The old risk-on carry trade is back on in the global financial markets, long financial assets and short Euro and yen to fund that exposure. A mix of reflexive trades and actual carry funded exposure makes these assets so well correlated.
In such a trade, a leveraged trader would look to buy high momentum instruments in the stock market and/or credit market and fund that exposure by borrowing in Yen or Euro. With Euro and Yen under pressure and their interest rates not expected to inch up any time in the foreseeable future, a speculator would be more than happy to have his obligation in those two currencies. However, a downward pressure on Euro and Yen reverberates through the FX sphere, making US dollar stronger against most of the global currencies, not just the majors. A strong dollar caps the interest in hard assets, mainly commodities. We are already seeing oil prices diverge from the stock prices.
With oil prices meandering close to their multi-year low, oil producers have started to feel the squeeze on their economies. Remember, a collapse in oil prices causes cost curve of almost all commodities to fall, leading to vicious cycle of lower commodity prices. IMF in its latest economic report said “Because the oil price drop is likely to be large and persistent, oil exporters will need to adjust their spending and revenue policies to secure fiscal sustainability, attain inter-generational equity, and gradually rebuild space for policy maneuvering,” it said, warning that adjustment plans in most MENAP oil exporters “are currently insufficient to address the large fiscal challenge.” IMF also warned that “if regional conflicts, such as the civil wars in Syria, Iraq, Libya and Yemen prove to be “more persistent than expected, they would reduce growth in the affected countries, with adverse spillovers to the region and beyond.”
The longer the divergence trade continues the sharper and bigger can be the re-adjustment when it occurs. However, barring a few of the major central bankers, most seem to be very aware of the fallacies of trying to build a damn in front of a rising ocean. It cannot grow taller forever and when it stops, the overflow and subsequent break can cause significant over reactions in assets markets and financial system. Last week, we saw how ECB launched verbal intervention in the foreign exchange market. They pre-announced further easing in the upcoming December policy.
ECB hinted at a mix of fresh easing, from more negative deposit rates to extension of QE to expansion in types of assets to be purchased and even tweaking of the size of the monthly QE. All in all, a fresh salvo was fired in the global currency war. It amazes us, how central banks in G8 can get away with direct attempts at currency devaluations, in the garb of the mumbo-jumbo of some economic phrases. We have said in the past, and we would like to repeat, that as long as Euro zone and Japan, who are demand importers or goods/services exporters, continue to stimulate through weaker local currencies, it will make the economic and financial adjustment in China all the more difficult.
China is trying to juggle a lot of balls all at the same time, and as a result, all but two are in the air most of the time.
With external environment becoming challenging by the day, Chinese policymakers find themselves in an unenviable position. Chinese monetary easing has not come as a surprise to us as we have been expecting it. We expect to see more easing in both monetary policy as well as fiscal policy. However, there economic stimulus is incomplete as long as it does not include a sizable depreciation in the Yuan. Chinese government has been doing backdoor devaluation by providing direct and indirect sops to exporters. However world over, many governments, in order to support local industries; have started to impose additional tariffs on Chinese exports. The longer China resists a weak Yuan, the more it will end up suffocating its domestic economy. Chinese fear that a sharp devaluation may trigger an exodus of capital, triggering massive unintended consequences in the high levered domestic economy. We have seen Chinese government adopt a path of measured reforms, with the intention of opening up capital markets but we need to understand that reforms are of little help when a highly levered economy has seen an end to a significant debt cycle. Debt reduction, debt liquidation, monetary easing and fiscal policies have to go hand in hand with reforms to prevent a hard landing of the economy.
In all these chaos, India seems like an island of calm (borrowing the phrase from Dr. Rajan). The world money managers are more than happy to over pay for stability in a chaotic world and that keeps them hooked to our country. However, Rupee remains over valued and with exporters under dire straits and domestic tradable sector feeling the heat from cheaper importers, we expect the central bank to play a much more active role in capping the advance of the Rupee. We expect an overall range of 64.50/70 and 65.80/66.0 over the near term. Imports and FCY obligations may be considered to be suitable to be hedged below on spot. However, hedging is a specialized business and one needs to consult his advisor or broker before indulging in them.