Risk-appetite is on a robust recovery course but is keeping its diet fairly simple for now, according to Stephen Jen, Morgan Stanley’s chief currency strategist, in his latest note on currencies. Despite a widely-anticipated impending slowdown in the US, underlying global economic fundamentals remain “very positive, on balance, with inflation relatively well contained”, he says.
Banks and financial institutions are well capitalised. Corporations appear to have immaculate balance sheets. “It is therefore no surprise that ‘simple’ (that is, unencumbered by complex derivatives) risky assets (for example, equities) are continuing to rally,” notes Jen.
The sell-off in July/August was indeed a buy-on-dip opportunity, and this trend is likely to extend further, he says. “Valuation (P/E and P/B) is not close to being a problem in the developed markets. Even if earnings are revised down modestly, and equities may correct temporarily, they are not yet in bubble territory.”
On currency trades: Hedge fund investors “love to hate kiwi”, while they “love to love the yen” notes Jen, although he predicts that the NZ dollar will keep rising and the yen will fall.
The recent rise in Japanese yen cross-trades, meanwhile, has invariably revived talk of a resumption in carry trades. Jen doesn’t like this term, “not because it is technically wrong, but because I get the sense that many people have a limited definition of what they are”.
Nominal interest rates matter for exchange rates, and “not only because speculators short the low interest-rate currencies and long the high interest-rate currencies”, he notes.
While there is no doubt that there are a lot of these types of activities, currency hedging is at least as important, says Jen.
After all, he notes, total G-10 cross-border assets and liabilities amount to just over $100 trillion now. “Small changes in the nominal cash interest rates could lead to relatively large hedging flows, given the size of the underlying assets that need to be hedged”.
The key difference between these two mechanisms – both of which respond to nominal yield differentials – is that these so-called ‘carry trades’ are not run by myopic and uneducated armatures, who are sure to lose their shirts in due course, according to Jen. “On the contrary, these trends are powerful, and could reflect the changing structural nature of the global financial markets.”
That said, a continued recovery in risk-taking should keep pushing up yen cross-trades. Already, most of them (EUR/JPY, NZD/JPY and AUD/JPY) have retraced close to 75 per cent of their losses during the sell-off in July/August.
Dollar-yen trade has been a laggard, but will, according to Jen, continue to drift higher. When risk-taking is challenged again - that is, when the US starts to slow and to scare investors - the yen crosses will likely sell off.
But as long as global equities are trending higher, investors should buy yen-crosses. Aside from risk-taking, Jen notes, he is “a strong believer in the structural outflow story in Japan”. This is not limited to the retail outflows (that is, retirees in Japan or the Mrs Watanabes), but also includes institutional funds, especially public-run funds.
On the direction of the dollar, economic de-coupling is now “a near-consensus view, despite this being a subject of intense debate only a month ago.” But what we’ve witnessed in the past month has more to do with the front-loading of the Fed’s rate cuts. When the US economy starts to decelerate – as it will, in Jen’s view - the dollar’s depreciation will slow, and may even stop, as the negative economic spill-over effects are felt outside the US.
The rest of the world will slow down in different phases, he predicts, with Euroland and the UK the first to show signs of a slowdown, followed by some emerging economies and then by China and the commodity-exporting countries.
And, on the upcoming G-7 meeting on exchange rates, says Jen: “Expect to see more smoke and heat than actual fire”. The euro-dollar trade will turn when Euroland starts to show signs of weakness and the ECB alters its stance. “We may not be far from that point. But until then, I think the ECB will have a hard time justifying verbal intervention.”
Above all, says Jen, the G-7 will need to decide what really worries them. Global growth? Inflation? Global imbalances? Or is it financial stability? Forcing the US – “the weak link in the global economy” – to revalue the dollar does not seem to make sense; and forcing China to have a maxi revaluation also seems a bit risky now, if global growth is the main concern.
The G-7 members must convey a clear ranking of their priorities, as the solutions to these various problems are not consistent with each other, he says. Jen’s view is that global growth and inflation should rank higher on their priority list than exchange rates.
For while the US dollar, Canadian dollar and yen all may be under-valued, “if the issuers of these currencies don’t have a problem with this, it will be hard for the Europeans to correct these misalignments”.
