Bank of New York Mellon’s London-based currency strategy team (made up of Simon Derrick and Neil Mellor) presented on Wednesday a very compelling view of what to expect in the forex markets in the next year.
The short view: euro, yen weakness cometh as the dollar strengthens. The longer three to six month view – ultimate dollar weakness and a gold rally.
Now for the very macro rationale…
Looking back over the crisis BNYM explain how most fx moves since 2001 could largely have been expected as they made complete rationale sense – eg. the development of the carry-trade because of Japan’s accomodative policy etc, and a hike in global liquidity because of low rates in the US. As they explain:
With two of the three largest economies in the world instituting highly accomodative monetary policies while all three were pursuing policies that implied that their currencies would weaken over time, investors sought out “stores of value” for their savings.
The search for a good “store of value” resulted, among others, in an investor flow to high yielding currencies like the AUD, precious metals, and commodities. It also encouraged flows to equity markets in nations with currencies linked to the USD but benefitting from export fuelled growth.
Noticeably BNYM says gold prices only broke gains in the period when the Fed was in its interest rate hiking cycle and when the Japanese finished with their QE efforts.
Of note too, of course, is the fact that rising liquidity saw the JPY fall against currencies whose central banks were battling inflation. This equated to the birth of the JPY carry trade. Consequently, Japanese investors preferred to buy treasuries over their own bonds too. Alongside Chinese investments into treasuries, all of this ultimately financed the boom. While it’s clear with hindsight — and many did warn about the problems at the time — BNYM stresses it was to be rationally expected.
Meanwhile, BNYM also point out the following correlation between the dollar and oil:
It really is a fetching chart, and as BNYM notes, shows just how severe the tipping point in the cycle was. The correlation being that oil really started to drive higher when the Federal Reserve began cutting rates aggressively in 2007. The petro-dollar issue was largely behind this, as the dollar’s subsequent fall essentially eroded export nations’ purchasing power and also their dollar reserves.
This rapid decline fed through into an equally rapid shift in interest rate expectations globally, say BNYM, with investors logically selling the currencies where the largest rate cuts were expected to occur. So came the collapse of the carry trade.
The impact was immense because the carry-trade had been built up over six years – it led no less to the largest shifts ever seen in the currency markets.
On the reserve issue, BNYM also remind about the euro-effect, or rather the impact the formation of the euro had on international reserves and currency flows.
According to the IMF in the first quarter of 2002 total fx reserves globally stood at just over $2,000b. Out of this amount the fund knew how $1,5700 of reserves had actually been allocated with 71% held in USDs and 19.7% in EURs. By the third quarter of last year total fx reserves had jumped to $6,900b (i.e. nearly 3.5 times the amount held six years earlier) while the USD now only represented 64.5% of known holdings. The EURs shares, in contrast, now came to 25.5%
It was this that was responsible for driving up the EUR to all-time highs last year they say, with other currencies like GBP also benefitting.
But then came the oil crash, which saw, for example, Russia’s fx reserves — at $592bn in July 2008 — deplete by about $200bn by early January as Russian authorities attempted to support the rouble as investors fled the market on fears of Russia’s dependence on oil. Meanwhile the flight to safe havens predictably supported the dollar.
Now, however, interest rates are converging around the world leading to a lack of obvious currency direction according to what previously drove flows. As a result, according to BNYM, investors should look to the nationalisation of debt being the dominant fx driver in the near future.
With the US expected to spend some $3,700bn in the next two to three years defending its economy, it is most likely the dollar will be most significantly affected, as their spending programme and debt raising will be the biggest.
Furthermore, the US has no choice but to become increasingly dependent on the printing presses as debt financing from traditional dollar surplus-holding countries will fallback alongside the slowdown in the growth of their reserves. This becomes increasingly likely as domestic spending programmes take priority. Without the inflows, overdependence on quantitative easing runs the risk of tipping the economy from a deflationary to an inflationary environment very quickly.
This becomes all the more likely because the alternatives to QE are so few. BNYM highlights that according to the IMF, even if US savings rose to 8 per cent of GDB, that would only raise $830bn by 2010 – a fraction of the spending needs.
In Japan, meanwhile, the triple “whammy” of a deteriorating economy on falling demand for Japanese products (exports in January declined by a record 45.7 per cent y/y), political ‘wobbling’ on response measures and waning competitivenes due to the effects of recent yen strength will begin to impact the yen.
BNYM refers to Japanese purchases and sales of foreign bonds and notes (see graph below) where a flattening of activity at the beginning of the year corresponds with the period of yen strength. That is now reversing. Note the most recent tip upwards, marking the biggest outflows in four years in Japan. These came in a period when repatriation flows are usually to be expected for tax reasons and despite a clear lack of incentive to put money on account of the Zirp (zero per cent interest rate) policy in the US.
And the flows are only growing, as BNYM highlight in their Thursday commentary:The Ministry’s latest figures, published today, show that Japanese investors bought JPY 1.23 Trn worth of foreign bonds in the week ending February 19th – a figure only exceeded over the past four years by the JPY 1.36 Trn worth of purchases the previous week. Whilst the magnitude of last week’s total spend is hardly a rarity, consecutive weeks’ purchases of such magnitude most certainly are, and we have to go back to the autumn of 2001 to find comparable figures.
To understand why Japanese investors are venturing offshore during a period that is traditionally characterised by fiscal year-end repatriation flows and at a time of collapsing yields around the globe, is to appreciate the clear risks of the JPY remaining firmly on its present track.
The three reasons we have cited previously to explain Japanese investors’ renewed affinity toward foreign markets have, if anything, become more substantial.
BNYM’s conclusion: Japan is clearly facing a renewed era of deflation. With that it will have no alternative but to turn on the printing presses at force and even possibly intervene in propping up their stock markets again, something that will ultimately lead the yen to revert to its weaker millennium averages — the analysts’ three-month target being 105 to the dollar.
The euro, meanwhile, must suffer in the near-term too because as the dollar element of more diversified global reserves is depleted, the euro weighting becomes increasingly large. With a higher euro risk-weighting anyway on account of increased eurozone sovereign default fears, chances are reserve managers will be looking to limit many of their holdings.
Ultimately, BNYM concludes in the current climate, as the history of QE in Japan shows, only gold is likely to outperform. This is especially the case as QE becomes increasingly employed across the world’s predominant reserve currencies (even the Swiss have alluded to the possibility). Conclusion: The clearest buy for investors remains gold.
Related links:
More about the yen: Y115 by year end? – FT Alphaville
The end of the yen’s safe haven status? – FT Alphaville
Gold (sub)standard - FT Alphaville