[achiever]

Following a prolonged period of USD weakness which lead to the markets being positioned short, there are now strong signals the USD is starting to develop strength. Actually, USD strength could come from two sides. Firstly, the US economy has responded positively to the fiscal and monetary stimulus thus reducing the risk premium for US assets. The introduction of QE in March has let the performance of the USD diverge from the guidance of real interest rate differentials. Now as the economic outlook has stabilised the relative yield and interest rates differentials should regain their impact on FX.

Secondly, equity markets have rallied and July was the best performing month since August 2003, however if you take a look at the volume figures the numbers weren’t that good. Recently the VIX forward curve has steepened suggesting that market participants are expecting volatility to rise and the last time the VIX index developed a similar positive slope when compared to today’s slope was back in August 2008 just before equities came under selling pressure. The better economic performance seen in the US and the Western World recently and the rising slope of the VIX index might contradict each other, but it makes sense since China has developed substantial tail risks. Within the first six months of this year Chinese banks have created an equivalent of USD1.1trn new loans. There would be no problem if loans were distributed for productive use, but the 90% surge of the equity market and the booming housing market tells us otherwise. 95% of credit provided has been given to the big state owned companies which use the funds for speculating into shares, commodities and even housing. Property sales climbed 37% in the first seven months from a year earlier and real estate prices are now 1% Y/Y higher which might look moderate, but must take into consideration that house prices had been overheating in the summer of 2008. Relative to income, house prices have moved to levels which makes with the real estate boom in Iceland or Spain look like a walk in the park. Credit growth must be curbed in order to avoid a bubble. In fact, the central bank have now told the largest state-controlled lenders to slow down growth in new loans, according to the FT, citing unidentified people familiar with the matter. The PBoC has admitted that about 20% of the credit growth has found its way directly into the equity market. Moreover, corporates which are often forced into taking loans have bought commodities on a forward basis, but when credit growth is reduced, equity and commodity markets are likely to roll over.

The USD rebound seen since Friday has developed mainly against the JPY, CHF, GBP and the EUR. The main driving force behind these currencies was the yield and rate differentials. However, once the Chinese equity market rolls over and commodity markets correct lower, commodity currencies will also lose against the USD.