FX Daily: You Just Can’t Keep Triple A Carry Down

23rd June 2014 By: Eimear Daly

  • ECB Draghi has said that quantitative easing is a strategy option that falls within the Bank’s mandate and could be used if inflation expectations were to deteriorate over the medium term. Draghi added however that he and his Governing Council colleagues were first prioritising the impact of the package of rate cuts and liquidity support announced earlier this month. (De Telegraaf)
  • Now is not the time to ease debt rules in Europe, according to ECB’s Coeure. Coeure has said “The Stability and Growth Pact should not be stretched to the point where it loses its credibility”, following repeated calls by France’s Hollande to soften the rules of the Maastricht Treaty. (MNI)
  • BoE member Miles would vote for a rate hike from its current record low of 0.5% before he leaves office in May 2015. Miles, a noted dove, said the UK economy has become “entrenched” with “subdued” inflation leading to “gradual” rate rises. (The Telegraph)
  • BoE’s Haldane has told borrowers that coming UK interest rate rises will be gradual and not reach the peak levels seen in the past, levelling out at a “new normal” area of between 2% and 3%. (Yorkshire Post)
  • New debt estimates revisions imposed by Brussels have pushed Britain’s “net debt from 1.27 trillion to 1.4 trillion, or from 76% to 83% of GDP”. The rise in revisions “follow disappointing news for George Osborne last week in the figure for borrowing in the first two months of 2014-2015,…accounting for more than a quarter of the government’s full-year target. (Sunday Times)
  • Central Banks are planning to trim their exposure to longer-term debt, according to a survey by Central Banking Publications and HSBC. More than 50% of respondents said they are adjusting their portfolio in preparation for higher rates and continue to shift funds into equities. (The FT)
  • China’s June Flash PMI rose to 50.8 versus May’s final 49.4. The increase was driven by a surge in the output subindex which rose to 51.8 from 49.8 in May.
  • Eurozone June Composite PMI fell to 52.8 from 53.5, missing expectations of 53.4. The drop was led by declines in both the Manufacturing and Services subindices.

China June HSBC Manufacturing PMI spiked to a seven month high of 50.8, exceeded even economists’ top forecast of 50.4 and the median forecast of 50.1. The stronger release is reminiscent of Chinese Premier Li’s odd statement in London last week “I can promise everyone honestly and solemnly, there won’t be a hard landing”. Li is not an economic prophet, instead the statement underlines the control Chinese authorities have over the economy. The risk of social unrest and sharp capital outflow if China weakens sharply means authorities will do what it takes to support growth, either through broad stimulus or this time around “targeted” measures. The surge in manufacturing output may have something to do with the 3% devaluation in the currency. The details of the report provide a less upbeat picture than the headline reading. The sharp pick-up in manufacturing output did not coincide with increased orders or export orders. While the sector is growing now, its outlook is less certain. The Chinese economy is transitioning away from overcapacity, over-investment and dramatic export growth to a consumer driven model. The booby traps policymakers have to sidestep on their way to a balanced economy include a bubbling property sector, credit defaults in the shadow banking sector, capital outflow on a sharp economic deceleration and social unrest if the economy cannot provide enough employment for the world’s largest population. It’s a hazardous path to economic reform that so far have meant a two steps forward, one step back approach. Right now we are in one step back territory. China clunky manufacturing sector cannot maintain these growth rates. Overcapacity and a rising cost base mean stimulus measures will only provide temporary relief. Industrial production, exports and retail sales have all responded to the government’s “targeted stimulus”, but the underlying economic weakness is evident in slower fixed-asset investment growth and persistent declines in home sales and new construction.

The commodity block currency shot higher on the Chinese release. The Aussie dollar, China’s defacto resource supplier, was up 0.49% and the New Zealand dollar, China’s food supplier, appreciated a corresponding 0.49%. While these currencies will appreciate on a positive Chinese outlook in the short-term, they face complications in the long-term as China transitions to a consumption-based economic model and implicit slower growth. This poses real problems on the ground for these countries which will have to adapt their business models in line with China’s.

An interesting dynamic has emerged in the Aussie dollar’s traditional correlation to iron ore. The two indices notably decoupled in April as evidence of a slowing China pushed the commodity price lower but AUD remained immune to China downside risk. Today the Aussie dollar traded higher in line with stronger iron ore prices – the Aussie continues to benefit on China upside risk but the correlation doesn’t hold in the opposite direction. The same can be said for the Canadian dollar’s recent stronger correlation to firmer WTI Crude Oil. The commodity currencies benefit from upside moves in the commodity space but are less susceptible to the downside. Support on the downside is provided by central bank reserve demand. The Canadian, Australian and New Zealand dollar are all triple A, high yielders and thus an attractive buy for global reserve managers who are greatly increasing their holdings. The FT ran an interesting article this morning that alluded to central banks reducing their US Treasury holding as QE comes to an end and looking for higher yielding alternatives investments including even equities and ETF’s. Reserve managers’ demand has been supporting the commodity block currencies for some time meaning the currencies haven’t weakened in line with worrying fundamental developments. These currencies may struggle once central bank reserve accumulation slows and the higher US yields makes the carry trade less attractive. Downside risk is currently limited in the triple A commodity currency space but current trading levels are out of line with the economic outlook and rate differentials. We continue to forecast a correction back to more fundamental levels.