FX positioning ahead of the September FOMC meeting

As of today, most market participants are getting prepared [and positioned] for the FOMC meeting on September 20/21st in order to see if policymakers stick with their Jackson-Hole hints, therefore I think it is a good time to share my current FX positioning.

Fed’s meeting: hike or no-hike?

I think that one important point investors were trying to figure out the last Jackson Hole Summit last week was to know if US policymakers were considering starting [again] their monetary policy tightening cycle after a [almost] 1-year halt. If we look at the FedWatch Tool available in CME Group website, the probability of a 25bps rate hike in September stands now at 18% based on a 30-day Fed Fund futures price of 99.58 (current contract October 2016, implied rate is 42bps).

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(Source: CME Group)

In addition, if we look at the Eurodollar futures market, the December Contract trades at 99.08, meaning the market is pricing a 1% US Dollar rate by the end of the year. We can clearly notice that the market expects some action coming from US policymakers within the next few months. However, recent macroeconomic data have shown signs of deterioration in the US that could potentially put the rate hike on hold for another few months. Following last week disappointing manufacturing ISM data that came out at 49.4 below its expansion level (50), ISM Service dropped to 51.4, its lowest number since February 2010 and has been dramatically declining since mid-2015. I strongly believe that there are both important indicators to watch, especially when they are flirting with the expansion/recession 50-level. We can see in the chart below that the ISM manufacturing PMI (white line) tracks really ‘well’ the US Real GDP (Annual YoY, yellow line), and as equity markets tend to do poorly in periods of recession we can say that the ISM Manufacturing / Services can potentially predict sharp drawdowns in equities.

Chart 1. ISM – blue and white – and Real US GDP Annual YoY – yellow line (Source: Bloomberg)

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Another disappointment came from the Job market with Non-Farm Payrolls dropping back below the 200K level (it came out at 151K for August vs. 180K expected) and slower earnings growth (average hourly earnings increased by 2.4% YoY in August, lower than the previous month’s annual pace of 2.7%).

This accumulation of poor macro figures halted the US Dollar gains we saw during the J-Hole Summit and it seems that the market is starting to become more reluctant to a rate hike in September. The Dollar Index (DXY) is trading back below 95 and the 10-year rate is on its way to hit its mid-August 1.50% support (currently trades at 1.54%). What is interesting to analyse is which currency will benefit most from this new Dollar Weakness episode.

FX positioning

USDJPY: After hitting a high of 104.32 on Friday, the pair is once again poised to retest its 100 psychological support in the next few days. This is clearly a nightmare for Abe and Kuroda as the Yen has strengthen by almost 20% since its high last June (125.85). If we have a look at the chart below, the trend looks clearly bearish at the moment and longs should consider putting a tight top at 105. I would stay short USDJPY as I don’t see any aggressive response from the BoJ until the next MP meeting on September 21st.

Chart 2. USDJPY candlesticks (Source: Bloomberg)

USDJPY.JPG

EURUSD: Another interesting move today is the EURUSD 100-SMA break out, the pair is currently trading at 1.1240 and remains on its one-year range 1.05 – 1.15. As a few articles pointed out recently, the ECB has been active in the market since March 2015 and has purchased over 1 trillion government and corporate bonds. The balance sheet total assets now totals 3.3 trillion Euros (versus 4 trillion EUR for the Fed), an indicator to watch as further easing announced by Draghi will tend to weigh on the Euro in the long run. The ECB meets in Frankfurt on Thursday and the market expect an extension of the asset purchases beyond March 2017 (by 6 to 9 months). I don’t see a further rate cut (to -0.5%) or a boost in the asset purchase program for the moment, therefore I don’t think we will see a lot of volatility in the coming days. I wouldn’t take an important position in the Euro, however I can see EURUSD trading above 1.13 by Thursday noon.

Chart 3. EURUSD and Fibonacci retracements (Source: Bloomberg)

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Another important factor EU policymakers will have to deal with in the future is lower growth and inflation expectations. The 2017 GDP growth expectation decreased to 1.20% (vs. 1.70% in the beginning of the year) and the 5y/5y forward inflation expectation rate is still far below the 2-percent target (it stands currently at 1.66% according to FRED).

Sterling Pound: New Trend, New Friend? The currency that raised traders’ interest over the past couple of weeks has been the British pound as it was considered oversold according to many market participants. Cable is up 5% since its August low (1.2866) and is approaching its 1.35 resistance. I would try to short some as I think many traders will try to lock in their profit soon which could slow down the Pound appetite in the next few days. If 1.35 doesn’t hold, then it may be interesting to play to break out with a new target at 1.3600.

Chart 4. GBPUSD and its 1.35 resistance (Source: Bloomberg)

GBP.JPG

I would short some (GBPUSD) with a tight stop loss at 1.3520 and a target at 1.3350. No action expected from the BoE on September 15th, Carney is giving the UK markets some ‘digestion’ time after the recent action (rate cut + QE).

USDCHF: For the Swissie, my analysis stands close to the Yen’s one, and therefore I think the Swiss Franc strength could continue in the coming days. I like 0.96 as a first ‘shy’ target, and I would look at the 0.9550 level if the situation remains similar (poor macro and quiet vol) in the short term.

AUDUSD: Australia, as many other commodity countries (Canada, New Zealand), remains in a difficult situation as the deterioration of the terms of trade will tend to force RBA policymakers to move towards a ZIRP policy. However, lower rates will continue to inflate housing prices, which continue to grow at a two-digit rate. According to CoreLogic, house prices averaged 10-percent growth over the past year, with Sydney and Melbourne up 13% and 13.9%, respectively. Australian citizens are now leverage more than ever; the Household debt-to-GDP increased from 70% in the beginning of the century to 125% in Q4 2015 (see chart below). This is clearly unsustainable over the long-run, which obviously deprives policymakers to lower rates too ‘quickly’ to counter disinflation. As expected, the RBA left its cash rate steady at 1.50% today, which will play in favor of the Aussie in the next couple of weeks. One interesting point as well is that the Aussie didn’t react to an interest rate cut on August 2nd, something that Governor Glenn Stevens will have to study in case policymakers want to weaken the currency. There is still room on the upside for AUDUSD, first level stands at 0.7750.

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(Source: Trading Economics)

Chinese Yuan: The Renminbi has been pretty shy over the past two month, USDCNH has been ranging between 6.62 and 6.72. The onshore – offshore spread is now close to zero as you can see it on the chart below (chart on the bottom). I don’t see any volatility rising in the next few weeks, therefore I wouldn’t build a position in that particular currency.

Chart 5. CNY – CNH spread analysis (Source: Bloomberg)

CNH spread.JPG

 To conclude, I think that we are going to see further dollar weakness ahead of the FOMC September meeting as practitioners will start to [re]consider a rate hike this time, especially if fundamentals keep being poor in the near future.

Eyes on Yellen (and global macro)

As we are getting close to the FOMC statement release, I was reading some articles over the past couple of days to understand the recent spike in volatility. Whether it is coming from a ‘Brexit’ fear scenario, widening spreads between core and peripheral countries in the Eurozone (German 10Y Bund now trading negative at -0.5bps), disappointing news coming from US policymakers this evening or more probably from something that I don’t know, I came across some interesting data.

First of all, I would like to introduce an indicator that is getting more and more popular these days: Goldman’s Current Activity Indicator (CAI). This indicator gives a more accurate reflection of the nation’s GDP and can be used in near real-time due to its intra-month updates. It incorporates 56 indicators, and showed a 1-percent drop in May to 1.2% due to poor figures in the labor market and ISM manufacturing data (see chart below).

Chart 1. Goldman CAI (Source: Bloomberg)

GoldCAI.png

The implied probability of a rate hike tonight is less than 2% according to the CME Group FedWatch, and stands only at 22.5% for the July meeting. If we have a look at the Fed Dot Plot’s function in Bloomberg, we can see that the implied FF rates curve has decreased (purple line) compare to where it was after the last FOMC meeting (red line), meaning that the market is very reluctant to a rate hike in the US.

Chart 2. US Feds Dot Plot vs. Implied FF rates (Source: Bloomberg)

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June hike, why not?

Many people have tried to convince me of a ‘no June hike’ scenario, however I try to understand why it isn’t a good moment for Yellen to tighten. Oil (WTI CL1) recovered sharply from its mid-February lows ($26/bbl) and now trades slightly below $48 (decreasing the default rate of the US high-yield companies), the US Dollar has been very quiet over the past 18 months (therefore not hurting the US companies’ earnings), the SP500 index is still trading above 2000, the unemployment rate stands at 4.7% (at Full employment) and the Core CPI index came in at 2.1% YoY in April.

However, it seems that US policymakers may have some other issues in mind: is it Eurozone and its collapsing banking sector, Brexit fear (i.e. no action until the referendum is released), CNY series of devaluation or Japanese sluggish market (i.e. JPY strength)?

The negative yield storm

According to a Fitch analysis, the amount of global sovereign debt trading with negative yields surpassed 10tr USD in May, with now the German 10Y Bund trading at -0.5%bps. According to DB research (see chart below), the German 10Y yield is the ‘simple indicator of a broken financial system’ and joins the pessimism in the banks’ strategy department. It seems that there has never been so much pessimism concerning the market’s outlook (12 months) coming from the sell-side research; do the sell-side firms now agree with the smart money managers (Carl Icahn, Stan Druckenmiller, Geroge Soros..)?

Chart 3. German 10Y Bund yield (Source: DB)

10Y bund DB.jpg

ECB Bazooka

In addition, thanks to the ECB’s QE (and CSPP program), there are 16% of Europe’s IG Corporate Bonds’ yield trading in negative territory, which represents roughly 440bn Euros out of the outstanding 2.8tr Euros according to Tradeweb data. If this situation remains, sovereign bonds will trade even more negative in the coming months, bringing more investors in the US where the 10Y stands at 1.61% and the 30Y at 2.40%. If we look at the yield curve, we can see that the curve flattened over the past year can investors could expect potentially LT US rates to decrease to lower levels if the extreme MP divergence continues, which can increase the value of Gold to 1,300 USD per ounce.

Chart 4. US Yield Curve (Flattened over the past year)

USIYC.png

(Source: Bloomberg)

Poor European equities (and Banks)

However, it seems that the situation is still very poor for European equities, Eurostoxx 50 is down almost 10% since the beginning of June, led by the big banks trading at record lows (Deutsche Bank at €13.3 a share, Credit Suisse at €11.70 a share). The situation is clearly concerning when it comes to banks in Europe, and until we haven’t restructured and/or deleveraged these banks, systemic risk will endure, leaving equities flat (despite 80bn Euros of money printing each month). Maybe Yellen is concerned about the European banks?

Brexit?

Another issue that could explain a status quo tonight could be the rising fear of a Brexit scenario. According to the Brexit poll tracker, leave has gained ground over the closing stages, (with 47% of polls for ‘Brexit’ vs. 44% for ‘Bremain’). This new development sent back the pound to 1.41 against the US Dollar, and we could potentially see further Cable weakness toward 1.40 in the coming days ahead of the results. Many people see a Brexit scenario very probable, raising the financial and contagions risks and the longer-term impact on global growth. It didn’t stop the 10Y UK Gilt yield to crater (now trading at 1.12%, vs. 1.6% in May), however a Brexit surprise could continue to send the 5Y CDS to new highs (see below).

Figure 1.  FT’s Brexit poll tracker (Source: Financial Times)

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Chart 5. UK 5Y CDS (Source: Bloomberg)

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CNY devaluation: a problem for US policymakers?

Eventually, another problem is the CNY devaluation we saw since the beginning of April. The Chinese Yuan now stands now at its highest level since February 2011 against the greenback (USDCNY trading at around 6.60). I am sure the Fed won’t mention it in its FOMC statement, but this could also be a reason for not tightening tonight.

Conclusion: a rate hike is still possible tonight

To conclude, I am a bit skeptical why the market is so reluctant for a rate hike this evening, and I still think there is a chance of a 25bps hike based on the current market situation. I don’t believe that a the terrible NFP print (38K in May) could change the US policymakers’ decision. Moreover, even though we saw a bit of volatility in the past week (VIX spiked to 22 yesterday), equities are still trading well above 2,000 (SP500 trading at 2,082 at the moment) and the market may not be in the same situation in July or September.

Quick review of the Chinese Yuan history

Back in November 2014, I wrote a quick summary of my favorite currency: the Japanese Yen. It was a very useful exercise for me first of all, and I hope it provided interesting information for my readers.

I think this time an interesting story of a particular currency that I tend to watch every morning is the Chinese Yuan or ‘Renminbi’. The difference between the two names: the Yuan is the name of a unit of the renminbi currency (i.e. you can say that a slice of pizza cost 10 Yuan, but not 10 renminbi.

The ‘Dark’ Beginnings… 

The Renminbi, which literately means ‘people’s money’, is the official currency of the People’s Republic of China (PRC). It was first issued on December 1st, 1948 by the PBoC, Public’s Bank of China, the country’s central bank. The bank was established on the same date under the Chinese Communist Party ruled by the Chairman Mao Zedong (also known as the founding father of the PRC). China experienced a massive monetary inflation between 1937 and 1945 (end of WWII) in order to fund the war with Japan. Studies showed that between 70 and 80 percent of the annual expenditures were covered by fresh printed money during that period. Therefore, the country suffered from a Great Inflation in the same years that was reflected on the exchange rate. Here are some figures (coming from the work of Richard M. Ebeling, the Great Chinese Inflation, 2010):

  • In June 1937, one US dollar was traded at 3.41 against the Yuan
  • By December 1961, the exchange rate of USDCNY rose to 18.93 in the black market
  • At the end of WWII, the Yuan depreciated dramatically to 1,222 (vs. the greenback)
  • In May 1949, USDCNY reached a dramatic 23,280,000

In the 1950s, the Chinese economy was so cut off from the rest of the world that it is difficult to find data on a potential meaningful exchange rate. All the information I have so far is that a second issuance of Renminbi took place in 1955 and replaced the first one at a rate of one new CNY to 10,000 old CNY.

The World Bank published an annual average middle exchange rate for US Dollar to Chinese Yuan since 1960. Between 1960 and 1971, one US dollar was worth 2.4618 Chinese Yuan, which makes me believe that China was ‘also part of’ the Bretton Woods agreements (I am speculating on that information based on the ‘pegged’ exchange rate). Then, after the Nixon ‘shock’, the exchange rate started to depreciate and reached a low of 1.8578 in 1977 before starting to soar to 2.40 in 1980.

The 1980s reform and RMB Devaluation:

With China’s economic reform in the 1980s, the Yuan started to become a more easily traded currency (exchange rate was therefore more realistic), thus data became public. The following historical exchange rates are based on Bloomberg (ticker: CNY BGN Curncy).

Starting with a grossly overvalued exchange rate in 1980, the Chinese Yuan experience a series of devaluation until the late 1990s until the Chinese authority settled the rate 8.27 CNY/USD.

As you can see it on chart 1, the rise of the US Dollar under the Reagan Administration (as a consequence of the Fed rising interest rate to 20% to counter inflation coming from the second oil shock) pushed the USDCNY exchange rate  from 1.65 to roughly 3.00 in September 1985 (before the Plaza Accord on September 22nd). In contrast, the real exchange rate was more much stable and remained virtually constant between 1981 and 1985 (during this period, the Renminbi was pegged to a back a basket of internationally traded currencies weighted according to their importance of China’s trade).

Between 1987 and the end of 1990, the Chinese Yuan was relatively pegged to the US Dollar, with a 26% Yuan devaluation that took place in the last quarter of 1989. However, these devaluations were not sufficient with the emergence of a black market pricing a much higher USDCNY exchange rate (i.e. cheaper Yuan currency against the US Dollar). Therefore, the ‘unofficial’ floating rate (a swap market rate) has constantly driven the ‘official’ rate (nominal rate on chart 1) until the massive devaluation of 1994 (and the official and ‘unofficial’ rates were eventually unified).

1995: The start of a new regime

One the two rates were unified, the Chinese currency was pegged to the US Dollar from 1995 to 2005 at an exchange rate of 8.28 Yuan per US Dollar. Therefore, the PBoC was ready to intervene (i.e. buy or sell Yuan) in the market to keep that rate steady. This policy was combined with a policy of restricting international capital flows, where the citizens were not allowed to convert savings into US dollars, Japanese Yen or British pound.

In consequence, the low exchange rate lead to political issues between US and China as many studies concluded that the Chinese Yuan was an undervalued currency. Exports were growing dramatically in China (see appendix 1), from 160 million US dollars in 1995 to 600 million dollars in 2005 according to the General Administration of Customs. The economic modernization, cheap labour costs in addition to a more ‘transparent’ exchange rate led to a surge in Foreign Direct Investment during the 1990s and 2000s. The economy average an average annual growth rate of 9-10% between 1995 and 2005 (appendix 2).

China’s economic growth and trade liberalization led to a sharp expansion in US/China commercial ties, and a constantly increasing US trade deficit with China. If we look at table 1, the US trade balance deficit widened from USD 10.4bn to USD 201.6bn in 2005, damaging the US economy. There are many reasons why China could have resisted from international pressures to maintain it peg during that period, but the two main ones that come to my mind is that China was mostly financing the US deficit (i.e. purchasing US Treasuries) and the US manufacturing was benefiting from cheap labour costs for goods produced in China.

The 2005 peg removal

Eventually, the PBoC removed the peg on July 21st 2005 and allowed a first one time appreciation of 2.1%, pushing the dollar down to 8.11 CNY. From there, China allowed its currency to float within a range determined in a relation to a basket of currencies (authorities told the world that it ran a ‘managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies’). The basked was dominated by its main trading partners – US Dollar, Euro, Japanese Yen and South Korean Won – with a smaller proportion of other currencies (GBP, AUD, RUB, CAD, THB and SGD). Until Q3 2008, USDCNY fell roughly 18% before the reintroduction of a de facto peg during the financial crisis from 2008 to mid-2010 at around 6.80 Yuan per dollar.

June 2010: A return to the daily trading band limit:

In June 2010, after a two-year peg, China allowed once again USDCNY to trade within a 0.5% band (daily limit for appreciation or depreciation of the CNY against the USD) amidst major pressure from international trade partners. The Yuan’s trading band was then widened to 1 percent in April 2012, which led to further appreciation of CNY (USDCNY fell another 11.60% to reach a low of 6.01 in January 2014).

The Yuan crisis in Q1 2014

In the start of 2014, we saw a little Yuan crisis with USDCNY erasing most of its Jun-2012 / Jan-2014 fall (62% roughly if we look at chart 2). There are many stories that could describe this sudden CNY collapse:

  • the PBoC willingness to join the global currency war and enhance export
  • the carry trade unwinds from structured products build on the hypothesis that the Yuan will appreciate continuously (FX Target Redemption Forward story for instance)
  • other thought that the PBoC was paving ‘the way for further liberalization of the Yuan exchange rate’

I think the carry trade unwinds is the most appropriate based on the one-way market positioning concerning the Yuan before that crisis. Products were structured by banks on the hypothesis that the Chinese Yuan will constantly rise against the USD until it eventually reached its ‘fair value’ which was estimated between 5 and 5.5 at that time (BEER, FEER fair value models). We know that carry trade currencies tend to depreciate gradually during some period so that carry traders could benefit from the interest rate differentials, however the risk-off aversion (i.e. carry unwind) is sudden and very drastic.

In mid-March 2014, the PBoC widened the range to 2 percent (allowing the exchange rate to rise or fall 2 percent from a daily midpoint rate that the central bank sets each morning). Until the August 11 devaluation that occurred the following year, the Chinese Yuan oscillated at around 6.20 against the Dollar.

August Devaluation

On August 11th, the PBoC suddenly allowed the Yuan to depreciate by nearly 2% against the USD, its largest devaluation in the past two decades amid slower economic growth and a depressed highly-volatile stock market. As you can see it on Chart 3, the Shanghai Shenzhen Index (CSI 300) started to enter into a bear market in June 2015 after it reached a high of 5,380. In the beginning of August 2015, the market was almost down 2,000 pts. and the fear of a ‘Chinese bubble collapse’ raised concerns over global investors. A second PBoC move was done the consecutive day and pushed the total devaluation to nearly 4 percent (from 6.21 to 6.44 USDCNY, see chart 4).

Watch the CNY – CNH spread

As China has been opening up its economy to the RoW (Rest of the World) since the late 2000s, the officials’ goal was to internationalize its currency to the market to settle trade and financial transactions. As you know, the CNY – or on-shore Yuan – is not allowed outside of China and is only convertible in the current account (i.e. trade) and not in the capital account (i.e. for investments and banking flows). Thus was born the CNH in 2009 – offshore Renminbi – which circulates in offshore markets such as Hong Kong (China Mainland Hub). Since then, there has been a rapid expansion of offshore clearing centres in financial cities like London or Frankfurt and the RMB has begun direct currency trading against the Euro, GBP, NZD in addition to USD, JPY or AUD.

The important criteria of the CNH is that it is allowed to float freely with no restrictions on cross border trade settlements, therefore I usually like to watch the CNY – CNH spread just to see the divergence sometimes that happens in the market (See chart 5). In the beginning of the year 2016, we saw a massive divergence between USDCNY and USDCNH, with the offshore Yuan (CNH) was depreciating at a much faster pace than the on-shore Yuan (CNY). On January 6th, the spread reached 14 figures, with USDCNY trading at 6.55 and USDCNH at 6.69. Eventually, the situation stabilized and the two exchange rates converged.

I think that by looking at the spread between the two rates, you can gauge the market’s perception toward the currency and its confidence in the PBoC’s policies.

Will the Yuan continue to weaken in the near term?

It has been a few years now that a group of investors have been watching closely China, especially its highly-leverage banking system. Over the past decade, China has expanded its credit market from 5tr USD to 35 trillion USD; for an economy of roughly 10tr USD, the banks’ total-assets-to-GDP ratio stands at 350%. China is massively exposed to the housing market, which represents roughly 15 percent of the country’s GDP (it was 5% in the US before GFC). Therefore, if the housing market halts or starts to decline (which it has already according to some housing market index), the country could be exposed to a non-performing loans cycle and therefore would be forced to recap its banking system, pushing the PBoC to increase its balance sheet. As China doesn’t offer short positions in equities (not very common from my knowledge) and no structured products or derivatives to short the housing market, people are positioned in the currency, expecting a ten to twenty percent depreciation. This scenario could bring the currency USDCNH somewhere between 7 and 8.

Chart 1. Historical USDCNY exchange rates (Source: Bloomberg)

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Chart 2. The 2014 USDCNY ‘crisis’ (Source: Bloomberg)

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Chart 3. CSI 300 Index (Source: Bloomberg)

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Chart 4. China CNY devaluation – August 11th

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Chart 5. CNY – CNH spread (Source: Bloomberg)

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Appendix 1. Exports (Source: Trading Economics)

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Appendix 2. Growth (Source: Trading Economics)

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Table 1. US trade with China (US ITCD)

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Gold: how far can the current trend go?

Since the beginning of the year, the commodity market has been regaining strength, and especially gold that has been up 23% since its mid-December low (slightly below 1,050 USD/ounce). As you can see it on the chart below, the recent spike in commodities can be explained by the dollar weakness we have seen over the past five months (DXY index in yellow line inverted vs. Gold in candlesticks). However, I am still convinced that Gold could continue to act as the ‘currency of the last resort’ (i.e. an insurance against the confidence on the monetary system) even if the US dollar is set to appreciate in the long term.

GoldUSD

(Source: Bloomberg)

As gold is traded primarily in dollars, many studies have showed that a weaker dollar makes gold cheaper and increases the demand for gold, which in the end pushes the price of the commodity higher. Therefore, Gold and US dollar should be negatively correlated. If we use HS spread analysis function in Bloomberg, we can see that the 1-month (20 Business days) correlation between Gold and DXY index (using the US Dollar index as a proxy of the dollar even if it’s mainly weighed in Euros, pounds and Yen) has been negative for most of the time over the past five years. However, this correlation can sometimes break down and turn positive for a small period of time.

GoldHSDXY

(Source: Bloomberg)

The question now that I am asking myself is to know the positive correlation between US dollar and Gold can last longer than just a week or two.

The reason why I think Gold is set to appreciate in the long term is coming from a long fat tail risk list that gets very concerning. In it, we could find the following events:

  • Japanese crisis in the bond market
  • Banking crisis in China coming from a rise in NPLs and a housing market collapse
  • Corporate default rates soaring in the US high-yield market
  • European Banking crisis

If one of those ‘black swan’ events rises in terms of probability, we would then see a sort risk-aversion environment with more demand for safe haven assets, such as US Treasuries or US Dollars. At the moment, the 10-year and 30-year Treasury yields both trade at 1.74% and 2.57% respectively, and a sudden risk-off sentiment could push LT US yields close to zero.

Academic studies have shown that there exists a cointegrating relation between gold and US real interest rates. If we stick with the assumption that inflation will remain low (i.e. close to zero) in the medium term (2-year period) based on the market’s expectation and that Treasury yields start to crater ‘once again’, an interest for gold could be a good alternative.

Tactical view on XAUUSD

Based on the chart below, it looks like the 50 SMA (purple line) has been acting as a strong support, however the momentum could continue in the future. The next psychological level stands at 1,300 on the upside, any break out could lead towards 1,325 then 1,350. On the downside, I see a strong support zone between 1,220 and 1,250 and could be a good entry point for a long term investment. The risk is if the US Dollar starts to appreciate to quickly based on this week’s FOMC ‘hawkish’ minutes with the market now starting to price at least a couple of rate hikes for 2016. For those looking for a more ST investment, a good psychological support on the downside to set up your stop stands below 1,200.

TechAnalysisGold

(Source: Bloomberg)

Brazil, on the menu of the next FOMC meetings?

With the VIX index trading 10 points lower at 17.08 and a very rangy USDJPY (trading sideways at around 120), I believe there isn’t any new outstanding topic to talk about, therefore I decided that a little article on Brazil could do it ahead of this new week.

Brazil’s summary on a chart

I would like to start this review by first commenting the chart below, representing the key elements that I usually like to watch. As you can see, the SELIC (Blue/White line), Brazil’s central bank (CBB) target rate, stands now at a 9-year high of 14.25%. Since the end of 2012, CBB policymakers have started a tightening cycle and has been forced to maintain it especially over the past 12 months as the currency – Brazilian Real – is collapsing. The real (yellow line) has depreciated by 56% in one year and now trades at 3.76 against the greenback. Looking at the range over the past 9 years, it reached a low of 1.5360 in July 2011 and a high of 4.2480, which represents a 178% devaluation. This aggressive depreciation of the currency has led to inflationary pressures (CPI YoY – green line – printed at 9.5% in September) and the CDS spread 5 year rose from 126bps to 418bps (with a high of 545bps in the end of September).

BrazilSummaryC

(Source: Bloomberg)

Brazil’s dollar-denominated debt…

Clearly, the central bank has been constantly intervening in order to calm investors’ fear of a potential default. Based on a study from the Bank of International Settlement (Working Paper No 483), dollar borrowings in Brazil has reached more than 300 billion dollars (with giant Petrobras holding one third of the shares). Holding a dollar-denominated debt (Loans, debt securities or offshore issuance) means basically that you are short US Dollar. Therefore, if the Brazilian Real keeps depreciating against the US Dollar over the long-term, all these non-financial Brazilian companies will have difficulty in meeting their debt obligations. For instance, the chart below shows the consequence on a Brazilian Company – Petrobras – that holds almost USD100bn of US-denominated debt. Its 5-year CDS spread (White Line) more than doubled over the past 6 months from 390 to 830 bps (with a high of 1025bps in the end of September), the equity price (Yellow line) almost decreased by half of its value and the company’s perpetual 2115 bonds are now trading at 71 cents on the par.

PetrosSitC

(Source: Bloomberg)

Brazil’s fiscal situation

As we are looking at the country’s financial stability, let’s review how the government is handling its budget. Brazil has an on-balance-sheet debt-to-GDP ratio of roughly 65% (as of July 2015), which has been constantly rising over the past 5 years due to the end of the commodity super-cycle. Based on article from the The Economist, the country’s budget deficit was projected to grow to 9% of GDP in 2015, with interest payments reaching an outstanding 8% (as a share of GDP). Higher short term rates to protect the currency and higher long term rates as investors lose confidence on the country’s sustainability, this situation can only deteriorate in my opinion.

BrazilInterestPayment

(Source: The Economist)

Its projected 2.3% contraction for this year (Brazil has now printed two quarters of negative growth QoQ, -0.7% in Q1 and -1.9% in Q2) has ‘forced’ rating agencies to downgrade its credit rating to junk status (S&P reduced it to BB+ with negative outlook last September). As you understand, the country has now entered in the so-called ‘negative spiral’, which usually leads to a long recessionary period. Economist are already projecting a zero-growth for the year 2016, and this is assuming the country’s institutions respect their debt obligations.

Political instability: Congress and Rousseff divergence

On the top of the current catastrophic situation for this used-to-be prosperous EM country, Brazil faces a political turmoil. President Dilma Rousseff currently faces many enemies in Congress (i.e. Congress blocking budget proposals) which can only worsen the country’s financial stability . For instance, her plan to reinstate a tax on financial transactions last month (38bps levy, known as CPMF) which could have raised 70bn Reals a year in revenue was eventually withdrawn as Congress would never have approved it. We saw on Wednesday that Congress postponed for a fourth time voting on whether to overrule President Rousseff’s vetoes on extra spending. The bills she vetoed would increase public spending by over 100bn real over the next four years. The central bank recorded a primary fiscal result (government budget balance before interest payments of 0.75% of GDP in August, therefore cannot afford to spend more than.

To conclude, both the political and financial situations are to follow closely over the next few months and we will see if the Fed will look at Brazil as an additional threat for the EM crisis.