Why calm currency markets are at odds with conventional wisdom

Things are quiet in currency markets. But it is not the reassuring peace. Conventional wisdom indicates that macroeconomic uncertainty should generate fluctuations in prices. Brexit is just over a month away while in Europe economic data has been diminishing as uncertainties over Italy and Spain persist. Looming European parliamentary elections at the end of May are another probable cause of political headwinds. And even though the euro has been trading in a narrow range between $1.12 and $1.18 against the greenback for over 70 trading days. Realised volatility – the measure of price moves that developed in a specific period – is now near the historic lows of 2014.

With the scarcity of reaction in currency markets is down to investors’ conviction that liquidity will remain to be ample, despite the precarious global growth backdrop. Paradoxically, it is that poor growth outlook that is allowing stock markets to rally while preserving a cap on large fluctuations in forex prices, because that subdued data are stopping central banks from “normalising” monetary policy and withdrawing liquidity from displays. The US Federal Reserve is indicating that it will not raise rates in the short term while the ECB is also again considering stimulus. The Bank of England, meanwhile, is developing into an improbable contender for tightening policy amid ongoing fears over Brexit.

Leaving FX markets in an analogous condition as during the post-crisis period when extra-low interest rate policies and stimulus measures dampened volatility coupled with the recognition that central banks will step into the breach once more and continue to provide markets with liquidity.

Could the new pools of liquidity be a mirage?

To paraphrase Oscar Wilde, a pessimist would say investors know the price of everything and the value of nothing. But the sensibility could be much worse because they may not even know the price.

For decades, investors and policymakers have accepted financial market prices as the critical gauge for the overall outlook on the economy and market performance. Some recognise that markets can become carried away as bubble dynamics develop, and since the 2008 financial crisis a veritable industry has evolved, seeking to single out the next bubble to pop.

Not a day passes by without Cassandras’ calling for the impending crash in China under a volcano of debt, or the break-up of the Eurozone or America’s corporate balance sheets buckling under years of excessive debt issuance.

Yet, through all of this, the faith in the market price has persisted. Most don’t dispute whether the basic formation of market prices is erroneous.

But what if market gyrations are less to do with moves in forecasts on the economy or company performance, and more to do with players coming to terms with a less efficient market?

The preceding few months have provided us with clear glimpses of this.
5 / 8
The harshest was seen in currency markets at the start of the year. The Japanese yen experienced a flash-crash when it jumped 4 percent against the US dollar in one day. This was indeed more remarkable because the cause was apparent selling of an emerging market currency against the yen, which ended up influencing the trillion-dollar-a-day yen market.

The final month of 2018 saw markets suffer extreme moves in the absence of much fundamental news. At one point US equities were down over 15 percent, before reversing those losses over the subsequent weeks.

Interest-rate markets swung from the prospect of advances in Fed policy rates for 2019 to reductions. All the actions, from currencies to equities to interest rates, were more likely precipitated by liquidity problems than deviations in underlying elements or credit risk.

So what has produced this growing fragility?

Three elements stand out. First, the growth of electronic trading on both the sell side and buy side, with robots replacing human market makers to produce endless torrents of prices. Buying and selling securities can be performed at the click of a button.

Not simply that, but entities that never made markets in securities can now plug into the streaming prices of a greater liquidity provider and determine them as their own. The chimaera of those prices and the elaboration of market makers provide the illusion of satisfactory market liquidity.

Second, it has lessened the role of banks in the market-making process. Thanks to the scars of the 2008 financial crisis, poor behaviour of traders and strengthened controls, banks have been squeezed.

In the past, they could hold securities if they could not spot a purchaser in the market, but now with balance-sheet constraints, they have to sell into thin markets, which could exacerbate price gyrations.

Third, the conspicuous presence of central banks in financial markets after their large-scale quantitative easing programmes has established a
6 / 8
credible buyer of last resort. This has made market players believe they can sell more freely than they actually can.

The result is that in “normal” times, liquidity (or the capacity to buy or sell a security) appears ample. Investors have endless prices flashing before them, there is no need to communicate with another human and central banks will always intervene if obliged to.

However, when “extraordinary” times hit, this liquidity can dissipate. The streaming prices stop as the robots freeze; human traders are inhibited to act, and central banks are slow to buy or have shifted policy to avoid serving as a buyer of last resort.

Today’s biggest risk could be that investors are underpricing liquidity risk. They assume their assets are worth one thing when they study movements of prices, but they may be worth another when they try to sell them.

It further means that extreme market movements could be less reflective of the credit or business cycle and more reflective of this repricing of liquidity. All providing new challenges to central banks as they undo their easing programmes. Thus, it may now be time to add another worry to the list: the unravelling of the market liquidity illusion.

Rally is tempting money managers to make more bullish bets on crude

Oil prices surged to a three-month high last week, as expectations for a US-China trade deal continued the enthusiasm stimulated by the news that Saudi Arabia was cutting production more aggressively than forecast.

After tumbling over 30 percent in the fourth quarter, Brent crude, the global standard, has jumped by better than a fifth this year in conjunction with the wider rebound in capital markets.

With some renewed optimism having been aroused by prospects that Washington and Beijing will avert an acceleration in trade tariffs.

The strength of this year’s oil recovery is encouraging money managers, jack-knifed by the severe drop in the fourth quarter, to develop into becoming a little more dynamic.

With Saudi Arabia’s disclosure, last week that it aimed to carry out greater than expected cuts to production injected further momentum into the rally. The kingdom said it would decrease production to about 9.8m barrels a day in March, more than 500,000 b/d below its pledged target under the deal agreed with global producers.

The resolution by OPEC and allies including, Russia in December, to decrease production was a marked turnaround from the drive to push supply in the midst of last year when US president Donald Trump urged the syndicate to curb rising prices. This year prices have again been lifted by US sanctions attempting to contain Iran’s nuclear aspirations and prompt a leadership battle in Venezuela, squeezing crude supplies from both countries.

With hopes for the trade deal and fewer OPEC barrels is proving sufficient for now to counteract fears over swelling US shale production. And at least in the short term then it would imply that not much remains in the path of oil now prices pushing for a test of $70.

Why markets should get set for “QE4”

Modern financial operations have become reliant on huge central bank balance sheets. Yet the resources of central banks around the world have shrunk, relative to gross domestic product, for the first time since the 2008 crash.

This is necessary to recognise and dangerous risk for both financial markets and actual economies because of the key part played by central banks in the finance process.

Markets wobbled last December, reflecting an earlier liquidity reduction by the Federal Reserve in May 2013 that contributed to the “taper tantrum”. Looking further backward, after the 1930s crisis, state intervention saved capitalism through governmental spending.

Now, following a comparable intervention engineered after the 2007/8 crisis through larger central bank balance sheets, we could quickly perceive a 1937/38-type incident as the punchbowl is once again removed.

With the European Central Bank ending its asset purchases, and the Fed already reducing its balance sheet, quantitative tightening (QT) is reversing previous spells of quantitative easing (QE).

Not all the post-2008 QE boost will be cancelled out by the planned QT, but the expected declines still dominate. In the US, for example, the Fed’s balance sheet, which climbed from $900bn in 2008 to $4.3tn in 2018, had been foreseen to go down to just under $3tn by the conclusion of 2020.

But even despite The Fed’s consoling signals, it may not be sufficient. To better interpret the risks, we must understand western financial systems as capital re-distribution mechanisms to refinance existing positions, rather than capital-raising mechanisms to obtain new money.

Will the currencies market ever wake up?

This is becoming a pressing question. Broadly, the forex market is in a deep sleep. Among major currencies, sterling is cornered in a Brexit soap opera that could induce it to be charging higher or tumbling through the floor.

Until investors know the outcome for certain, they are reluctant to place bets. Similarly, the euro and the dollar are locked in a tug of war, each bearing challenges around economic growth, central bank monetary policy, and political risk. The yen is likewise in thrall to US monetary policy.

In the interim, it is quiet out there. Indices tracking volatility in major currencies have been trending lower for around a year and a half. As such, it is tough to identify a trigger in the coming week that will rouse foreign-exchange markets from their slumber. It could be a delay in the Brexit date. But even that event seems to be already priced in by traders. The outcome of trade talks between US and China could be another one, notwithstanding it will generate volatility more on the stock markets.

The Value of crypto currencies is only in the eye of holders

After much hype and soaring valuations in the latter part of 2017, cryptocurrency prices dropped back to earth in 2018. While the crash in valuations vindicated critics, it does not appear to have deterred true cryptocurrency believers from selling its potential.

New cryptocurrencies continue to materialise (it is believed that there are now over 2000). Their precipitous falls – plummeting 90 percent for those who enjoyed the bubble – have prompted some in the market to construe this as a buying opportunity.

The expected investment case depends on two interdependent but inadequate ideas: first, that each cryptocurrency has inherent value; and second, that its price should appreciate as blockchain, (the distributed ledgers to which cryptocurrencies are tied) delivers on its potential as the next great disruptive technology. It likewise speculates that policymakers will permit these movements to continue on unhampered. To grasp the central issue with valuing cryptocurrencies, it is worth dwelling on the factors that make fiat money– that nation-states declare to be lawful tender so compelling.

Fiat money works because it is circulated by an authority that: has tax-raising powers; can pay interest; can achieve production in the form of trade; has a monopoly on minting new money; supports all of this with the legitimate use of physical force (through writing regulations and raising an army); and is recognised by other nation states. Thus the more stable the government and the international system is the higher societal trust there is in fiat money as a store of value.

Libertarians and cyber-utopians, which are among the loudest advocates of cryptocurrencies, point out that monetary authorities have debased their currencies. But, in comparison to fiat money, cryptocurrencies are a claim on nobody, cannot generate an income stream and are too volatile to be deemed safe for deposits. And they are every bit as susceptible to debasement as fiat money, not least because of the proliferation of platforms and the omission of a fundamental authority to establish a universal standard.

In this context, it is worth making an observation about gold, which likewise lacks some attributes that help fiat money succeed. While the metal has its detractors, it has proved itself as a store of value and over millennia.

The notion that a crypto currency’s value might be tied to the success of blockchain is just as contentious. Blockchain may bring about some utility in the form of enhanced security and reduced transaction costs, and may indeed turn out to be transformative. But it does not follow that the tokens used to support transactions should be elevated to the status of tradable currency and positioned as a store of value, or worse still, an investment opportunity. It seems those distributed ledgers that adopt a fixed exchange rate, asset-backed tokens — a digital version of the chips used in casinos — stand a better chance of succeeding in the longer run.

As an asset or a currency, then, the value of a cryptocurrency is in the eye of the beholder. It has no intrinsic value, so to buy in now on the basis of how far the coins have fallen in price would be to succumb to a value trap on a grand scale. In short, cryptocurrencies are wholly unsuitable for investment. Whatever the future uses of blockchain, investors should steer clear of cryptocurrencies as an investable asset. Instead, they would be best advised to seek returns through active asset allocation that support societal and economic development.

Renminbi claws back post lunar holiday losses

The renminbi strengthened on Wednesday, having now clawed back most of the ground lost after the lunar year break and the dollar eased against major peers.  The onshore renminbi – bound by a trading band set by Chinese central bankers – was 0.3 per cent firmer at Rmb6.754 per dollar by the early afternoon in Hong Kong. The currency, having firmed over the past two sessions, was just shy of it the Rmb6.74 mark it traded at ahead of last week’s holiday. The offshore rate, which is not restricted by a trading band, was 0.2 per cent stronger at Rmb6.7622.

The moves came amid cautious market optimism after Donald Trump last Tuesday opened the door to an extension of the US-China trade truce beyond the current March 1 deadline. The CSI 300 index of major stocks in Shanghai and Shenzhen was one of the stronger performers in the region on Wednesday, up 1.2 per cent.

Downward pressure on the Chinese currency had diminished amid improving US-China relations and rising yields for US Treasuries. Although with the economy likely to slow and interest rates likely to fall further over coming months, pressure is likely to return later this year.

Elsewhere in forex markets, the dollar index measuring the greenback against a basket of peers was 0.1 per cent weaker and the Japanese yen, often a haven during periods of market uncertainty, eased 0.1 per cent to ¥110.69 per dollar, its lowest since late December.

Have central banks lost their nerve?

It looks like it. Perhaps the highest-profile pullback last week came from the Bank of England, which employed its quarterly Inflation Report to cut its economic growth forecast to the lowest point in 10 years. It also rubbed out its objective to raise interest rates several times in the coming months.

Blame the usual culprit: Brexit. It remains painstakingly complex to formulate a rational bullish case for sterling until the construct of the caustic disconnect from the EU takes shape. Budging far from $1.29 to the pound is proving to be an arduous struggle. But it is not merely the BoE that has caught a dose of the collywobbles.

The US Federal Reserve has similarly folded in the face of market volatility. Also, the week prior, the Reserve Bank of India surprised markets by cutting its benchmark rate by a quarter of a point. With all those nerves jangling, it is simple to see why markets are unsure.

Has having had the world’s reserve currency allowed the US to make too many policy mistakes?

The US government has executed three significant policy mistakes since late 2017. In December that year, Congress cut taxes just as the US economy reached full employment. Then, in April 2018, the Federal Reserve turned hawkish as it misjudged the temporary sugar high from the tax cut for higher trend growth. A month afterwards, President Donald Trump abandoned America’s abiding commitment to free trade by levying an extensive assortment of duties on Chinese imports. Despite these policy blunders, the currency went up. If any other country had played the same game, it would have been punished in currency markets and devalued by credit rating agencies.

Why can the US act in this manner with plain impunity in the markets? The answer rests on the dollar’s stature as the world’s pre-eminent global reserve currency. Such a position is like insurance – it ensures access to funds in rough moments. The US can access finance even when it causes crises as in 2008-09. It likewise controls the extent of its own insurance payout by setting the number of Treasuries it issues.

Whilst financial controls also assist in the currency’s exceptional prominence with US government bonds are given a 0 percent risk assessment under Basel III because they are considered risk free. Whilst rating agencies do their part by allowing higher valuations to the US bonds than to bonds in less beholden, quicker growth countries without reserve currency status. The piece de la resistance: central banks earmark over 60 percent of the world’s $11tn of forex reserves solely to the dollar. However, these immense advantages do not ensure that the dollar, a floating currency since October 1976, will maintain its power. The policy mistakes since late 2017 now weigh on the dollar, which is down this year despite European and Chinese economic vulnerability.

If the US slowdown becomes more intense, there may be more near-term support for the Swiss franc, Japanese yen, gold and even crypto currencies. At root, the dollar’s reserve currency status depends on American willingness and ability to lead.As America shrinks from global leadership, it is prudent that all investors begin to take currency diversification far more seriously than they have done in recent years.

The trading week ahead – week commencing the 18th of February

Key things for this trading week on the economic front include the Eurozone consumer price index (CPI), which will be published on Friday 22 and some important sentiment indicators for different countries.

On Tuesday 19, some important data on the UK labour market will be published, including the December Average Earnings Index, the claimant count change and the December unemployment rate. The ZEW indicators of the economic conditions for Germany and for the Eurozone for the month of February will also be published.

On Wednesday 20, data on Japanese exports, expected to decrease by -1.9% and the balance of trade for the month of January, expected to -30M will also be published. For Germany, the monthly Production Price Index (PPI) will be published, referring to January, forecasted at -0.2%. For the United Kingdom, data on the industrial trend orders in February will be published. For the United States, the minutes of the last FOMC meeting will be published and there will be important statements by the President of the FED of Saint Luis James Bullard.

On Thursday 21, data on January CPI for Germany, expected to fall by -0.8%, France, expected to fall by -0.5%, and Italy, expected to increase by +0,1% will be published. For France, the February manufacturing PMI, Markit Composite and Services PMI indexes will also be published. The same indexes will be published for Germany, with that of the manufacturing sector expected to increase to 50.0, from the current 49.7 and that of the service sector expected to decrease to 52.6, from the current 53.0, and for the Eurozone, with the manufacturing index expected to remain steady at 50.5, the composite index expected to increase to 51.1 from the current 51.0 and that of services which should remain unchanged at 51.2. The ECB will publish the minutes of the last monetary policy meeting. For the United States, data on orders for “core” durable goods will be published, expected to increase by +0.2% in December, orders for durable goods, expected to increase by +0.8%, the Philadelphia FED Manifacturing Index, expected to decrease to 14.0, Markit indicators related to the manufacturing, services and composite sectors for the month of February and the January existing homes sales, which should remain stable at around 5M. Data on crude oil inventories will be published as usual.

On Friday 22, the German IFO Business Climate Index and the GDP for the fourth quarter of 2018, expected unchanged (0.0%), will be published. For the Eurozone, the January CPI will be published, which is expected to grow by +1.4% on an annual basis, while the core CPI is expected to grow by +1.1%.