Dollar Mixed as Risk Off Takes Hold

  • The uncertainty over the intentions of Chinese policy makers, and the opaqueness of the decision-making process, rightfully spooks investors who recall the contagion effect last August
  • The drop in oil prices is a significant and separate development
  • The Japanese yen continues to shine; we note that the yen buying has been particularly pronounced in the Asian session, with some consolidation often seen in North America
  • Mexico reports December CPI as USD/MXN makes new all-time highs; elsewhere in EM, the carnage continues

Price action: The dollar is mixed against the majors amidst strong risk-off trading. The yen is outperforming once again with dollar/yen making a new cycle low near 117.35 before bouncing slightly. This is the lowest level since August 24. The dollar bloc and sterling are underperforming. The euro has recovered to trade near $1.0850, while sterling is making new cycle lows near $1.4550. EM currencies are mostly weaker. The CEE currencies are outperforming while ZAR, MXN, and TRY are underperforming. The rand and the peso have traded at new all-time lows today against the dollar, and more EM currencies are expected to join them in the coming days. The PBOC fixed USD/CNY higher by the most since August, leading spot CNY to weaken to levels not seen since early 2011. MSCI Asia Pacific was down 2.1% on the day, with the Nikkei down 2.3%. MSCI EM is down 2.5%, with the Shanghai Composite down 7% and the Shenzen Composite down 8.2% after triggering the new -7% circuit breakers. Euro Stoxx 600 is down 3.2% near midday, while US futures are pointing to a lower open. The 10-year UST yield is down 3 bp at 2.14%, while European bond markets are mixed. Commodity prices are lower, with oil down 2% to new cycle lows and copper down 3% and nearing new cycle lows.

One might be forgiven for believing that nail-baiting start to the year is all China’s fault. It has repeatedly (for eight sessions) fixed the yuan lower, including earlier today, at a seemingly accelerating pace. The new equity market circuit breakers, introduced on Monday, appear to be adding to the volatility. Chinese share trading was stopped today after the first hour with the CSI 300 off 7%. It appears that the central bank through its agents intervened in the offshore (CNH) market.

The uncertainty over the intentions of Chinese policy makers, and the opaqueness of the decision-making process, rightfully spooks investors who recall the contagion effect last August. Note that China foreign reserves fell a greater than expected $108 bln in December to $3.33 trln, the lowest level since December 2012. Yet while the China effect is important, it is not the only disruptive force at work, weigh on risk appetites.

The drop in oil prices is a significant and separate development. While some may link the drop in oil prices to China, it is a bit of a stretch. It seems widely understood that the Chinese stock market is only loosely connected to the underlying economy. Recall the spectacular run-up in Chinese share prices in the first part of last year even as the economy slowed. Recall the dramatic stock market decline in Q3 15, when economic activity was little changed.

No, the drop in oil prices cannot be solely laid at the feet of Chinese policy makers. The tensions between Saudi Arabia and Iran make it even more difficult to envision a cut in OPEC output in the middle of the year. Although US oil inventories fell last week, according to the US Department of Energy, the glut was simply shifted to the products. Gasoline inventories, for example, surged by the most in more than two decades. Stocks of distillates, which include diesel and heating oil, rose by the most in nearly five years.

The US rig count is at a five year low, about a third of its peak in late 2014. Yet US output has continued to surprise in its resilience. Output rose to by 17k barrels a day last week, to 9.22 mln barrels a day. This is the most since August. OPEC output has been rising for two years and non-OPEC producers, such as Russia, are reporting strong output. This does not yet include the new Iranian output that is expected to exacerbate the glut when sanctions are anticipated to be lifted later this month.

The price of oil fell about 30% last year. It is off another 12% so far this year. In the first four days of 2014, it fell nearly 8.5%. Investors are anticipating a policy response. The drop in oil prices, more than China’s yuan and equity developments, have pushed the Canadian dollar to new multi-year lows and has sent the Norwegian krone to its weakest level against the euro since late-2014.

Sterling has been sold to new six-year lows today. The drop in oil prices, in the context of mostly disappointing UK data, reinforces ideas that the Bank of England will be unable to raise rates until much later in the year, at the earliest. To explain the heaviness of sterling, many observers are trying to make connections with the EU referendum later this year. We are not convinced that sterling would be trading much differently if there would be no referendum.

Consider this. From early 2013 through Q3 2015, sterling appreciated almost 22% on the Bank of England’s broad trade-weighted index. The decline in sterling over the past 4-5 months has seen the trade-weighted index ease by around 4.5%. This is to say, sterling’s weakness against the dollar masks its still-elevated levels on a trade-weighted basis.

The price of oil has fallen by a little more than a quarter since the ECB met in early December. The ECB’s staff forecast, which saw only minor adjustments from last June’s iteration, did not anticipate such a decline. While it is too early to draw any hard conclusions, one can only assume that those forecasts will be adjusted in March to the downside.

After holding Tuesday’s low (~$1.0710) yesterday, the euro recovered to almost $1.08, and extended those gains another 3/4 of a cent today. Unwinding positions, such as selling European shares and buying back short euro hedges, may account for the euro’s firmer tone.   At the same time, the euro-sensitive two-year swap rates between the US and Germany has edged lower from 142 bp on December 29 to 134 bp today, the lowest since Christmas Eve.

The Fed’s Vice Chairman Fischer reiterated yesterday that four rate hikes this year was still “in the ball park” but this failed to impress investors. His comments were understood to show that the Fed was not panicking over the tumultuous start to the year. Some saw the FOMC minutes as dovish in that they talked about the need to actual inflation to increase. The strength of the ADP estimate, which if anything reduces the risks of a significant disappointment with tomorrow’s national figures, also failed to sway the market. The market appears to be more comfortable anticipating two rate hikes this year, not the four that Fed’s dot-plots indicated.

Lastly, the Japanese yen continues to shine. The dollar has been sold through JPY118, triggering stops and optionality on the way, to almost JPY117.30. It is the lowest level for the dollar since August 24 when it approached JPY116.20. The yen is up 2.2% this week against the dollar and 2.4% against the euro. The yen’s strength has yet to draw a response from Japanese policy makers, but some response would not be surprising. The yen’s strength (nearly 5% on a trade-weighted basis over the past month), if sustained, will hamper efforts to boost inflation.

We note that the yen buying has been particularly pronounced in the Asian session, with some consolidation often seen in North America. The intra-day technical warn that the pattern may continue today. The JPY118 level may acts as resistance now.

Mexico reports December CPI, and is expected to rise 2.10% y/y vs. 2.21% in November. This would be another record low, and further below the 3% target as well as nearing the lower bound of the 2-4% target range. The next policy meeting is February 4, and no change is expected then. Banxico officials have suggested that they will be largely taking their cue from the Fed, which is not expected to hike again until the March 16 meeting. The weak peso could complicate things, however, with USD/MXN taking another leg higher to another all-time high near 17.70 today. For now, there’s been little inflation pass-through from the weak peso but the central bank will likely remain very concerned.

Elsewhere in EM, the carnage continues. USD/ZAR made a new all-time high above 16.20 before stabilizing a bit. The rand has now completely given up its post-Gordhan relief rally, and is set to continue weakening further. USD/TRY is moving further above 3 and is on track to test its all-time high near 3.0750 from September. USD/RUB is making new cycle highs above 76, and the all-time high near 79 is within sight. With copper down 3% today, we expect USD/CLP to make a new cycle high above 718 when markets open, and the all-time high from 2002 near 760 is within sight. USD/BRL has lagged a bit in recent days, but some catch-up weakness is likely after weaker than expected IP data today (-12.4% y/y) and we expect the pair to test and move beyond the all-time high near 4.25 in the coming days.

Emerging Asia has held up relatively well, but many currencies are still trading at multi-year lows against the dollar. These include CNY, SGD, and TWD, but others are expected to join this club soon.

One major exception here has been the Czech koruna, where EUR/CZK continues to trade firm near the 27 floor against the euro since November. This has necessitated central bank intervention, as the $2.5 bln gain in foreign reserves last month suggests. The $64.8 bln total is the highest on record. Note that a senior official said that the koruna cap exit is becoming more likely in early 2017. Current forward guidance is until “at least” H2 2016, and so this is a bit of a dovish shift.