Saturday, 31 January 2015

February - FX and rates thoughts

Since my last blog post, we've seen a lot occur in the markets. In what was probably the most interesting month since the euro crisis of 2011/2012. We've had more than a lot of policy action, with Surprise cuts from Canada, Denmark, the move from the SNB and of course ECB QE to name just a few.

What is still being banked on across the financial markets, especially FX is the divergence of monetary policy, most clearyl visualized with the 1y1y USD and EUR rates charts as below.

USD vs EUR 1y1yf rates
However what is evident in the long end, and is becoming more evident in the rhetoric from central banks is that the doves are really acting as anchors... And while we've banked on this divergence, it may be far more difficult to materialize.

If we look at 5y5y rates, a basic proxy for terminal rates we can see that, yes while USD and GBP rates are higher, they are being dragged lower by those of Europe etc.

USD, GBP and EUR 5y5yf rates
Thus far, the impact has really only been on long end rates with investors obviously demanding USD rates at 160bps over EUR ones and therefore as EUR rates drop, there is a constant bid underneath USTs. Not only this, but for every down tick in the USD international investors will look to USTs and thus there is a lot of support / interrelationship, even if there is a so called divergence.

But bringing it back to central bank rhetoric, the FOMC mentioned how it has increased its attention of international developments, be it economic data or policy. As such, while the short end may still be chasing this dream of a 2015 divergence, in reality it may be far harder than we first thought.

There has been an uptick in market expectations for inflation across the world, and this seems simply as the last hurdle to overcome before we have hikes, however given the recent central bank action, I am finding it harder and harder to believe the Fed will (or even can) hike rates this summer, with Sept/Dec being far more likely to me.

However this, I think, is probably a transitory reaction function to global central banks - and the fundamentals still remain in tact, so a later / faster hiking cycle is what I look for.

Short sterling vs ED curve


As we can see here, we have Short sterling and Eurodollar curve between M6 and M8, both of which are incredibly flat. EDs back to 2012 flats and SS even flatter!

However, given the fundamental picture that remains in both countries, with strong labour markets / growth prospects and wages being the key drawback - steepeners on both I believe will work. However timing this is key, because so long as people are receiving the long end, this curve will get flatter and flatter, and right now everyone and their dog is loving duration (with good reason), however this a different trade that is just being pushed in the same direction by the flow.

So I've so far argued that the US is less likely to hike given the RoW, but at the same time suggested a steepener.. hmm... contradictory, but like I said, not entering just yet...

Short sterling curve vs 6mo ago
Pretty much every sector of the SS curve is >1% lower than where it was 6 months aog, and there is just over 50bps worth of hikes priced in between summer '16 and '18 which seems to little.

In FX land, the GBP is still being ruled by rate spreads, in a model with variables that haven't been updated in a year now, and still going strong. The biggest variable in this is the 1y1y spread.

GBP vs model FV
Looking at the EUR, this chart from @Fwred (from credit agricole) shows the resulting move in FX after a QE announcement.


I like this chart a lot, as one would expect the ccy weakens into the announcement, but in 3 of 4 cases (this doesn't include GBP, which in 2012 also rallied post BoE) the currency started to appreciate over the coming couple of months.

EUR-US CESI and EU/US equity ratio
Looking at this picture, we can see that for that European economic surprises have overtaken US ones, potentially the tide is turning somewhat with a possible acceleration from Europe later on in the year and a cooling off in US (much like what happened in the UK!!)

On top of this we see the relative equity performance between Europe and the US, which might result in EUR inflows which was a major factor supporting the EUR in the 2012/14 rally.

So the EUR... reasonably cheap right now, but it is still dangerous to short the USD even if it is getting (wayyyyy) ahead of itself. But 1.20 seems possible to me.

JPY vs nikkei
Therefore looking to fund long EUR in JPY, as currently JPY is a touch expensive to the nikkei at the moment, and coiling for a potential leg higher. EURJPY trades jsut above 130 and to me is good value for longs.

The Bank of Canada shocked us all with a rate cut, though in hindsight, much like Norway seems to make sense with weakening fundamentals and the immense drag of drastically lower (and still falling) oil prices. The CAD has reacted as expected, but it's not something I am willing to to fade, as against rate spreads its perfectly fair.


However, looking at the AUD, we've a tad divergence occuring. In this case the long standing correlation between AUDUSD and 5yr us real rates


Has suddenly diverged...


AUD rates has been heading lower, with the market definitely pricing in rate cuts from the RBA, the recent rhetoric from the RBNZ has flipped from hawkish to perfectly neutral with the 90 day bank bill futures curve flat out through 2017 at 3.5%

It would not overly surprise me to see a rate cut from the RBA, but house price growth is a big consideration here, in any case, vis a vis the USD and JPY I do think that the AUD is getting to be decent value especially as this divergence highlighted above grows... AUDNZD is still a favourite of mine.

Finally a little bit on EMFX, not my strong point, but noticing a few differences in the recent sell-off as opposed to older ones. Spot EMFX is trading lows (as per JPM index), and especially noticeable weakness in TRY / MXN. However, looking at rates, most likely due to the drop in global inflation / core DM rates, we've seen Turkey, SA rates drop meaningfully etc, but unlike other times, the demand in bonds is not at all reflected in a strong ccy.

USDTRY vs 10s
As we can see, in the past TRY sell offs we saw yields spike along side, yet in this case the opposite is occuring for the reasons mentioned above. But the currency is selling off for a reason... and problems exist in EM, however with global funding rates dropping the impact of higher rates is being pushed further back, and as such it might not be that unwise to look to EMFX.

A similar picture in South Africa,

$ZAR vs 10s
This historical picture shows the correlation, but currently $ZAR spot trades 1 big figure higher, whilst rates are 1 big fig lower at 7.1%, thus another sizeable divergence. Considering the supporting factor from lower US / core DM rates, it looks reasonably attractive.


However both ZAR and TRY are at their least attractive levels (based on carry/vol) in a year. CNH remains top even though implieds have spiked massively here. (25 delta riskies and ATM)


But when considering that there has been a global pick up in vol, comparing to G10 vol composite, CNH vol is in fact near the lows, and with high carry looks to be attractive. Whether we look to buy spot or take advantage of high implieds / riskies.


There has been discussion of a widening of the trading band from fix +/- 2% to maybe 3% as china looks to float the currency a bit more, but for the meantime, with spot at low levels vs the USD and on a vol adjusted carry basis, CNH looks aight.

Anyway, quick one from me today, been busy at uni... some contradictory trades to themes, but timing as ever is key blah blah blah.

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