Market Highlights:
- China Awakes, Commodities Rally
- Loosening of the Yuan Peg Ahead?
- Ask Karl: All Together Now
China Awakes, Commodities Rally
The Canadian dollar hit a three week high over the last trading cycle before pulling back slightly as positive economic reports from China supported global growth expectations. Chinese industrial production was 16% higher this October relative to last year, and trade surpluses doubled. The Dow hit a 2009 high, and bourses rallied around the world. China’s role as the largest contributor to marginal demand caused the commodity bulls to run, and crude oil briefly pushed through the $80 mark while gold moved to $1,119 an ounce.
Federal Reserve Bank of Dallas President Fisher addressed the role of low interest rates in devaluing the USD, but said that the decline had not been overly “disorderly” and inflation remained too low. The DXY trade-weighted dollar index fell to a 15-month low in response.
The Bank of England’s Governor Mervyn King said “The depreciation of sterling should lead to a recovery in economic activity. We have a completely open mind as to whether to do more asset purchases or not.” Traders took the sterling down a few notches, but it managed to hold the 1.6550 level reached after downgrade threats from Fitch yesterday. The euro held just south of the $1.50 level, and appeared set to hold its gains in advance of a GDP report to be released tomorrow, which is expected to show a slight expansion in eurozone economic activity.
Canada’s dollar outperformed all other major currencies, having posted a 3% gain over the week. From here the outlook is quite uncertain. The Bank of Canada is the fly in the ointment for traders looking to push the CAD past par. As discussed previously, direct intervention remains highly unlikely, but Governor Carney has been successful in talking the dollar down in recent months. Whether he attempts the same trick again, and whether the markets continue to listen are key variables to watch over the next few weeks. If commodity prices continue to strengthen, traders may make another attempt on the summit.
Loosening of the Yuan Peg Ahead?
One of the most interesting statements over the last twenty-four hours came from Ma Delun, Deputy Governor of the People’s Bank of China. According to a report in the Business Standard of India, the Deputy Governor hinted at the possibility of a revaluation of the Chinese yuan, saying “going forward, we are gradually promoting liberalization of the exchange rate.” The latest Monetary Policy Report also said that the central bank would consider “capital flows and changes in major currencies” as a basis for foreign exchange policy.
Trade imbalances with Asia are increasingly referred to by American policymakers, and protectionist pressures are increasing within the United States. The yuan’s peg to the US dollar is often identified as a primary reason for persistent deficits with China. Any sign of restructuring in this exchange rate regime will be greeted with great enthusiasm, but the USD has declined more than 15% on a trade-weighted basis since the beginning of the year. This means that any loosening of the currency peg would have the effect of reducing external political pressures and supporting domestic consumption, without having a material effect on China’s competitiveness with the rest of the world. This ability to score political points without fundamentally addressing trade imbalances makes a revaluation increasingly likely.
Ask Karl: All Together Now
Writing our updates over the last year has become more difficult. Once upon a time, a development in one area of the financial markets led to a complex chain reaction that had non-deterministic consequences in other markets. However, trading patterns over the last year have been reduced to a very simple dynamic. The markets have become a giant seesaw, with the U.S. dollar on one end and riskier assets such as equities, commodities, and emerging market currencies on the other. When optimism goes up, the dollar goes down and everything else goes up. When fear dominates, the opposite occurs. This is great for traders, but not so great for analysts trying to invent new ways to describe the same dynamic every day!
Optimism about the economic recovery, confidence that central banks will keep liquidity flowing, and record low borrowing costs have all combined to produce a rally of historic proportions in financial markets around the world. One of the most distinguishing characteristics of this rally has been its widespread nature – asset classes such as gold and emerging market equities have moved upward, largely in synchrony with each other.
Financial markets are more interrelated than ever before, and last year’s crash affected virtually every asset class in every market economy. Therefore, a simultaneous recovery makes intuitive sense. The more interrelated the global economy becomes, the more assets will tend to track each other. But something more profound is occurring - bond yields have fallen over the last six months, at the same time that equities have risen. This is an extremely rare occurrence, and has only happened twice in the last fifty years, and then only for very short periods of time.
Most likely, this dynamic is being driven by massive central bank intervention. By printing money and purchasing their own government bonds, the central banks are keeping demand artificially high, and interest rates artificially low. This has created the incentive to borrow money in low interest rate jurisdictions and lend it out at higher interest rates in other countries – a manoeuvre known as the carry trade. Given the size and depth of the US capital markets, borrowing in USD has been the favoured strategy. From another perspective, the United States is busy printing money and borrowing more, while effectively lending it to the rest of the world.
The currency has depreciated as millions of traders have sold dollars against other currencies. Some participants have earned returns in the 50% range over the last year as negative real interest rates and rapid currency depreciation have improved both sides of their positions. New York University economist Nouriel Roubini recently called this the “mother of all carry trades.” While earning tremendous returns for traders, this flow of money out of the United States has pushed up asset prices globally and increased their values in USD at the same time (something also known as the “numeraire” effect). This largely explains the worldwide correlation between asset classes that we have been observing.
This situation is unlikely to persist for long – the very same forces that are creating deflationary pressures now will eventually reverse and create inflation. In consequence, interest rate differentials around the world are likely to converge as stimulus efforts are removed by central banks. Eliminating artificial demand should force bond yields back up as competition between issuers and asset classes increase. Asset classes will diverge once again.
As the rationale behind the carry trade begins to weaken, exchange rates may follow an interesting pattern. Primarily, negative demand for US dollars should begin to shift, as carry traders sell other currencies and purchase dollars with which to repay borrowings. Market movements may be dictated by more complex narratives, and the risk seesaw may begin to bend in the middle. This is a good thing, as long as everything remains stable – if asset prices or exchange rates move in the wrong direction, traders will run for the exits as quickly as possible.
A Civil War soldier once described war as “long stretches of boredom, punctuated by brief moments of sheer terror.” This unwinding of the carry trade may turn out to be orderly and boring, but if history is any indication, abrupt adjustments will occur as well. There may be hope for foreign exchange analysts after all…
By Karl Schamotta, Market Analyst
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