Risk appetite had something of a reality check yesterday with stocks, commodities, high-beta currencies and the euro all lower. After sneaking back through 1.38, the single currency threatened 1.37 amidst a wall of selling by sovereign wealth funds. The mood towards the euro worsened after the ECB Monthly Report observed that the outlook was coloured by intensified downside risks – in other words, growth is looking much worse than it thought a few months back when it was tightening rates.
Oh, what a policy blunder it was. Overnight, the news that S&P downgraded Spain by one notch to AA- briefly weighed on the single currency, but it recovered and is back near 1.38 early in London trading. High-beta currencies such as the Aussie were offered – AUD dropped below 1.0150 after almost reaching 1.0250 earlier. European equities lost around 1%, Asian equities are down similarly and the gold price fell USD 15 from its earlier high. The process of book-closing is damping volatility as risk positions gradually diminish and as a result, the VIX index, which has been very elevated over the last three months, has fallen back sharply over recent trading sessions. To some degree, respectable US Q3 corporate earnings are helping to steady frayed investors’ nerves.
Guest post by FxPro
Commentary
Mixed messages in latest UK trade figures. After the incredibly depressing news on the UK labour market earlier this week, there was a faint hope that the August trade figures might offer some respite from the constant drumbeat of economic doom and gloom. Unfortunately, there was very little to celebrate. Indeed, the closer you look the worse it gets. Encouragingly, the trade balance seems to be improving – the deficit of GBP 1.9bln is the second lowest since the final quarter of 2008 at a time when imports were collapsing. Worryingly, however, the terms of trade (which measures the relationship of export prices to import prices) fell another 1%; since early last year, it has declined by 4%. The plunge in the terms of trade is troubling, because it reflects a significant decline in national income, and hence spending power. Little wonder that the private sector is suffering so terribly during this period of unprecedented austerity. According to these figures, those pressures are only intensifying.
The Chinese export machine feels the pinch. Against the backdrop of a significant slowing in the pace of global growth, it is hardly surprising that the world’s largest exporter is feeling the pinch. Export growth in China slowed to 17.1% YoY last month, not a dreadful outcome by any means but still noticeably weaker than earlier this year when growth rates of around 30% were more common. Some of the softening in exports is natural, as previous gains were somewhat exaggerated given the massive deterioration in global trade in 2009. With disarming alacrity, officials in China warn that the trade sector faces “severe challenges” over coming months because of weak growth and rising protectionism in both the US and Europe, the appreciation of the yuan, financing difficulties and rising labour costs. Export growth to Europe, a very lucrative market, has dropped very sharply and is now just in the single digits. Interestingly, the value of the yuan fell markedly overnight in Hong Kong by more than 1%. Currently, the offshore yuan rate trades at a 2.4% discount to the official onshore rate, a record margin. Typically, the offshore yuan rate trades at a decent premium to the onshore rate. More than anything, it suggests that investors are nervous about the outlook for the Chinese economy at a time when the world’s economic problems have never seemed greater.
A stark warning for Asia from the IMF. In a remarkably frank assessment, the IMF has warned that Europe’s sovereign debt and banking crisis represents a “severe” risk for Asia. Its growth projection for Asia for this year has been sliced from 6.8% to a still creditable 6.3%. Furthermore, the IMF cautions that the difficulties being experienced by European banks are likely to result in further selling of Asian assets, a reduction in credit lines for Asian companies and a difficulty in rolling over maturing loans. Conscious that investors around the world have built up very substantial positions in Asia over the last few years, the IMF is concerned that a sudden fire-sale of assets in the region could trigger contagion in both the bond and equity markets and weaken local currencies. Last quarter, we witnessed a snapshot of how rapidly sentiment in the region can shift and how dramatic the impact on markets can be – the MSCI Asia Pacific index of stocks fell by 16%. Asian policy-makers face a subtle and very tricky dilemma: growth is clearly slowing but inflationary pressures are still evident and financial conditions are still relatively accommodating. Asia’s two large economic elephants, China and India, face the most complicated policy task, as their economies are overheating and monetary policy is still accommodative. Elsewhere in Asia, however, lower rates are likely. Should Europe’s contagion continue to infect the rest of the world, then the IMF is absolutely correct to warn that Asia is vulnerable.
The narrowing emerging rate gap. We highlighted yesterday the momentum that is growing for rate cuts in emerging markets and considering this further, we have created a proxy for emerging market rates by taking the top six (BRICs plus Mexico and South Korea) and weighting their policy rates by GDP shares, then doing the same for the G4 (UK, US, eurozone and Japan). The chart below shows the difference between these two series. The big widening we saw in 2008 was on the back of the lowering of rates in the G4, with the narrowing in 2009 on the back of cuts in emerging market rates. Since the middle of last year, the trend has been for higher rates in the emerging market space as central banks have tried to keep on top of rising inflationary pressures. So whilst Turkey, Brazil and Indonesia have eased rates over the past two months, there is plenty more scope to follow judging from the chart. Of course, we’re not going to get near to the levels that prevailed in mid-2007 when G4 rates (with the exception of Japan) were either neutral or slightly accommodative. However, there remains a chance that Mexico may ease rates today. Thereafter, the Brazilian central bank meets next week. There is probably less chance of an easing here, given the surprise move back in August. Nevertheless, with food prices having peaked and inflation in China likely having done the same, the scope for lower rates could well increase over coming weeks. The recent weakening of emerging market currencies, combined with the potential for lower policy rates, is going to further undermine carry trades. These have already underperformed massively in recent weeks, and even though we’ve seen some rebound this week in carry currencies, the potential for rate cuts is likely to deter investors from exploiting carry in the coming months.
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