The violent nature of last week’s movements in the market is remarkable and it is not clear how long this risk-reduction phase will last – but beware the “domino effect”; several months on, the current market turmoil will be seen as “yet another buy-on-dip opportunity”, predicts Stephen Jen, Morgan Stanley’s global head of currency research.
Jen says the current sharp sell-off in investment grade bonds and equities is based on a “major disconnect from robust real economic fundamentals”. The world is currenty firing on N-1 cylinders, which is critically different from 1998, he says.
The “next big move” in the currency markets will be a reversal of the recent trends, according to Jen, who believes that EUR/USD, GBP/USD, USD/JPY and AUD/USD will all head higher, as risk-taking recovers.
He cites several reasons for this view: (1) The downside surprises in US macro data (housing in particular) may have fuelled a change in investors’ emphasis from a mainly ‘technical’ move in the mortgage and credit markets to something closer to a ‘growth scare’ for the US.
The reduction in risk-taking in emerging markets is consistent with this interpretation. However, for now this is just a risk. Existing data still point to an extraordinarily strong global economy, he says. A resolution of this dichotomy between the financial markets and the real economy will have “significant implications for asset prices”, says Jen, reiterating his earlier prediction that “the financial markets will converge to the real economy, not the other way around”.
(2) For the forex markets, it is most critical to get the call on general risk-taking right, Jen says. Recent upheavals in the currency markets were “primarily a reflection of risk-reduction, rather than underlying macro trends,” in his view.
Though there wasn’t a clear-cut trend for the dollar, we saw the same pattern back in February-March this year and May-June 2006. While the yen-cross trade attracted most investor attention, all G-10 exchange rates showed “a systematic relationship with the general level of risk appetite. Specifically, they all moved toward their fair values as risk-taking was pared back”, he says.
(3) Despite the sharp widening in credit spreads in the US, the G-3 weighted average bond and equity yields continue to be in favour of equities, though for the US, this gap has essentially closed. It is, therefore, “critical for the world’s cross-border flows to resume in order for the risky assets in the US to resume their uptrend”, says Jen.
Risk-reduction has dictated G-10 currency trends this past week. The dollar strengthened against the euro, pound and Australian dollar, but weakened against the yen.
Back in February-March, general risk-reduction led to a curious trend in the G10 currencies: virtually every single exchange rate in the G10 moved toward its fair value. This trend underpins his view that capital flows, not economic fundamentals, are more important drivers of exchange rates, and that exchange rate misalignments these days could be larger in size and last longer in duration than in the past.
Investors are concerned about the “domino effect”, whereby the (temporary) seizing up of the credit derivatives market forces credit spreads to widen, even for the investment grade papers, Jen notes. “In turn, such a rise in the cost of credit is feared to undermine the financing conditions for LBOs or other types of equity acquisition. This could then be bad for equities, many investors think: the supply of CLOs in the pipeline is lumpy and could force this market to undershoot.”
Overall, the yields on bonds and equities still favour equities, from a G-3 weighted average perspective, even though within the US, this bond-equity yield gap has more than closed, notes Jen.
What it all means is that cross-border capital flows and risk-taking in general need to resume before US equities can resume their ascent, says Jen. But this circularity “will make it tricky to find the level at which investors should buy”, he adds. In any case, the current trends, in Jen’s view, are reallly more a “buy-on-dip opportunity for risky assets”.