USD Strength in EMFX, poor China data and hawkish ECB members


FX markets follow yield curves carefully. Overnight it has been the release of weak Chinese trade data pushing yield curves into a flatter territory taking the USD off the boil. September exports declining in USD terms by 10% and imports by 1.9%,undershoot consensus expectations by a substantial degree .Fortunately, other Chinese data including bank lending has been stronger. According to MNI, quoting sources familiar with the subject, new bank lending rebounded sharply in September with total new loans likely to be as strong as August if not higher. Our proprietary MSCHEX indicator rebounded in August to 9.2showing its strongest reading since March.

Still, it would be a mistake to dismiss China’s disappointing September trade performance completely bearing in mind that similar September trade weakness has been spotted in Korea and Taiwan suggesting that trade is slowing down or what some in the market have suggested as being a understating of exports in order to keep hard currency. Whatever the outcome here it would not bode well for AxJ currencies and hence we reiterate our call selling TWD, KRW, SGD,and THB.

Our long-term bullish USD call is founded on the observation of diverging output gaps. Asia’s output gaps have stayed wide and in this respect we look at capacity utilisation rates for Korea and Thailand. Korea’s use rate has been in a steady decline since 2011 and is now reported at 70 low (for Aug). Thailand’s unused capacity is even bigger with its use rate currently at 64.4. Here deflationary forces will stay in place. Yesterday’s release of the FOMC minutes suggested that the decision to keep the rates on hold in September was a close call. Fed officials are getting increasingly convinced that the US economy may have closed its output gap which warrants taking some monetary accommodation off. USD/AxJ long positions make sense and may receive an additional shot in the arm should China’s poor trade performance either indicate weakening local trade or potentially that China’s entities are starting to hold hard currencies as they are worried about RMB depreciation.

The Fed and the rate path. Once again the Fed seems to deploy ‘calendar guidance’ towards tightening, a strategy it used last year when it increased rates despite seeing the economy slowing down in Q4. The big difference from last year is that market pricing for the path of US rates is much slower today. Following the December 2015hike, the market priced in the Fed hiking 2.5 times in 2016. Nowadays there is only one hike priced in for 2017. What at first glance may seem a good reason to moderate USD bullishness, it is at second glance a pro-USD argument.

Risk turns red. When the Fed faced tightening financial conditions in February 2016, it could ‘ease’ by reducing rate hike expectations. The USD–TWI declined 6.5% from its top when the Fed signalled that it was no longer intending to hike rates soon (according to market pricing). Now the front end of the money market curve is flatter and thus is the room for the Fed to moderate expectations. Should – against our base case – China’s poor trade data set the starting point for another global trade moderation weakening economic prospects then it may be the reduced room for the Fed to react creating a bearish risk framework. Needless to say that this interpretation will not only push USDAxJ higher it will as well not bode well for high yielding EM currencies. We reiterate our bearish calls for ZAR, TRY and COP.

Hawkish ECB members start to question the usefulness of super easy conditions. Overnight it was Mersch suggesting that the focus of policymakers should be that the “equilibrium interest rate has declined, compressing the room available for monetary authorities above the lower bound to ease policy, precisely when global structural headwinds are already impeding efforts to achieve price stability”. The EUR should stay strong on the crosses, but EURUSD should be dominated by USD strength.