Oil and Saudi Arabia, CAD, SEK and USD flows
Saudi Arabia appears to be changing strategy. Instead of being near full capacity, aiming to price out alternative oil production facilities, it is now the first time since summer 2014 that oil production of traditional producers is being contained. The US may be the ultimate winner, with higher oil prices boosting its shale oil industry’s profitability, its credit standing and last but not least its willingness and capacity to invest in its own production capacity. OPEC’s agreement supports our view of a higher USD in 2017.
Higher oil prices are likely to boost oil exporters’ terms of trade and thus allow related currencies to rally. However, the upside in CAD would likely be capped as the US’s renewed push into oil sector investment suggests that Canada will need to seek overseas markets for its oil. Canada’s oil distribution costs may rise, reducing the beneficial effects of higher oil prices. Moreover, we expect the BoC to ease again once it realizes that it had been too optimistic on growth and inflation.
SEK has been the big European underachiever as it was increasingly used for funding purposes. However, negative interest rates did not impact bank profitability as much as it did in the EMU and Japan, allowing its credit multipliers to stay strong. The Riksbank remains cautious for now, but should the ECB signal tapering of its QE operations next year, the Riksbank may turn hawkish. The extensive SEK short funding position could then turn SEK into an out performer. We are not there…yet.
The USD should stay offered unless bond markets tell us otherwise. Yield curve flattening keeps the USD under selling pressure, with high yield EM benefiting the most. This trade has limited potential, however. It may bechallenged either bya ‘perception of reflation’ hitting the bond market or investors questioning the ability of theFed to fight off the next recession. Oil currencies, including RUB, COP and NOK, havefurther upside potential, while CAD remains an under performer.
Liquidity conditions remain ample, with Japan’s latest flow of funds report suggesting its corporate sector cash position increasing to USD2.2trn. Hence, demand for safe assets remains ample, pushing valuation for these assets to high if not extreme levels. Investors seem to have little choice other than piling into yield-enhancing strategies, suggesting accepting high risks relative to returns. However, it is not only the hunt for yield that is putting the USD under selling pressure. Rising USD funding costs coming on the back of rising US LIBOR rates have reduced international demand for USD-denominated debt. Despite foreign accounts slowing their purchases of US bonds, US bond yields have come down, which for us provides additional evidence that the US economy is slowing down. s. When bond yields are falling at the same time as foreign purchases ease, it suggests that the internal supply-demand balance for US capital market is shifting toward the demand side. This in turn suggests that the slowing US economy is creating additional net savings, causing its capital costs to fall. The remaining yield is no longer high enough to attract the same amount of FX unhedged inflows. Instead, these funds go elsewhere looking for higher yield, but this yield comes at a higher risk too.