flows into USD, but it should also decrease the selling pressure on the currency if, and

Figure 1: CHF, JPY and EUR offer lower funding costs than USD

when, investors cease to fund long positions in cyclical G10 or EM currencies via USD. This – coupled with the natural buying pressure on USD that comes from its world reserve-currency status (i.e. foreign central banks and reserve mangers buy USD naturally) as well as its cheap long-term PPP (purchasing power parity) valuation against most G10 currencies – makes USD’s medium- to long-term prospects bright, in our view. Indeed, the Japanese yen (JPY), Swiss franc (CHF) or even EUR look set to replace the US dollar as funding currencies of choice, given their relatively worse prospects and even more attractive funding costs (Figure 1). As a result, we believe that we are entering a new epoch for the US dollar.

 From beta to alpha – the differentiation begins

In terms of the Group of Ten (G10) FX, currencies do not trade in blocks any more. From 2009 until last year, we were used to strength in USD, JPY or CHF being accompanied by weakness in the Australian dollar (AUD), the New Zealand dollar (NZD) or the Swedish krona (SEK), and vice versa. However, this has started to change; long-standing correlations have begun to fade (Figures 2 and 3) and investors are increasingly trading currencies on the basis of their idiosyncratic properties, rather than as part of global risk-on/risk-off moves.

And this is true for most G10 currencies whether measured against USD (Figure 2) or in trade-weighted terms (Figure 3). The trade-weighted indices show how currencies trade against their main trading partners (not just the US, which can have its own very distinctive trading characteristics). In trade-weighted terms, the correlations of the four most risk-sensitive currencies (AUD, CAD, NZD and SEK) have fallen by more than one third so far this year, while risk sensitivities have increased for safe havens (USD, JPY and CHF).

The main reason behind this change is, in our view, the fall in investors’ perception of potential risks and the subsequent stabilisation in markets (although, ironically, FX volatility has picked up so far this year, precisely because of the new differentiation in FX

markets). This in turn reflects reduced concerns over the potential breakup of EUR, signs of a soft landing in China, and the recognition that – despite public spending sequestration – the US economy continues to grow.

Figure 2: Correlations normalised so far this year

Figure 3: Correlations normalised so far this year

With the influence of “beta,” or risk in general, fading, “alpha”, or idiosyncratic risk, has started to matter more. Several examples stand out:

  • The new Japanese government’s attempt to prop up the economy and bring the country out of deflation territory. This has materially changed the prospects for the yen and, after years of appreciation, the currency has fallen markedly.
  • The year-to-date fall in sterling. Ongoing local economic weakness, stubbornly high inflation, a dovish Monetary Policy Committee, and fading safe-haven demand for the currency (due to diminished risk of EUR break up) all weighed on it and made sterling a serious rival to JPY in the race to the bottom.
  • The Canadian dollar has been struggling because of disappointing domestic economic data and relatively dovish comments from the Bank of Canada.
  • The Swedish krona rose as investors scaled back their expectations of further easing by the country’s central bank.
  • Despite the strong performance of equity markets this year, the Australian dollar is only marginally up against US dollar (Figure 4). We think investors are placing more emphasis on domestic factors such as the Reserve Bank of Australia’s easing bias.

In the “old world”, such dispersion would not exist. JPY and USD would follow one another, AUD would be up against USD – tracking rising equity markets – while CAD would not struggle as much. But in the “new world”, we should get used to a pro-cyclical USD and currencies that no longer trade in risk-on/risk-off blocks.

Investment implications

The US dollar strengthens

We believe that the above changes will affect FX markets meaningfully. Among the major currencies, we see USD as the main beneficiary. Better US growth prospects, relative to its peers; the currency’s ability to benefit from positive domestic data (as seen in the latest US NFP and retail sales); the US dollar being seen as an investment, rather than a funding, currency; and its attractive valuation should all benefit the currency in the years ahead.

Figure 4: Correlations normalised so far this year

Figure 5: Correlations normalised so far this year

The yen weakens further

One of the main losers in the new world is likely to be JPY. And we believe that there is more JPY weakness to come as Japanese authorities work to raise inflation to the new 2% target. So far, JPY has weakened on the back of market expectations, rather than actual measures from local authorities. But, once they follow through with actual steps – as we expect them to – the market (both foreign and domestic investors) should see it as a confirmation of government intensions and sell the yen (and, in the case of Japanese investors, reduce their hedges on investments abroad). Further USD/JPY

weakness is one of our high conviction views and we would treat any rebound in JPY (likely to be temporary) as a selling opportunity. We expect USD/JPY to reach 103 over the next six months.

Sterling: The struggle goes on

We are not overly enthusiastic about sterling’s prospects, but we feel that most of the currency’s weakness is behind us (at least for now): too much bad news is already priced-in. We expect sterling to remain broadly flat against the US dollar in the months ahead. That said – and because the differentiation should matter more in the new epoch – we ultimately expect GBP to soften against USD (towards 1.47 on a 6- to 12-month horizon). The UK’s growth prospects should lag those of the US – and this should, among other thing, affect relative monetary policy (with the BoE likely retaining a dovish bias as a result). But while GBP should soften, we do not expect it to collapse like it did early this year when it fell from 1.62 at the start of the year to its trough of 1.48 in early March.

The Australian dollar slumps – in the long term

Another currency for which we believe local factors will matter more than previously is AUD. Although we do not expect a major sell-off in the currency for now (and AUD may actually do well for the time being), an extremely expensive valuation, falling terms of trade, a persistent current account deficit, big net foreign liabilities (the second highest among the G10 currencies – Figure 5) and its diminishing sensitivity to stock markets (as evident in Figure 2 and Figure 3) make it vulnerable in the long term. But for the near term, our favourite short remains JPY (due to more material anticipated JPY weakness and more attractive funding costs).

The euro weakens

Finally, we continue to expect EUR to weaken against USD for structural reasons. Weak growth, divergences between the member states (i.e. the peripherals vs. Germany), and what we expect to be diverging monetary prospects (namely, between the European

Central Bank and the Federal Reserve) should keep EUR soft against USD. But this softness is likely to be gradual, as we believe that the EUR’s existential risks will be contained. In other words, and in the spirit of this note, EUR should weaken for idiosyncratic local reasons, rather than because of general risk (including that of EUR fragmentation, which would effectively be a “global” risk). We expect EUR/USD to fall to 1.25 and 1.23 on a six and twelve month view respectively.

That said, we prefer buying USD against CHF, rather than EUR, for several reasons:

1. The franc’s funding costs – interest rates – are lower than those in the eurozone;

2. The Swiss central bank will act to cap the franc’s rise at 1.20 francs per euro;

3. The franc is expensive, making depreciation more likely (eventually even against the euro).