Citi On The Five FX Issues Waiting To Play Out

With equities sat the edge of an ugly-looking cliff and precious metals leaking lower, FX markets remain somewhat less shell-shocked (for now). Citi's Steve Englander provides a quick-and-dirty view of the five key issues FX investors are focusing on.


Via Steven Englander, Citi

1)     QE and markets.

So far winners are precious metals  (unlike QE1 and QE2), which makes you think that investors are looking for paper currency substitutes rather than cyclical assets. In Figure 1, we set all asset prices to 100 in mid-August, just before QE3 became a reality. The red line is silver, the grey is platinum and the light blue is gold. Dark blue is the S&P, green is the small G10 currencies against the USD, and violet is a basket of EM currency versus the USD.. My view -- QE will eventually spill into other asset markets, including a weaker dollar, but investors are reluctant to chase cyclical FX and other assets in Q4 without a clear signal of a bounce either in the US or EM. But even if the broader recovery in risk-correlated currencies is delayed a little, I would still prefer to be positioned to take advantage of the eventual pop.


Figure 1. Asset prices since QE3 became a real concrete possibility in mid-August

2)     Electoral politics and the fiscal cliff

The Presidential election was considered a done deal two weeks ago. Although Obama still has a comfortable lead, the resurgence of the Romney candidacy has raised the question of whether tightening of both fiscal and monetary policy is in the cards. So if Romney’s odds rise further, the perception that Romney will be more business friendly (and probably USD negative) will battle against the fear that premature policy tightening could slow US and global activity (and paradoxically raise the USD.) 


Few investors now expect the fiscal cliff to be an extended problem. The view is that either the fiscal cliff will be averted quickly after the election or, if not, very soon in 2013. There is almost nothing that is priced into asset markets. Any prospect that the fiscal cliff becomes a less benign event will be a jolt to asset markets – again paradoxically a USD positive, but a reflection of global asset market weakness.

3)     When to buy back into EM?

EM currencies and small G10 currencies are positively correlated with both risk appetite and commodity prices. Yet a wide gap has opened between EM and G10 currencies (Figure 2). In part  this reflects the role of AUD, CAD, SEK, NZD and NOK as safe havens. However, it also reflects tremendous pessimism that has shifted from the US and euro zone onto countries such as China, Brazil and other EM countries, even while pessimism with respect to the US and euro zone has diminished and policy has become more stimulative. tail. The question is when risk appetite will be strong enough to lead to re-investment in EM.and outweight the cyclical and structural concerns that investors now view as being so critical.


Figure 2. EM and small G10 currencies diverge

4)     The euro as a non-issue

It would have been hard to believe two months ago that the euro would be off page 1. EUR has been driven mainly by tail risk attached to disruptive default or euro zone breakup scenarios. Now the question is whether a trend can be established when both the US and EUR monetary policy authorities are to provide significant liquidity, baseline growth expectations are very modest, and underlying structural issues are unlikely to be resolved. The combination points to a 1.25-1.35 range trade more than a major trend. If anything, a bigger EUR upside is more likely to come from an unexpected strong upturn in China and EM that renews global risk appetite or Fed desire to accelerate growth beyond what seems on the cards now, than from an policy that the European authorities can put in place. 

5)     The return of the reserve managers

Reserve managers have not had much of a footprint in markets recently. Reserves growth has slowed sharply and the great diversification program appears to have come to an end. Nevertheless, if the Fed implements QE aggressively and the euro zone continues to be weighted down by debt and austerity, reserve managers in aggregate will have 85-90% of their reserves in currencies that private and public investors view as under suspicion. So as risk appetite is restored, their big overweight in structurally weak currencies means that any renewed diversification program will put significant upward pressure on small EM and G10 currencies.