The French Need More Time to Succeed

Both Merkel and Hollande agreed
The French need more time to succeed
By Twenty Fifteen
Their budget they’ll wean
From deficits its been decreed

The FX markets are still trying to come to grips with all the confusion in other markets as well as the flow of new data that comes on a daily basis.  What we have seen of late is many of the previous relationships between markets breaking down as investors and traders try to understand the potential outcome from changes in monetary policy that seem to be inevitable.  Will the Fed taper their bond purchases?  And if they do, what impact will that have on equity prices and the dollar?  Will Japan stretch into purchases of more equities or foreign bonds?  Will the ECB initiate a true QE program or will they extend more LTRO’s?  There are a lot of possibilities with very little certainty attached to any of them, at least with regards to their timing.  And all of these will result in some pretty significant market gyrations if/when they come.

I would argue the Fed remains the key driver of most market activity as the debate about QE3 continues.  Once the idea that the Fed may reduce the level of bond purchases hit the markets, the dollar started an immediate rebound against most currencies.  While the euro traded back above 1.30 yesterday, which is pretty much its highs for the past 2+ weeks, it is easy to forget that on May 1, the euro was above 1.32.  We have seen a similar pattern across the other G3 currencies, with both the pound and yen rebounding off recent lows, but still weaker than at the beginning of May.  So the Fed story remains the primary market mover.  However, underlying that are the idiosyncratic issues in each currency.  For example, the EU data last night showed Unemployment at a new record rate of 12.2%, confirming the ongoing policy problems on the Continent.  The European Commission officially sanctioned a longer time-line for France, Spain and Portugal to achieve their budget deficit targets of 3%, although with or without sanctioning, it was going to take longer.  And these things helped undermine the euro’s recent rally.

In Japan, data showed better than expected IP in April, +1.7%, but CPI at -0.4% Y/Y in April, indicating that the BOJ still has much work to do to successfully defeat deflation.  And still, in Japan, there is more discussion of the technical aspects of their policy and how to implement it smoothly rather than any further changes in policy.  While it seems we have been above 100 for quite a while, in fact, we did not break that level until May 9.  The fact that we have retraced a small percentage of the movement is neither surprising nor damaging to the long term trend.  A popular theme in the market right now is that the yen has moved as much as it can based on Japanese activity and the next bout of weakness will be driven by the Fed’s activity.  Certainly if the Fed does taper bond purchases, USDJPY should rally sharply, but I still believe that Kuroda has a few more things to do if the inflation data does not start to move toward positive numbers, notably purchasing riskier assets and foreign bonds.  While neither of these is likely soon, don’t rule them out by the end of the year.

Market response to the Fed story has been quite notable in the emerging markets, where currencies across the board have fallen quite substantially this month.  In fact a quick look at some of the main EMG currencies this month show the following declines:

ZAR                   12.5%
MXN                   5.8%
INR                   5.1%
BRL                  4.9%
KRW                   2.5%

Clearly there are other things beyond the Fed impacting the ZAR, with local labor strife and weak gold prices in the mix, but looking at BRL, MXN and INR, I would say that is largely the change in sentiment with regards to the Fed.  Will these declines continue?  My gut tells me that despite momentum increasing and capital flows reversing (EMG bond funds saw outflows of $2.94 Billion last week), this has the feeling of selling the rumor, rather than the news.  Certainly another percent or two seems viable, but not much more than that.  What does this mean for hedgers?  Payables hedgers should be layering in again as current levels represent close to the best that we have seen in the past 12 months.

Good luck and good weekend

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