Higher U.S. Rates Pose Risk To FX Carry

Higher U.S. Rates Poses Risk To FX Carry

The main takeaway from last week’s better than expected U.S. economic reports and October’s FOMC meeting is that the Federal Reserve is getting closer to tapering asset purchases. Regardless of whether the Fed chooses to pare monthly bond purchases in December, January or March, within the next 4 months, we expect the central bank to reduce stimulus and when they do, it will not be a one off move but the beginning of a series of reductions. This summer, Fed Chairman Ben Bernanke hinted to the market that the Fed could cut asset purchases this year and end Quantitative Easing completely in the middle of 2014. While their timeline has been delayed by the government shutdown, it is important to remember that the final goal of the central bank is to stop asset purchases completely. This means investors should expect a consistent rise in U.S. yields as the Fed unwinds Quantitative Easing. Thanks to Friday’s stronger than expected non-farm payrolls report 10 year U.S. yields are making its way to 3%. Higher U.S. rates are positive for the dollar but negative for high beta currencies and FX carry. We can see its impact on the AUD and NZD Monday, which shrugged off stronger domestic to trade lower only because investors are still adjusting their positions for earlier tapering by the Federal Reserve.

However even with the positive surprises in U.S. data, many investors are still undecided on how quickly they think the Federal Reserve will taper. The less dovish tone of the last FOMC statement and stronger data means that tapering in December is still an option. Yet next month’s meeting is Bernanke’s last and shortly after his successor takes office, Congress is expected to reenact the fiscal debate as the debt ceiling was extended only until early February. This makes the comments from Federal Reserve Presidents this week exceptionally important.

Kocherlakota, Lockhart, Fisher, Plosser and Fed Chairman Ben Bernanke are scheduled to speak and while none of these policymakers are voting members of the FOMC this year (except Bernanke), Kocherlakota, Fisher and Plosser vote in 2014. It will be important to see if they are share their colleagues worries about the costs of too much stimulus and feel that the Fed should advance its timetable for tapering given the recent improvements in data. The dollar would benefit from less dovishness from these officials even if they do not have a vote in the FOMC until next year. Remember, December and March are not the only time when the Federal Reserve could act because there is also a meeting in January and even if there is no press conference scheduled, this does not preclude the possibility of one being held if the new Fed Chairman deems it necessary. Aside from these speeches, investors will also be watching Janet Yellen’s confirmation hearing on Thursday. If the hearings go smoothly and there is no major opposition to her confirmation, the dollar could rise in relief because there will be one less uncertainty weighing on the market.

GBP: No Major Surprises Expected In CPI

It is a busy week for the British pound, which traded lower against the U.S. dollar and euro. EUR/GBP was hit hard over the past 2 weeks by euro weakness and Monday’s rebound is the strongest for the currency pair since the steep sell-off on October 31. Unfortunately with nothing more than a relief rally behind the move, we are skeptical about how much further EUR/GBP will recover. The outlook for sterling this week hinges on U.K. data but with the central bank comfortably on hold, we don’t expect any major surprises. The week kicks off with Tuesday’s U.K. inflation reports. Producer prices are expected to stabilize after falling in September but consumer price growth, which is most important for the Bank of England, is expected to slow. While price pressures are above the central bank’s 2% target, they have been trending lower and therefore less of a problem for the central bank. This means that the CPI report may not have a significant impact on sterling unless there is a major surprise. The most important event risk for the currency this week will be the Bank of England’s Quarterly Inflation Report in which they update their growth and inflation forecasts. In addition to CPI, employment and retail sales figures are also scheduled for release. Any one of these reports could trigger a big move in sterling and the fact that they will be released successively means that it should be a busy and active week in the currency.

EUR: Long Term Downside Risks

The euro rebounded against the U.S. dollar after last week’s steep losses. With no economic reports released from the U.S. or the euro zone, Monday’s move should be categorized as nothing more than a relief rally. While we continue to believe that the euro is headed lower in the near term, our colleague Boris Schlossberg provided some solid points explaining why the currency exhibits Teflon like resilience. He said “first and foremost the currency continues to be a beneficiary of capital flows. Asian central banks remain avid buyer of the unit partly for diversification reasons, but also for investment reasons as well. The Chairman of Bank of China noted last week that they view European equities as their favorite investment vehicles given their relative undervaluation and the prospect of recovery in the region. Secondly, despite the rate cut from the ECB, market analysts believe that there were several dissenters on the board including Weidmann and Nowotny. Therefore some currency traders believe that the ECB may be nearly as accommodative as initially thought especially if the data from the region continues to show modest improvement and the final inflation readings are revised upward.” However even if last week’s rate cut simply accelerates a move that was expected in December and leaves the central bank on hold for the next 12 months, the Federal Reserve is preparing to reduce asset purchases to zero over the next year and this process will pressure the EUR/USD lower.

AUD: Shrugs Off Stronger Australian And Chinese Data

The Australian and New Zealand dollars traded lower against the greenback Monday despite signs of improvements in their domestic economies and China, one of their most important trading partners. Overnight we learned that Australian home loans jumped 4.4% and investment lending rose 5.2%. This more than made up for the past month’s decline in new home loans and is an encouraging sign for the housing market. In New Zealand, credit card spending jumped 1.4% in September after falling 0.9% in August. The New Zealand economy is still on track for a stronger recovery especially when compared to Australia, which has in turn kept AUD/NZD near a one month low. Meanwhile industrial production rose faster than expected in China last month and this should have extended gains for the AUD. Between the steady pace of retail sales growth, stronger exports and industrial production, China is poised for a healthier recovery to the benefit the global economy. No economic reports were released from Canada but Monday night had Australian business confidence numbers on the calendar. Despite the RBA’s concerns about a strong currency, we expect confidence to be bolstered by the faster recovery in China and easy monetary policy in Australia. However just because the outlook for Australia has brightened does not mean that the AUD will rally because as we discussed in the first part of our commentary, higher U.S. rates poses a risk to high beta currencies like the AUD and NZD.

Yen Crosses Supported By Stronger Data

Most of the Japanese Yen crosses are trading higher Monday thanks to better than expected economic data and a rebound in the Nikkei. While U.S. bond markets were closed for Veteran’s Day, the sharp rise in yields on Friday continues to lend support to USD/JPY, which is quietly inching higher towards 100. The move will likely be slow crawl due to the lack of U.S. data. A stronger global recovery and the results of Prime Minister Abe’s policies helped to boost Japan’s current surplus and narrow their deficit, although the improvement in trade was less than economists anticipated. Due to the government’s efforts to stimulate the economy, the Japanese Yen weakened and this helped to boost overseas investment income, driving the country’s current account surplus to a 5-month high. Unfortunately not all news was good news for Japan. The country is still running a trade deficit, which is a major challenge for Abe’s government and bad news for a country that thrives on exports but thankfully they are still moving in the right direction and the people in Japan are responding as indicated by the outlook component of the Eco Watchers, which increased for the second month in a row in October. All of this will be important to keep in mind when the Q3 GDP numbers are released later this week. Economists are looking for slower growth in the third quarter but given the recent improvements in data, growth should accelerate again in Q4 and Q1 when consumers rush to spend before the consumption tax is increased.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.