"We are all FX traders these days" - that is what we said yesterday, and unfortunately courtesy of record risk correlations to the EURUSD persisting, this is what will likely be the case until the end of the year and into 2012. As such, fundamentals go out of the window, and the only thing that matters is beta and the various FX pairs, with the EURUSD by far the most critical. Which brings us to what Goldman believes will be the key highlights in FX trading until the end of the year in 9 convenient bullets. As a word of caution: few have ever made money being across the table from Goldman; usually it is much wiser to be axed the same way Goldman's flow desk is position, i.e., doing the opposite of what the firm advises its clients.
From Goldman Sachs: FX Themes Into Year End
- Risk correlations will likely remain high, at similar levels to what we have seen since 2007/2008. Broader macro shocks continue to dominate country-specific factors and most FX cross rates.
- Broad USD weakness to persist in the background, with the trade deficit averaging around US$45bn per month, private capital flows into the US (excluding foreign flows into treasuries and official flows into agencies, corporate bonds and equities) have averaged zero in recent months, underscoring the weak US balance of payments.
- Euro zone muddling along: Our view remains that a permanent solution to Euro-zone periphery tensions remains elusive, as Huw Pill has articulated in various publications recently (see, for example, European Views: The ECB and G-20 Meetings – Implications for Italy and the Euro Area Markets, November 6, 2011). This means that EUR/$ will likely remain subject to volatility from the fiscal risk premium and—more broadly—risk appetite will remain unsettled. Overall, however, we continue to think that the Euro-zone is remarkably balanced from an external point of view, and hence the depreciation and appreciation pressures should broadly offset each other. We project a broadly stable trade-weighted EUR over our forecasting horizon.
- Current account differentiation to persist. Given our expectation for continued macro uncertainty and financial market volatility into year-end, countries with current account deficits will likely find it difficult to attract sufficient capital inflows to stabilise their currencies. This strategy has been the most successful of our GS Current tradable indices since the beginning of the year, and has performed particularly well during the recent period of unsettled risk sentiment.
- EMEA currencies coming under more pressure: Within the EM universe, Eastern European currencies have among the weakest external balances and tend to be highly exposed to bank funding flows from the Euro zone into local bank subsidiaries. However, at the same time, many Euro-zone banking groups are subject to balance sheet pressure from tighter capital requirements and valuation losses on sovereign debt holdings. As a result, it is quite possible that funding flows into the EMEA subsidiaries will slow at a time when other investors also hesitate with more overseas investors, given the broader risk aversion. Among the CE3 countries, Hungary appears to be most at risk, as it has particularly large banking sector liabilities to foreigners—much larger than Poland, for example. Turkey is also at risk, mainly because of the continued large current account deficit.
- Cyclical dynamics: On our forecasts, the Euro zone is heading into a recession, as fiscal contraction will affect many countries, including Italy and France. We expect annual average growth in 2012 to be negative in Italy and Spain. Recent cyclical data have gone in the direction of supporting our forecast, with the manufacturing PMIs in Italy and Spain dropping off sharply in recent months, and Spanish unemployment and industrial production showing renewed weakness. Against the European growth slowdown, it is important to highlight the potential for Chinese credit easing on the back of declining inflationary pressures. This in turn will likely support commodity prices, all else equal.
- Safe haven FX: As we have flagged recently, the safe haven status of the USD has grown since the onset of the global financial crisis. This correlation has, at the margin, become even stronger since the authorities in Japan and Switzerland have started to intervene more aggressively.
- The US fiscal policy debate will likely flare up again, as the Super Committee is scheduled to report on a plan to bring US deficits and debt levels under control. Given the late-November deadline, the period into year-end could be dominated by this debate.
- Seasonalities into year-end: As we suggested in the last issue of our annual Foreign Exchange Market, there is a relatively clear seasonality pattern into year-end. European currencies tend to strengthen, in particular the Euro, relative to the USD.
Overall this means that the Dollar could strengthen temporarily on the back of rising risk aversion, in particular if European political dynamics develop as we expect, with a continued ‘muddling through’, and if growth slows as forecast. However, the current account and capital flow dynamics are powerful and any USD strength will most likely remain muted, similar to what we have seen during the year already.
The Dollar will more likely than not continue to weaken against Asian surplus countries. We expect periods of Dollar strength in Asia to be very short and these should be used as an opportunity to go long Asian FX. We currently recommend long positions in MYR and SGD.
Perhaps the most direct fallout from the ongoing European sovereign concerns has been for EMEA currencies such as the HUF, PLN and CZK. As explained above, these seem to be most at risk across EM. We currently recommend short positions in HUF against the RUB, which could potentially enjoy further support from rising oil prices.
For the time being, we also prefer beta-neutral ideas relative to those recommendations with large directional exposure to overall risk sentiment. The macro and political picture is too uncertain.
Things that would make us more comfortable to express directional views, mainly via short USD exposure, would be firm evidence of a reacceleration of growth in China and some form of solution to the European crisis—if only a temporary one. Even if equity markets were to stabilise—without a rally but with declining volatility—this would probably be enough to weaken push structural diversification flows out of the USD and into currencies with less structural imbalances.