Markets after the Fed: Carry on?

This post dissects the recent rally in risk assets and examines the prospects going forward.  The main points are:
• A combination of (inter-related) factors have supported risk appetite: (i) The Fed’s suprising dovishness on 16 March, with apparent more focus on the international impacts of its actions and greater willingness to let inflation run hot for a while, following the ECB’s more aggressive than expected 10 March easing (see here) and Chinese announcements of further fiscal and monetary easing; (ii) decreasing concerns over China’s devaluation risk, helped perhaps not coincidentally by dollar weakness; (ii) signs of the weakness of global macro data bottoming out;  (iv) A bounce in oil and other commodity prices, albeit largely only reversing a small part of their previous falls; (v) decreasing concerns over Euro Area banks (although the rally has recently reversed and EA inflation breakevens have worryingly continued falling).
• That said, the underlying global macro-financial situation remains fragile. Worries about the ability of monetary policy to deliver stronger demand, given the lack of substantial fiscal support (except in China), plus structural China concerns lurk.
• But risky assets have neverthless been supported – with equities rebounding (albeit only to start-2016 levels with bank equities weaker) and EM FX appreciaing alongside continued USD weakness (albeit with very recent rebound) – although this also seems partly due to a short position squeeze and so could peter out.
• The recent EM FX rally has been strongly correlated with the recent equity market bounce.  And currencies with higher risk-adjusted carry have also risen by more.
• Risk-adjusted carry is most attractive for TRY, INR, IDR, BRL, RUB and ZAR (plus KRW and MYR in AxJ). While up recently, risk-adjusted carry is often lower than in mid-2015 indicating that increased investor risk appetite has also been important in supporting EM FX and suggesting caution in getting carried away with carry trades.
EUR and JPY have remained strong despite the risk-on environment, strong Japanese purchases of foreign securities and foreign sales of EA securities as markets have focussed on ineffectivness of BoJ negative rates and ECB’s switch credit easing. It may also indicate that other currencies e.g. TWD have funded AxJ carry trades (into KRW).
• The oil/commodity price rally has supported commodity-FX (CAD, RUB, NOK etc).  But the elasticity is smaller than during the previous oil price falls.
Challenges to the recent risk-on environment include Brexit uncertainties growing/spreading, the 17 April OPEC-Russia meeting disappointing and the technicals-driven oil price rally running out of steam, the BoJ disappointing growing expectations of further easing on 28 April, the Fed surprising hawkishly in April or June and China concerns returning.  But overall it seems more likely than not that the recent risk-on environment will extend further over the next few weeks, although longer-term challenges remain.
• The recent rally in commodity and EM FX could also be challenged by central bank pushbacks.  This seems more likely in countries with low inflation (HUF, CZK, PLN, ILS) than those with high-inflation (BRL,RUB, ZAR, TRY, INR) where the appreciations will be more welcomed.  Indeed, CBR and SARB have recently been relatively-hawkish.
•But policymakers also seem to be taking commitments not to pursue competitive devaluations more seriously after the G20 meeting, reducing the chances of dovish reactions (in G10 they seem most likely for RBNZ and Norges Bank).
Elevated Brexit betting odds mean GBP will likely continue to struggle to benefits from any extension of the recent risk-on rally. The TWI has fallen to it’s lowest since December 2013 and as I expected GBP implied volatilities have continued to set fresh highs and downside risks have extended further. More of the same seems likely.
• Despite recent less dovish FOMC comments (Williams, Lockhart, Harker and Bullard) a surprise April Fed rate increase seems very unlikely given the need to get more evidence on inflation and global developments.  But the market may be underpricing a June Fed hike, even if I favour September and December.  The market will be closely watching the forthcoming US (core) inflation and labour market data plus FOMC comments, starting with Yellen’s comments on Tuesday.

Market Risk Appetite Supported by Fed and ECB

The Fed’s surprisingly dovish “dots” on 16 March, which shifting straight to my view of only two rate 2016 hikes due to concerns about the global environment and doubts about whether recent rises in US core inflation will persist/extend caused market rate expectations to shift further down. So only a 41% chance of a June hike and 74% chance of a single 2016 rate hike are currently priced, see Chart below.  Risk markets reacted positively to the bottom lines that: (i) FOMC are placing more weight on the global impact of their actions – a number of EME countries operate dollar pegs and/or have substantial USD-denominated debt while a weaker dollar helps the Chinese out of their policy dilemma (see here and below) which is ultimately beneficial for the global economy and hence the US; (ii) they seem likely to let inflation run hot for a while to encourage further falls in U6 unemployment and forestall USD strength and tighter financial. So USD unsurprisingly initially fell sharply. That said, there have also been more recent hawkish Fed comments, which have reversed some of USD’s losses (see below).

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And this reinforced the risk-supportive effects of the ECB’s more dovish than expected 10 March easing, featuring more focus on Credit easing rather than prospective further large further rate cuts, with the latter assuaging concerns about EA banks and supporting the Euro (see here).  That said, on 17 March ECB Chief Economist Praet backtracked on Draghi’s unnecessary aside that the lower bound to rates had been reached.  And the worry for the ECB will be that EA inflation breakevens have continued to decline despite the ECB’s actions and the initial support for EA banks has waned (see below).  By contrast, US inflation breakevens have rebounded – with positive correlations with dollar weakness and S&P’s bounce.

Decreasing concerns over China’s devaluation risk and macro prospects

The Chinese authorities 5 March announcement of prospective monetary and fiscal easing (planned 3% of GDP fiscal deficit, up from 2.3% in 2015), focussing on supply-side reforms rather than Yuan depreciation, have reassured market concerns about a Chinese hard landing and Yuan devaluation. The message about not devaluing has been repeated several times, most recently by Chinese Premier Li Keqiang when he argued that on 24 March that China has sufficient policy tools to ensure a stable economic performance.  The slowing in the rate of decline in Chinese FX reserves (down “only” $29bn in February) and the narrowing gap between onshore and offshore Yuan rates have also helped reassure markets.  Consequently markets have, for now, become less sensitve to recent weaker than expected Chinese data (exports, industrial production, retail sales).

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But the Chinese authorities have also been fortunate that it’s also been a period USD weakness.  That’s allowed the CNY TWI (CFETS RMB index) to edge down at the same time that USDCNY has fallen i.e. CNY has appreciated against the dollar but not as fast as other currencies. The fall in the TWI hasn’t yet been sufficient for the market to question the commitment to the broad TWI stability (around 100 for the index), although the authorites are walking a delicate line (and their testing the water over a Tobin tax was misplaced).  As metioned above, this reflects the Fed apparently paying more attention to the international impacts of it’s actions (which then feed back onto the US). I’ve argued since last summer that the Chinese authorities should realise that a substantial Yuan devaluation would ultimately feed back on them in substantially adverse ways (see here and  here). But a gradual real CNY depreciation over time, to reverse some of the 60% real appreciation since 2005, seems close to inevitable. However, that can be achieved best when the global economy is more secure.

Signs of Macro data bottoming out and commodities rebound but situation remains fragile

The improvement in market sentiment has also been supported by macro data bottoming out.  That’s been more apparent in the G10 (led by the US, albeit with some recent disappointments) than in EMEs.  But even Chinese data surprises have improved a little: the forthcoming PMIs will be carefully watched, after last month’s weakness. But overall the situation remains fragile, in light of concerns about the ability of monetary policy to solve the issues of deficient global demand (we won’t get sight of the impact of the ECB’s TLTRO II policy for at least several months) given the lack of any substantial fiscal stimulus (China apart, see here). And the Chinese policy easing possibly elevates concerns about debt sustainability, if the authorities don’t decisively follow through on bad debt and supply-side reform promises.

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Alogside that, commodity prices have rebounded – although except for Iron ore prices this only unwinds a small portion of the previous falls (see Chart).  The rise in brent oil oil prices back above $40 has been supported by expectations of a supply freeze being announced at the 17 April OPEC-Russia meeting in Doha, even if Iran and Libya seem unlikely to participate and have the most barrels to add.  And it seems like much of the information news has already been incorporated in the price, so I’m not expecting large further upside ($45 may be achievable).  That said, the bounce in metals prices indicates less pessimism about global growth prospects.  And that’s underpinned  commodity FX in general (see below).

Risky Assets and EM FX have rallied (as USD has remained weak)

All the above has supported risky assets.  Market discussions have also noted how equity valuations are relatively attractive and how positioning had become overly bearish, with crowded trades short risk assets, short commodities and short EM.  While such positions reportedly haven’t yet fully unwound, rallies generated by such short-squeezes can end up beign less durable (investors aren’t yet sufficiently confident to initiate fresh long positions).

But the bottom line is that global equities prices have rallied, albeit this only takes them back to their start-2016 levels.  And equity volatility (VIX) has fallen to multi-month lows, with the retracement exceeding that of G10 FX volatilty. Bank equity prices have also recovered, although they remain 10-15% below their start-2016 levels.  And worryingly for the ECB EA bank equity prices have shown greater signs of recent weakness (see Chart), with iTraxx EA bank credit spreads also recently rebounding.

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Risk-on apparent in FX markets as carry trades become more attractive (but not yet that atractive)

Risk-on dynamics have also been very apparent in FX markets.  Of course, the major development following the Fed’s surprising dovishness on 16 March has been broad US dollar weakness, at least until the mini rebound versus G10 FX prompted by recent more hawkish Fed comments (Williams, Lockhart, Harker and Bullard arguing that April and June are “live” meetings). But it’s notable that USD has also been weak versus EM FX – with indeed the second chart below illustrating that there’s been less recent USD bounce versus EM FX after the more hawkish Fed comments. And such EM FX strength has occurred despite some EMEs suffering from economic and/or political frailties (although growth dynamics have also improved in EMEs such as Turkey).

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But the combination of risk-on dynamics, helped by the Fed’s apparent greater concern about international developments, and commodity price bounces have outweighed such concerns, at least for now.  For example, the chart below illustrates that there has been a close correlation between the recent EM FX appreciation and higher global equities.

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Moreover, the previously-discussed reduction in FX implied volatility has supported carry-seeking behaviour in FX markets.  Indeed, the chart above illustrates that both G10 and EM FX implied volatilities have fallen back. While both remain at relatively-elevated levels, there’s probably room for FX vols to fall further near-term given that there don’t seem to be that many significant risk events to overcome in the next few weeks (see below) and momentum effects may kick in.  That said, they also probably won’t match the VIX’s multi-month lows.

The chart below indicates that risk-adjusted carry (i.e. carry divided by FX implied volatility) is most attractive for TRY, INR, IDR, BRL, RUB and ZAR (plus KRW and MYR in AxJ).  And its seems marginally more attractive for EUR-funded carry trades than JPY-funded ones (although it’s more likely that carry trades into EMEA will be EUR-funded while those into AxJ will be JPY-funded). That said, the allure of relatively-high risk-adjusted carry in AAA-rated Australian debt (plus the iron ore price rebound) seems to have contributed to AUDUSD’s recent rise.  A similar argument helps explain why NZDUSD hasn’t fallen despite RBNZ’s surprise 25bp rate cut on 9 March (although Kiwi debt isn’t quite as highly rated).

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Moreover, the second chart above illustrates that there’s a positive relationship between (lagged) risk-adjusted carry and recent FX movements: high-carry currencies have appreciated more over the past month. And the main outliers, with greater FX strength than implied by risk-adjusted carry, are commodity currencies (RUB, COP, BRL).  That said, BRL has also benefitted from the incrased probability of President Rousseff being impeached.

But it’s also notable that while risk-adjusted carry has increased for many currencies, on the lower FX volatility, it currently isn’t exceptionally attractive.  This confirms that increased investor risk appetite has also been important in supporting EM FX. Specifically, of the top four highest risk-adjusted carry currencies only TRY and INR have seen their carry attractiveness increase in recent months, to above 2015 levels.  By contrast, IDR and BRL risk-adjusted carry metrics have actually become less attractive in recent months.  Moving further down the rankings, the second chart below demonstrates that while risk-adjusted carry for several currencies (RUB, MXN, AUD, NZD, PLN) have risen recently they are again lower than in mid-2015.  This suggests caution in getting carried away with carry trades: selectivity and taking account of country-specific factors remain key as the recent bounce in investor risk appetite could prove brittle.

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It’s also notable that EUR and JPY, the obvious funding currency in carry trades, have remained strong despite the risk-on environment (see Chart). Moreover, the weekly BoJ data showing near-record Japanese investor purchases of foreign securities.  And the (less timely) ECB data show continuing portfolio outflows from the EA, driven by strong foreign sales of EA securities (see Chart). This seems to reflect the market judgement on the ineffectivness of BoJ negative rates and the ECB’s away from further negative interest rates (a EUR negative) and towards credit easing (TLTRO II, a potential EUR-positive as it may encourage foreign portfolio inflows, see here). Plus, of course, much of the EUR and JPY strength has been versus the generally-weak USD.

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But the resilience of JPY and EUR could also indicate that other funding currencies are being used in carry trades.  For example, Asian-FX carry trades (e.g. into KRW given the relatively high carry available and KRW’s positive link with risk appetite) may have been funded by short TWD positions given that implied rates have recently turned negative.

Risk rally likely to extend near-term, but longer-term challenges remain

Will the risk rally extend?  While difficult to predict, some optimism is provided by the risk event challenges seeming limited in the near-term and the extent of global monetary policy dovishness.  So recent developments in market risk appetite and (FX) volatility seem more likely than not to extend over the next few weeks.  The main challenges seem likely to be:
Brexit uncertainties growing/spreading.  Thus far Brexit impacts have been fairly contained, largely felt via a weaker GBP and very high GBP implied volatilities. While that could conceivably change (see below on potential CHF support) this seems most likely to be occur as the 23 June Referendum gets closer rather than over the next few weeks.
• The 17 April OPEC-Russia meeting disappointing, leading to renewed oil price falls and concerns about global deflationary pressures. In any case recent rises in US oil inventories have stalled oil’s rally and the move seems partly driven by a short position squeeze rather than fresh long positions being estalished. So, as discussed above, further oil price gains seem likely to be limited but equally a renewed oil price plunge also seems unlikely.
China concerns returning, on weaker data or policy mis-steps.  But Chinese officials seem likely to continue stressing that they’ve got the tools to address weaknesses and are doing the right thing by focussing on structural reforms rather than FX devaluation.
• The BoJ disappointing growing expectations of further policy action at its 28 April meeting. The latest BoJ minutes confirm the picture of division over negative interest rates, consistent with my previous scepticism about further major BoJ action.
• The Fed surprising hawkishly in April or June. Yellen flagged on 16 March that both were “live” meetings and recent more hawkish comments by Williams, Lockhart, Harker and Bullard have reinforced such a possibilty.  Nevertheless, an April hike seems unlikely given FOMC concerns about whether the recent US inflation uptick will persist (Yellen’s volatile components point), ongoing global concerns and the desire to avoid a disruptive global tighteing of conditions.  But the recent comments suggest that the market may be underpricing the eventual chances of a June Fed hike (currently only 41%).  Indeed, the more hawkish Fed comments caused USD to have it’s best 5-day run since January.  But a major Fed repricing seems unlikely to occur in the next few weeks unless the US core inflation proves the Fed wrong by rising further, wage growth spikes, activity data are stellar and Yellen (plus Brainard) does a volte face. Such a combination seem more like a tail risk rather than a realistic possibilty.

Policy pushback to EM and commodity FX strength? 

But one further potential challenge to the recent rally in commodity and EM FX is that domestic policymakers could push back against the recent FX strength. This seems more likely in countries with low inflation (HUF, CZK, PLN, ILS) than those with high-inflation (BRL,RUB, ZAR, TRY, INR) where the appreciations will be more welcomed as helping get inflation under control.  That said, the Polish Central Bank has been standing by it’s pledge to resist easing, even though it recently sharply cuts its inflation forecasts.  They will likely want to avoid PLN falls given the difficulties in sorting out the long-standing CHF-denominated mortgages isssue and will be reassured by the recent improvement industrial production growth. So short EURPLN may be attractive despite the relatively-modest, but increasing, risk-adjusted carry available (see above). Similarly, the BoI seems likely to be reassured by the recent GDP acceleration even though inflation remains negative.  By contrast, the the Hungarian Central Bank surprised dovishly on 22 March, seemingly in response to the unwanted HUF strength in the risk-on environment. And the CNB may yet face issues about the EURCZK floor.

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Amongst the high-inflation countries the Russian and South African central banks have recently been relatively hawkish, with SARB actually hiking in March, helping support raise risk-adjusted carry and reinforcing the support from higher commodity prices (while countering the political negatives). While the CBR’s main focus seems to be buttressing their credibility, they will also likely have been resassured by the recent industrial production bounce and the positive terms of trade effects from the oil price bounce. The Turkish Central Bank seems more likely to ease, but the current risk-adjusted carry is the highest available and markets may like the signs of better growth prospects (see Chart above).

Major policymakers also seem to be taking commitments not to pursue competitive devaluations more seriously after the G20 meeting, reducing the chances of dovish reactions. For example, the RBA was recently criticised for it’s earlier AUD jawboning and recent RBA have consequently been milder. Governor Stevens noted that there are “some risk that the currency may be getting ahead of itself” while Assistant Governor Debelle comment about the RBA said that the RBA would welcome slightly lower exchange rate, he also recognised that many other central banks think the same. That said, the RBNZ seems more likely to proactively ease further, given concerns about inflation expectations, dairy prices and the lack of major NZD response to the surprise 9 March easing.  And Norges Bank signalled potential further rates cuts when it eased on 17 March.  The Bank of Canada, meanwhile, has hitherto been content to watch for the impact of fiscal the value  to be the most likely to G10 commodity currencies to ease further

GBP: Resurgent Brexit Uncertainties mean that not benefitting from risk-on environment

If there’s one “risky” currency that seems substantially less likely to benefit from any sustained risk-on moves it’s sterling, given the recent resurgence of Brexit uncertainties. The latest opinion polls have been fairly evenly-balanced (within sampling uncertainty) and bookmaker-implied Brexit odds have risen back above 40%.  The chart below illustrates that GBP TWI weakness has been fairly-closely correlated with spikes in Brexit odds: the TWI has fallen to its lowest level since December 2013, down 10% since mid-November.  I argued here and here that close opnion polls would get market nerves jangling and be negative for sterling (with GBPUSD falling below 1.40 and EURGBP likely rising above 0.80 despite fresh ECB action). The latest MPC minutes acknowledged the impact on GBP and pointed out the potential adverse activity impacts by the elevated uncertainty over the next three months (and longer if “Leave” wins!) while Governor Carney argued that Brexit was the biggest risk to UK financial stability.

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Brexit worries have also caused substantial rises in GBP implied volatilities, with their  ratios to other G10 FX already substantially exceeding those around the 2014 General election and 2015 Scottish referendum.  And, as I noted here, shorter-maturity volatilities seem likely to rise as we approach the 23 June referendum: the ratio 2-week volatilities around the Scottish referendum substantially exceeded the ratio of 3-month volatilities. Intersetingly, EURGBP implied volatilities look less unusually elevated: the Chart below illustrates that the volatility ratios at relevant maturities are “only” around their pre-Scottish referendum levels.  This could reflect Brexit’s perceived negative impacts on the Euro Area (it could derail the fragile EA recovery) and hence adverse impact on the euro.   That said, it’s perhaps surprising that there hasn’t been a bigger reaction in euro bilaterals.  So this could also grow e.g. with EURCHF falling on such european uncertainties, which would likely concern the SNB (who stood pat on 17 March despite the ECB easing, but downgraded their growth and inflation forecasts).

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But the chart above illustrates that, as I previously expected, markets have increasingly priced greater GBP downside risks. Consistent with the implied volatilities these risks seem slightly more elevated versus USD than EUR.  But it’s also notable that the downsise risks aren’t anticipated to dissipate after the referendum: 6m risk reversals lie below their 3m equivalents for GBPUSD.  This could reflect the political upheavals that may eventuate irrespective of the referendum result.

Oil price support for oil FX shows signs of waning

I’ve discussed above how the oil price bouce has helped support commodity FX. But the chart below demonstrates that the FX betas on oil prices have generally been falling in recent months as oil prices have bounced, lying below their levels when oil prices were falling. This indicates that further oil price rises might not take oil FX back to their previous levels. The asymmetry could reflect the negative terms of trade impacts of oil price falls becoming increasingly telling at lower oil prices.  The main exception to this pattern is CAD, where the beta has actually risen above it’s previous levels, athough this could reflect the support to CAD from lower expectations of BoC easing on the anticipated fiscal expansion.

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