FX
Global FX, Commodity Currencies and Asia
We think it is time to move into bullish EUR,SEK and CHF crosses, selling select AXJ currencies, AUD and CAD. Yesterday’s release of the ECB minutes leaves the impression that the central bank is standing ready to prolong its €80bln per month easing programme beyond its current March 2017 projection. EMU’s inflation expectations have eased again and while traditionally an easing announcement suggests a weaker FX, we think EMU has reached a stage finding it difficult to weaken its FX rate. Due to the position of core EMU yield curves, the ECB no longer has the transition mechanism in place allowing a further increase of the ECB’s monetary base to filter into a weaker FX rate(see our explanation here). Instead, EUR has switched into ‘auto pilot’, with commercial EUR demand and rising real rate differentials pushing the currency higher. Post Brexit data not coming as weak as feared should allow GBPUSD to move back to 1.3450, dragging EURUSD higher too. The EURGBP bull run may pause at this stage, suggesting looking for alternative liability currencies.

KRW, TWD and SGD yield curves have flattened and, while we have little doubt that these curves will move into inversion within the later stage of the cycle, we think that curve flattening will pause for now. The main engines of flattening trades derive from internal short-funded carry trades, i.e., banks using short-maturity funding, say 3m,and using that to make longer-maturity bond purchases, and the excess of domestic savings finding their way into financial assets. The first flow is of tactical nature, while the second flow is structural. When curves become too flat then the focus of these short-maturity-funded domestic investors into the long end of the yield curve steers away from yield towards potential capital gains. Here the trade becomes unstable and reverses when the upward momentum in bond prices gets stuck. It seems that we have reached this critical stage.

The first leg of the AXJ inflows was fixed income-dominated as foreign investors participated in the bond bull run. Consequently, falling bond yields allowed share markets to aim for higher valuation levels. Inflows converted from being fixed income- towards equity driven. However, with local bond markets interrupting the bull run, the equity market valuation rise may get stopped in its tracks too, suggesting inflows easing. China’s recent poor data releases take some glamour away too, pushing low-yielding AXJ currencies into an offered position.

When it comes to China we may have to differentiate between the growth and the inflation effect. Most of China’s growth slowdown lies behind us as China’s real economic growth rates slowed by 6% over the course of three years. This growth shock hit economies with significant direct trade exposure– frequently commodity delivering countries – most. While China’s growth slowdown sent commodity prices sharply lower, impacting the global inflation outlook, it may now be the price decline of China-produced products unleashing the next negative impulse for global prices. It will be the importers of China’s exports experiencing most of this impact, in our view. Australia, Korea and Taiwan belong in this category. Similar to Japan’s impact on the global economy in the 1990s, we believe that it will not be the China growth concern, it will be deflation concern driving markets. China runs debt-funded overcapacity, but since its debt is internally funded it is likely to follow in the foot steps Japan left behind in the 1990s.

Buying EUR,SEK and CHF against KRW,TWD, AUD and CAD would benefit too should the Fed hike rates early against our expectations. Worryingly, the Fed’s Williams, proposing th Fed to increase its inflation target on Monday, said overnight that the economy would be strong enough for the Fed to hike rates too and theFed’s Kaplan views the US election as irrelevant to when theFed acts. An early Fed rateat times of depressed US inflation expectations and China’s RMB weakness exporting China’s deflationary pressures into the global economy would not betaken lightly by equity markets. Risk would sell off. HenceEUR long positions should bea necessary add to FX portfolios heavily geared towards carry.

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