Part of this has been the breakdown in the effectiveness of proxy trades, which was a costly feature of March. Part of it has been the lack of volatility- G3 FX vols remain at or near all time lows. Part of it has been the stretched valuations of many of the more popular EM currency trades (TRY and BRL, I’m lookin’ at you) combined with a seasonal tendency towards underperformance. And part of it has been the degree to which central banks continue to dominate the landscape, whether via reserve accumulation or via diversification/maintenance of reserve portfolio benchmarks. It’s difficult to get terribly excited about throwing loads of risk at a market whose hegemonic participants have a tendency to push things away from where the private sector would prefer to take them.
Nevertheless, the currency market is throwing up a couple of interesting talking points. A number of currency pairs are at, near, or just through critical long-term technical levels:
* GBP/USD 2.00
* AUD/USD 0.80
* AUD/JPY 100
* AUD/CHF 1.00
* USD/NOK 6.00
* EUR/USD 1.3670
The obvious features here are dollar weakness and carry currency strength. Carry currency strength is largely down to low volatilities, benign global asset market conditions, and ample liquidity. If gold were at $620, the SPX at 1400, and US 10 year yields at 5%, Macro Man suspects that the Aussie dollar, for example, would be a heckuva lot lower than it is now. Failing those developments, however, there may not be much to stand in the way of further strength.
The dollar, of course, is the real issue that could provoke renewed interest in currency markets. It’s remarkable how little fanfare has accompanied the dollar’s descent towards multiyear/multi-decade lows against a number of non-funding currencies. Part of the lack of clamour is simply a function of the fact that the greenback spent all of Q1 tracing out a range against, say, the euro. Indeed, EUR/USD is only 1.5% above where it closed 2006.
However, EUR/USD has shown a remarkable tendency over the past few years to consolidate within a fairly narrow range before exploding higher. Granted, there has been a declining marginal return from each range breakout, but the repetitive pattern is nevertheless instructive. Macro Man has dubbed this behavioural pattern the “Rule of Four Point Two.”
Consider the following:
* In the summer of 2004, EUR/USD traded in a 4.2% range before central bank buying helped drive a breakout which extended 12 big figures
* In Q1 2006, EUR/USD traded in a 4.5% range before central bank buying helped drive a breakout which extended 6 big figures
* In summer 2006, EUR/USD traded in a 4.2% range before central bank buying helped drive a breakout which extended 4 big figures
* In Q1 2007, the range in EUR/USD was 4.2%, which we’ve now breached, with reports suggesting increased central bank activity
Now, a glance at the chart above will suggest that Macro Man is to some extent fitting his facts to the story. In the first two instances mentioned, EUR/USD had made a prior, lower, low before settling into the 4.2% +- range for a few months. But let’s face it: “The Rule of Four Point Two” sounds better than “The Rule of Four to Six Percent”. In any event, those narrower ranges were actively felt and traded by the market, so it’s a liberty that Macro Man feels justified in taking.
What does it all mean? Macro Man senses a growing risk that the dollar could be susceptible to one of its periodic step shifts lower against the euro. He feels that central banks are behaving like sharks circling a dying whale...as soon as one commits, they will all pounce and the result will be a frenzy. Whether this should happen is almost beside the point, though rate spreads suggest that most of the dollar’s recent weakness has been justified. Perhaps a shocking trade figure on Friday could energize the market?
While Macro Man is leery of buying euros at the current nosebleed levels, and particularly ahead of Thursday’s ECB meeting and the weekend G7, he nevertheless feels that a potential run on the dollar is an opportunity that should not be missed. He therefore executes an initial purchase of €10 million at 1.3425 spot basis, 1.3436 to May 3. If the trade pans out, risk will likely be added on top. 1.3250 will serve as an initial review level. Although GBP offers superior carry, Macro Man is reticent about buying ahead of “the deuce”, particularly as cable has been paid up today on the potential non-story of a “UK HIA.”
Elsewhere in currency land, Brad Setser had an interesting post yesterday on the RMB and China’s trade surplus. Brad suggests that shifts in the USD/RMB rate overstate the degree of RMB appreciation, and that burgeoning exports to Europe suggest a reasonable sensitivity to the EUR/CNY rate.
Macro Man decided to do a little digging to discover the extent of the difference between USD/RMB and an export-weighted currency index. The results are set out in the charts below.
It has certainly been the case that the RMB has weakened over the entirety of the period in which China’s trade surplus has exploded. Its export-weighted TWI is some 5% below the level prevailing at the beginning of 2002, while the dollar is some 7% lower.
That having been said, the RMB TWI has appreciated since the currency was “floated”, albeit not as much as the straight RMB/USD rate. However, since last May the rate of appreciation has been broadly similar versus the TWI and against the dollar. How can this be when the buck is so much lower against the euro, sterling, etc? It’s down to export weights. The US and Hong Kong dollars represent half of China’s exports, and the RMB has obviously strengthened against those. Japan and South Korea are the fourth and fifth largest export destinations, respectively, and the RMB has appreciated quite a bit against those as well. So while Macro Man feels comfortable castigating China for its FX reserve policy, he doesn’t think that RMB “weakness” has been a prime mover of rampant trade surplus growth (other than weakness relative to where the private sector would set the rate.) For what it’s worth, Macro Man feels that China’s transformation from an importer to an exporter of metals (steel and aluminum) has been a key factor in the recent surplus blow-out.