Calyon FX the Day Ahead - Risk on, Risk off

By Calyon Fixed Income MArkets Research

* CIT reveals that it is unlikely to receive any US government funding
* July US Philly Fed, Q2 earnings including Biogen Idec, Google, and JP Morgan in focus

Risk on, Risk off

Reviewing comments, questions and feedback following client seminars in Hong Kong, Beijing, Shanghai, Seoul, Taipei, and Singapore as part of Calyon's mid year Asian client road show, it is clear that many Asian investors are cautious about the outlook in the months ahead. Although there is clear relief about the turnaround in financial and economic conditions, many see this as not being durable and we concur. In particular, obstacles to recovery including US consumer deleveraging, business retrenchment, rising unemployment, further banking sector problems, especially in Europe, as well as the lack of adjustment in savings surplus countries from export led growth to domestic growth, have been noted as the major risks in the months ahead. The durability of China's growth engine and whether it will help the rest of the world was a key issue that emerged.

This week at least it appears that risk is back on the table as gauges including Calyon's Risk Aversion Barometer have shown improvement. Over the last two weeks the Barometer has dropped by 2.3% and over the last 3-months it has dropped by 26.5% as most of its components, especially credit indicators and emerging market bonds have revealed firmer appetite for risk. A combination of better than expected data and earnings were sufficient to push stocks higher overnight with gains in the US echoed in the Asian session, albeit with less magnitude. This drivers included stronger sales forecasts from Intel and better than forecast readings for US industrial production and Empire manufacturing. Confirmation overnight that China's GDP grew by a very healthy 7.9% YoY in Q2 will no doubt give further support to investor appetite for risk trades.

News about CIT Group Inc, the troubled US lender, has however, acted as an excuse for some profit taking as it announced that it is unlikely to receive any Federal money. It appears that the US authorities view the problems at CIT an unlikely systemic risk event despite the likely impact of failure on “thousands of retailers”. As the US Treasury noted “there is a very high threshold for exceptional assistance to individual companies”. Markets will eye developments about CIT and economic data in the US including the Philly Fed survey and Treasury TICS data today, to gauge further direction. There are also plenty of earnings on tap including Biogen Idec, Google, and JP Morgan. So far Q2 earnings have been beaten estimates by an average of 20% according to Bloomberg estimates though there are still many companies left to release earnings. On balance, risk trades have gained the upper hand as equities push higher, government bonds come under pressure and the USD and JPY weaken but it already seems as though the move is losing momentum into the European session.

The US Treasury TICS data is not usually a big market mover but it will be interesting to see what the data today reveals about foreign purchases of US government bonds in the wake of data showing that China's foreign exchange reserves topped $2 trillion at the end of Q2 2009; reserves increased by a massive USD178bn over the quarter. Much of the gain in reserves may have come from a sharp reversal in hot money flows rather than trade and investment flows. The news is not exactly good given that it adds more problems for China's reserve management and the jump in reserves will likely lead to greater calls to allow the CNY to strengthen further. It appears that despite their calls for a new reserve currency the Chinese authorities have been buying huge amounts of USD assets to maintain a stable exchange rate. This is good news for the US administration who have to sell huge amounts of Treasuries to fund the burgeoning fiscal deficit but it shows that little has changed in the symbiotic relationship between China and the US despite the financial crisis.

The April TICS data revealed that China held $763.5 billion in US Treasuries. Over the month foreign investors including China bought a solid $42 billion in US Treasuries, massively outstripping the weak demand for other types of security. Purchases of US Treasuries in May are likely to have been even bigger despite the easing in risk aversion over the month that would have dampened safe haven demand for bonds. The strong increase in Fed custody holdings and the high proportion of indirect bids at US Treasury auctions over the month give clear evidence that foreign investors, especially official investors, increased their purchases of US Treasuries. Indeed in May indirect bids were just shy of 41%, reflecting the strongest foreign interest since September 2005. China likely accounted for a large part of this as it pays the price for a stable exchange rate policy. This is good news for the USD and supports our view that diversification away from the USD is a long term process with the USD only likely to weaken gradually over the coming months.

Mitul Kotecha Head of Global Foreign Exchange Strategy