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.
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.