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Citi Warns Risk FX Investors To Substantially Lower Their Optimism

Tyler Durden's picture


Citi's Stephen Englander, who has been quite bearish over the past several months, continue his series of "negative outlook" pieces on risk currencies with this morning's note "Why this sell-off in FX risk is different", in which he warns traders  "we are concerned about risk correlated currencies because we see different forces at play now than over the past two years. The casual assumption that monetary policy remains expansionary, and can ramp up if needed, is questionable -- no one argues that there is a shortage of liquidity. Fiscal policy is, to say the least, not what it used to be. Investor positions and we suspect pricing largely continue to reflect optimism, but this time the assumed policy response may be much more limited than in the last two years, and probably less effective." Naturally, what one can warn about risk FX pairs applies just as well to risk assets in general. And both are things we have been saying for months.

Full note:

Investors who cut positions in any of the sell-offs over the last two years have largely lost money. Policymakers have been pretty quick to respond to any signs of slowing -- ZIRP, QE1…QEn, liquidity facilities, CB buying of debt, TARP, accelerating reserves accumulation. Investors have by now come to expect that asset prices have only so much to fall before there is a policy response, so there is much less reluctance to pull the plug now than eighteen months ago, even when the data are very soft. This is as much the expectation with respect to EM policymakers as with respect to those in the US.

Our second observation is that we can not find evidence that investors have cut long risk positions nearly as much as casual conversation would suggest. Based on our evidence investors may be shorter risk, but certainly are not neutral, let alone short risk. Sounding pessimistic has become fashionable, but pessimism is more reflected in commentary than in positions as far as we can tell. (Figure 1. Type "ALLX CPAIN' on Bloomberg to get the latest readings on CitiFX PAIN. CitiFX PAIN is a joint product of Citi's QIS team and G10 FX Strategy to give an intuitive and market based approach to determining investor positions.) Given how often 'cry wolf' instances have emerged over the last two years, this skepticism on pullbacks is understandable, but we think it may be wrong.

We argue below that the resilience of risk-correlated currencies and asset markets is less now than has been the case over the least two years (and freely admit that this is a minority view both among colleagues and clients.).

First, consider that monetary policy was entirely unconstrained two years ago: 1) inflation was well below target; 2) the output gap was wide and widening; 3) the dollar was strong; 4) foreign investors and policymakers wanted the US to be expansionary. Central bankers may be worried in this type of world but there is nothing to inhibit the full-steam-ahead with respect to monetary policy.

Second, fiscal and monetary policy had room to expand and most of us thought the policy levers would be effective.

Third, commodity prices were low and not viewed as constraining growth Fourth, valuations were lower -- in August 2010, when QE2 was mooted, the S&P was in a 1050-1125 range, AUD was 0.88-0.92, the VIX was 22-27, oil was in a $7282/bbl range. Whether you are a fan of QE2 or not, it seems incumbent on optimists to explain what is better now that was not known then.

Fifth, in August 2010 positions were overwhelmingly short risk -- now they are not.

We would argue that this is the first pullback in which these positive forces are largely restrained. QE2 is popular neither among the public nor politicians. There is little discussion of 'escape velocity' now. Abroad CBs are tightening, not easing and inflation is well above target. EM countries remain more focused on both asset price and goods/services inflation than on growth. With few exceptions the room for fiscal expansion is limited, certainly as compared to what we saw in 2009. We would argue that these restraints should be given more attention since the policy response function has been a major driver of the asset market rebound in past.

We would also argue that two additional factors deserve consideration --

1) Commodity currencies and commodity prices may have been driven up in part by the FX market reaction to QE2. The first half of 2010, when the discussion was on exit strategies, saw stable commodity prices and stable commodity currencies. When QE2 came into the picture commodity prices rose sharply (Figure 2). Commodity prices and currencies may have shifted from reflecting expectations of global supply and derived demand for commodities for production purposes to supply and demand based on the role of commodities as a substitute for monetary assets. We see some of the demand for commodity currencies as having been driven in part by this USD demonetization phenomenon -- and there is no guarantee that the FX valuations and asset/commodity prices that emerge from this USD dumping will be appropriate from the point of view of producers. Many investors are arguing that lower commodity prices will stimulate growth -- it is possible that the lower commodity prices reflect the current headwinds to growth.

2) Monetary policy may be tighter than it seems from the viewpoint of non-commodity producers. Many producers can not pass on commodity prices in full, let alone widen profit margins. Nevertheless when they pass on commodity prices in part, both headline and core inflation can rise -- think of a bus company or taxi driver that raises fares. Even though their contribution to inflation is zero or negative, the  passed on commodity prices still lead to policy rate hikes.

Most CB's have not raised interest rates nearly as much as headline inflation has risen. This is viewed as reflecting a global monetary bias to being behind the curve on tightening, which will continue to support asset markets. Our EM colleagues have written on this and argued that the decline in commodity prices, if sustained for a couple of months, will lead to lower headline inflation and lower rates. We would argue in addition that from the perspective of a G10 or EM producer whose valued added is at best constant, and probably squeezed, these rate hikes represent a real tightening and affect production decisions. Consider that for a sample of non-commodity producing EM countries, the GDP deflator (which reflects domestic value-added inflation) is low and stable (Figure 3). It is hard to argue that monetary policy is expansionary from this perspective, and if that is the case, it is hard to argue that their growth will bail out global asset markets as was the case in 2009/2010.

In summary, we are concerned about risk correlated currencies because we see different forces at play now than over the past two years. The casual assumption that monetary policy remains expansionary, and can ramp up if needed, is questionable -- no one argues that there is a shortage of liquidity. Fiscal policy is, to say the least, not what it used to be. Investor positions and we suspect pricing largely continue to reflect optimism, but this time the assumed policy response may be much more limited than in the last two years, and probably less effective.


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Mon, 06/13/2011 - 07:26 | 1364294 Cassandra Syndrome
Cassandra Syndrome's picture

Or in corporate tradese, ease off the Charlie

Mon, 06/13/2011 - 07:29 | 1364297 Franken_Stein
Franken_Stein's picture


Goldman Sachs' head of global trends, John Obvious,  warns:

"In the evenings there is a heightened risk of gradually increasing darkness."


Kudos to GS, I've been pointing this out for years now, but nobody would listen !

Darn, I feel marginalized.


Mon, 06/13/2011 - 07:30 | 1364300 A Man without Q...
A Man without Qualities's picture

Maybe people no longer look at the likes of NOK and SEK as risk currencies.  Maybe they see the strength of these economies, and the high quality of their debt and compare it to the likes of USD and EUR and think it's safer there....  

Mon, 06/13/2011 - 08:17 | 1364374 SheepDog-One
SheepDog-One's picture

The salad days are apparently over.

Mon, 06/13/2011 - 08:41 | 1364422 Smiddywesson
Smiddywesson's picture

I agree with the article, but believe that Englander ignores the influence of hype.  All along, the market has ignored the failure of stimulus to stimulate any part of our economy other than equities and commodities.  Any additional stimulus will similarly fail to aid the economy, but I don't see any reason for it to not ramp equities based on hype.

That being said, I have to agree that stimulus this time may be more limited, more stealthy (therefore dampening the hype effect) and less likely to be joined in by our counterparts overseas.  However, Bernanke has no other option than stimulate, the debt is too large to tighten.

Bernanke has to play for time, but that game is delivering diminishing returns.

Mon, 06/13/2011 - 08:56 | 1364448 bugs_
bugs_'s picture

substantially lower their bonus expectations

Mon, 06/13/2011 - 11:38 | 1364883 sitenine
sitenine's picture

Main street would be well advised to do the same. Interesting stats on Gallop - says 63% polled believe the economy is getting worse, but 47% believe their standard of living is getting better. Enough said.

Mon, 06/13/2011 - 12:17 | 1364994 Mallenet
Mallenet's picture

I like pessimistic: it holds a ring of truth these days, no matter where you look to or from.  I have set my own path, which may or may not be the right one: but I can live with the outcomes, regardless of how bad it gets (I don't worry about the up side: only black holes can hurt me now - I think?)!  I may have over-cooked as I am set for Fiat to collapse (or at best rebase to zero + more promises = not much): which has destroyed my income potential and locked my capital up because I suspect I 'peaked' too early.

Reading commentary of this nature gives me a warmer feeling about my 'early exit' from life as we know it (Jim): until I think of relatives who are still doing what they have always done!  Only a couple of weeks ago a relative of mine proudly told me he has put his entire diversified portfolio with an adviser that is now consolidating all into a single mutual fund "that is guaranteed to out-perform the market"! Commission for adviser = 3% (face value): guarantee = worthless (face value).

I pointed to the obvious and was basically told to 'F off': that is the problem with 'main street' and 'Joe Sixpack' plus the most loved "Mom & Pop": they will trust the 'old way' more than common sense.  Doctors never make mistakes, bankers never cheat, politicians never lie!

We need salesmen of sense to be as good as salesmen of BS: then the world has a chance.  These rather technical briefs are OK for me, but totally wrong for the people that need to know: real people that are being hurt now by the same people that hurt them in 2007, 1998-2001, 1994, 1987, 1970's and beyond: marketeers dressed as financial advisers!

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