FX Research : Risk returns

By Calyon Fixed Income Markets Research

Highlights

* USD and JPY gain as markets get rattled about scope and pace of recovery despite a string of positive economic figures.
* Bolstered by rising risk aversion the USD has managed to shake off renewed BRIC inspired comments regarding its reserve status.
* Data focus on German IP, with upside risks after yesterday's strong orders report.

Risk returns

The FX market remains on “recovery watch”, with any increase in economic sentiment still likely to weigh on the safe haven currencies of the USD and JPY, but for now the scope and pace of the economic recovery is starting to be questioned, despite some recent positive economic numbers. There remains much for the optimists to focus upon, yesterday's release of German factory orders showed that not merely did demand rise, but the increase was concentrated on those all important export markets. Germany is still expected to contract a whopping 6% this year, so it is still too early sound the all clear, but firmer foreign demand mirrors what was seen in recent PMI surveys and is crucial to the recovery hopes of not only Germany, but also the export dependent economies in Asia. So as those green shoots started to edge further out of the recession hit ground the EUR gained against the USD and managing to break above the 1.4000 level once more, albeit temporarily. Given that where demand goes, production is likely to follow, the strong orders data point to upside pressure on today's German IP report. It might be too early for the full impact of the orders increase to be felt on the production side, but a firm number should provide further EUR support, with EUR/GBP a strong candidate to eke out further gains after UK manufacturing figures disappointed and the market becomes more cautious on Sterling ahead of the MPC decision tomorrow.

The final Eurozone Q1 GDP should be shrugged off as purely historic, even though it is expected to confirm a 10% annualised decline in activity at the start of this year. Instead, aside from the German figures, an expected increase in French business confidence may reassure that the worst is over for Europe, despite media speculation that at the G8 meeting policymakers are likely to warn that economic recovery is not guaranteed as yet. A more cautious sounding G8 should help underpin the USD in to the end of the week and limit any negative fallout from yet more reported comments from the BRIC countries casting doubt on the USD's role as a reserve currency.

Further, on the data front a string of positive figures from Australia on borrowing and consumer confidence support the view that post the RBA decision it now looks increasingly likely that there easing cycle is over. These provided limited support for the AUD as the shine was taken off by weak Japanese machine orders. They do highlight the fact that though, that it is not difficult to find increasingly upbeat signals with regard to the global economy and up to now the FX market has seemed relaxed with the view of a steady, if unimpressive recovery. The market may now be questioning this stance primarily taking it s lead from development sin the equity markets. Much has been made of the recent rise in the price of puts on the S&P 500 as investors move to protect themselves against further declines in the equity markets. Such positioning seems to raise question marks over the recovery, a view that if shared by the FX markets would normally favour a move back toward the USD and JPY. Some exchange rates, and in particular the EUR/USD have already reflected the change in equity sentiment. The S&P 500 rose 40% between early March and June, over the same period EUR/USD could muster a comparatively muted 12% rise in carry adjusted terms.
Since the start of June however the equity market has lost around 5% with EUR/USD losing a more comparable 2.25% in response. This apparent greater sensitivity does indicate that the EUR would be vulnerable if concerns over equities come to fruition, but other crosses would be even more at risk. Namely, the so called “recovery” trades such as long AUD, NZD and GBP may become increasingly overstretched, favouring long USD and in particular JPY positions. Indeed, whilst the EUR may suffer against the USD if equities head lower, it is actually well placed to gain against these other currencies. The correlation between EUR/AUD and the S&P 500 has been just short of -0.90 over the past three months, signalling that a big decline in stocks should prove sufficient to push the cross back to the 1.6000 mark last seen in June 2008. For further details on the possible threat to FX posed by current equity market sentiment, see “S&P puts take the strain – FX Options Alert”, published yesterday.

Stuart Bennett Senior FX Strategist