Forex Investment and Currency Trading

Much at the activity that we’ve lately has been interest in selling USD on the left hand side. Both corporates and hedge funds are looking for ways to put money to work. This activity would most likely be incite risk on trades and weaken the USD. The activity has been very visible in non-Japan Asia where USDKRW and USDTWD traded down to levels not seen recently. The TWD was largely influenced by laws permitting greater cross-strait relations and investments. We’re also seeing stabilization in Japan as March production came in stronger than expected. Inventory ratios also corrected for the fist time in 6 months after heavy declines. Turning to Europe, unemployment came in at 8.9%—higher than expected.

Yesterday, the US FOMC kept existing policy parameters unchanged, as expected, noting also that economic conditions have improved at the margin. The results of both the stress test and the latest banking survey were available to the committee, but there is no indication that these data had any special influence on the decision.

US 30-yr Treasuries posted an extremely weak performance yesterday, selling off 7bp (which is especially striking given that the 2-yr sector rallied slightly). The US Treasury market appears to have been disappointed that the statement did not contain an increase in the Fed’s total amount of intended Treasury purchases. That said, the longer end of the curve underperformed yesterday as the Treasury decided to extend 30-year bond auctions into a full monthly cycle.

Yesterday’s quarterly inflation report in Mexico underscored that the balance of risks to growth continues to deteriorate and is greater than the risk of inflation, despite the recent sticky inflation prints. The report’s language on monetary policy did not differ materially from the April 17 press communiqué. Therefore, the view is that policy rates will be cut twice more, by 75bp per meeting, to a level of 4.5% by June.

Overnight, the RBNZ delivered a 50bp cut as expected, but its statement was significantly more dovish than the market had foreseen. This triggered a sharp rally in local fixed income (3-mth OIS has fallen more than 15bp, 2-yr bonds rallied over 25bp), and the currency sold off notably. The New Zealand economy is likely to underperform the Australian economy given the slower pass-through of monetary policy, and this should eventually be reflected both in the FX and the rates markets.

We also had stronger-than-expected March production numbers for Japan (+1.6% mom versus market expectations of +0.8%), in what is the first monthly growth after half a year of heavy declines. The inventory ratio also declined (-4.9% mom) – again, the first improvement in 6 months. Equally important, the production outlook for April-May looks quite optimistic too: +4.3% mom in April followed by +6.1% mom in May.

Dissecting the Movements in Gilts…
The fixed income market has sold off since the beginning of April. The price action in UK government bonds is particularly noteworthy – yields for 10-yr Gilts have moved from 3.1% to 3.5% over the course of this month. In G-4 space, the month-to-date performance of intermediate Gilts is the second-weakest after US Treasuries. Here we take a look at recent
movements and what caused them in order to assess whether current levels are sustainable.

A common view on the UK market currently is that asset prices are embedding large deterioration in public sector indebtedness: 10-yr Gilts are trading at a premium to corresponding OIS rates (currently about 25bp). However, the recent movements in Gilts cannot be adequately explained by the situation in public finances. For instance, lately CDS market has been only loosely co-moving with UK government yields, suggesting that the creditworthiness of the UK is not the primary driver of the recent yield dynamics.

FX market behaviour is also consistent with this hypothesis. Since the beginning of 2009, sell-offs in Gilts were more often associated with a stronger Sterling (and vice versa). If fiscal sustainability were the main concern of investors, all UK assets would likely have been hit, including Sterling. (Nor does it appear that the more attractive interest rate differentials as a result of the underperformance of UK rates were behind the Sterling appreciation during sell-offs in UK fixed income.)