USD Shortage Across Markets, A Dovish Rate Hike by the FED, RMB Offshore Rates and BOJ Bond Buying

Signs of an USD shortage are rising putting our emphasis towards Australia’s wholesale funding-dependent banking sector now experiencing tighter funding conditions. AUDUSD has tested levels near its 200- day MAV with the help of rallying commodity prices. The November consumer climate has eased towards its weakest level since April following earlier reported real estate weakness. AUDUSD should break lower and we are positioned via short AUDNZD. We remain GBPUSD bullish ahead of today’s Carney speech (which is not on monetary policy).For the first time in five years UK PPI is expanding at a more rapid pace than the CPI, helping GBP in the short-term.  

Today, the Fed should aim for what we call a ‘dovish rate hike’ putting rates up by 25bps but signaling that there is no rush to hike rates further from here. The still relatively weak investment cycle suggests monetary policy will stay accommodative for longer, leaving markets with a mixture of liquidity, inflation and growth helping pro-cyclical equities such like financials to outperform. So far, the equity market rally has focused on DM leaving most EM markets behind.

RMB offshore interest rates have sharply risen this morning as authorities absorb liquidity to stabilise the RMB. The overnight CNH Hibor rose another 2.7% to 7.3% today, rebounding after a dip on Tuesday and taking the overnight rate to its highest level since last Monday’s 12.4%. Meanwhile, suggestions claiming China’s authorities may return back towards a fully managed FX system have become louder. Sheng Songcheng, ex-head of the PBoC’s statistics department and now a PBoC advisor, warned that the RMB could face greater depreciation pressure at the beginning of next year as the annual foreign exchange quota of USD50k reopens for individuals in January. He warned a weaker RMB could undermine financial stability and eat further into China’s USD3.1trn currency reserves. Currency reserves have declined by USD900bln in less than two years.

Interestingly, by restricting capital outflows international USD liquidity seems to have tightened as Chinese companies will be forced further into the offshore debt market to fund their more than USD200bln in acquisitions announced this year. China’s USD denominated debt sales – in the past targeting Chinese investors aiming to diversify into USDs – seem to no longer have access to this group of investors as China’s authorities tighten capital account related regulations. Consequently, Chinese companies may have to look for alternative funds to absorb USD liquidity from Asia’s offshore USD markets, pushing yields for these funds higher. Over recent months USD denominated claims against China’s corporate sector have increased again to USD619bn in 2Q, suggesting two things. First, funding tightness leaving the USD market as a quasi ‘ lender of last resort’ and secondly increasing the vulnerability of corporates again should the USD continue to rise.

There are increasing signs of a USD shortage in offshore markets. One expression of this tightness is the widening of the cross currency basis most emphasised in the case of USDJPY. USD front end funding costs have become increasingly expensive which. within the current constellation of widening bond yield differentials, Japan’s markets offering virtually no yield and Japan’s insurance companies runninghigh FX hedging ratios, could spark a rapid USD rally going into the next year. This is why a dovish Fed today may provide opportunity to pile into cheap USDs.

Tightening offshore USD liquidity increases FX hedging costs, but with the BoJ managing its yield curve, JPY based investors have little other choice looking for yield outside. However, with FX hedges becoming increasingly expensive they may have to seek foreign yields on a currency unhedged basis. Existinghedges, often with a maturity between 3 – 6 months, were established at cheaper costs, but when these hedges are due for prolongation it may no longer make sense to continue to run these hedges. Expiring hedges lead to more currency demand and a weaker JPY. Typical for those situations is seeingFX moving unrelated to the release of economic news.

Predictably, the BoJhas increased the scale of its longer-end Japanese government bond buying operations this morningnot only to cope with the recent rapid rise in longer-end bond yields but also to ease market concern over possible volatile moves in future, an official at the BoJ’s Financial Markets Department told MNI. The amount of JGB buying with a remaining life of 10 to 25 years was raised to JPY200bln from the previous amount of JPY190bln while bond buying with a remaining life of longer than 25 years was increased to JPY120bln from JPY110bln.