Risk Rally Ending for Currencies Turns Focus to New Least-Ugly Alternative
The best-performing currencies of 2011 are falling out of favor as the Federal Reserve plans its exit from record monetary stimulus just as the global economy shows signs of slowing, buffeting commodities and stocks.
A basket of nine currencies including Australia’s dollar and the Norwegian krone has dropped 4.2 percent in May against the U.S. dollar, after rising 7.3 percent in the first four months of 2011, according to data compiled by Bloomberg. Demand for contracts insuring against a drop in the euro versus the greenback are trading at about the highest levels of 2011.
The depreciation shows investors are downgrading their estimates of global economic growth. The Fed is scheduled to stop purchasing Treasuries in June, reducing its injections of money into the U.S. financial system. Japan entered a recession in the first quarter, and Europe’s debt crisis is deepening. A drop this month wiped out all the gains since mid-March in the Standard & Poor’s GSCI Index of 24 commodities and sent the MSCI World Index of stocks down 4.3 percent after dividends.
“The market is just getting cognizant of this concern that a lot of the pricing on equities, commodities and currencies is dependent on growth being as robust as has been expected,” said Steven Englander, the head of Group of 10 foreign-exchange strategy at Citigroup Inc. in New York. “There is more of a question mark surrounding that now than there was last month.”
Barclays Plc, the U.K.’s third-largest bank, forecasts the global economy will expand 4.1 percent this year, down from 4.9 percent in 2010, the London-based firm said in a report last week. Morgan Stanley, one of 20 primary dealers of U.S. government securities that trade with the Fed, said in a May 18 report growth will slow to 4.2 percent.
One of the biggest beneficiaries of the flight to safety has been the dollar, which has risen against all 16 of its most-traded counterparts in May after falling against each one except the yen in the first four months of the year.
“The chance of a further bounce in the dollar is quite strong,” said Ken Dickson, investment director of currencies in Edinburgh at Standard Life Investments, which oversees $250 billion. “The currencies that appear to be unloved by the market are also undervalued.”
Currencies of commodity-exporting countries dominate the list of the most expensive against the dollar, according to the Organization for Economic Cooperation and Development’s purchasing power gauge. Norway’s krone is 39 percent overvalued against the dollar, the most after Switzerland’s franc. Australia’s dollar is third at 38 percent, and the euro is 12 percent above fair value.
IntercontinentalExchange Inc.’s U.S. Dollar Index, which measures the greenback against six trading partners, slipped 0.4 percent last week to 75.435, and was at 76.163 at 1:25 p.m. in New York. The dollar fell 0.3 percent against the euro to $1.4161 and rose 1.1 percent against the yen to 81.70 in the five-day period, spurred by news that the Japanese economy slipped into its third recession in a decade. The U.S. currency strengthened 0.8 percent to $1.4045 per euro today, and fetched 81.80 yen.
The rebound in the dollar may prove short-lived as the Fed maintains its benchmark interest rate at a record low of zero to 0.25 percent, diminishing the allure of U.S. financial assets.
Treasuries due in one to three years yield 1.02 percentage points less on average than government debt with similar maturities in the rest of the world, Bank of America Merrill Lynch indexes show. In March 2010, Treasuries yielded 0.03 percent more than debt in the rest of the world.
‘Awash in Money’
Investors outside the U.S. bought a net $26.8 billion of U.S. government debt in March, the least since October, the Treasury Department said May 16.
The central bank will continue to invest the proceeds of maturing securities back into the bond market, meaning “the economy and the banking system in particular will remain awash in money,” said Axel Merk, president and chief investment officer of Palo Alto, California-based Merk Investments LLC, which manages $700 million in mutual funds that specialize in currencies.
“There’s a lot of potential stimulus available, and that’s not going to change,” said Merk. The Merk Hard Currency Fund (MERKX) has returned 4.15 percent this year, beating 91 percent of its peers, Bloomberg data show.
Minutes from the Fed’s April 27 meeting, released last week, showed a majority of policy makers preferred to reverse record stimulus by ending reinvestment of asset proceeds before raising rates. Talks over the exit strategy don’t mean tightening “would necessarily begin soon,” the minutes said.
‘Ducks in Order’
“The minutes showed that while there are no imminent tightening plans in terms of timing, the officials were obviously talking about exit strategies,” Brian Kim, a currency strategist at UBS AG in Stamford, Connecticut. “They’re starting to get their ducks in order. We are looking for a bit of a bounce in the dollar.”
Commodity, stock and bond markets are all flagging increased concern that the global economy will weaken.
The Standard & Poor’s GSCI Index of 24 raw materials has fallen 11 percent this month, after surging 20 percent in the first four months of 2011. The MSCI World (MXWO) Index of stocks gained 9.4 percent from the end of December through April.
Government debt yields have fallen to 2.27 percent on average from this year’s high of 2.51 percent on April 8, Bank of America Merrill Lynch’s Global Sovereign Broad Market Plus Index shows.
In addition to the end of the Fed’s bond purchases, Japan said last week that its gross domestic product contracted an annualized 3.7 percent in the first quarter as the March 11 earthquake and tsunami disrupted production and prompted consumers to cut back spending.
In Europe, austerity measures enacted by debt-laden nations from Greece to Portugal mean the euro-region’s economy will expand less than 2 percent this year and 1.6 percent in 2012, according to the median estimate of at least 29 analysts surveyed by Bloomberg News.
S&P reduced its outlook on Italy’s A+ sovereign debt rating on May 20 to “negative” from “stable,” saying “potential political gridlock” means the prospects for reducing the government debt have diminished.
Demand for contracts insuring against depreciation in the euro have risen as measured by the so-called risk reversal rate for one-month options on the euro versus the dollar.
The rate rose to a 1.78-percentage-point premium in favor of puts granting the right to sell the euro over calls giving the right to buy, the highest level since December. The comparable dollar-krone rate reached 1.95 last week, a level not seen since July.
The biggest loser in the foreign-exchange market this month among the 16 most-traded currency pairs has been the Norwegian krone, which has depreciated 6.5 percent. The drop follows a 10.9 percent gain in the first four months.
South Africa’s rand has lost 6.2 percent, following a gain of 0.9 percent. The euro is down 5.4 percent, after rallying 10.6 percent. Sweden’s krona is 5.1 percent weaker, compared with an 11.1 percent gain in the January through April period.
The exit from higher-risk assets may best be seen in the so-called carry trade, where traders borrow in currencies of nations with low interest rates and use the money to buy currencies of economies with higher yields, such as Australia.
Carry Trade Losses
The strategy has lost 2.1 percent in May, after gaining in the three prior months, as investors reversed bets on signs the economy is slowing amid the slump in commodity and stock prices, according to an index compiled by UBS. Australia’s dollar has weakened 4.1 percent, after appreciating 7.2 percent in the first four months.
“We are at the end of the road for risk,” John Taylor, chairman of New York-based FX Concepts LLC, which runs the world’s largest currency-hedge fund, said in a May 12 telephone interview. “This is the end of the nice slow-moving risk rally that has lulled us pleasantly to sleep since the first half of 2009.”
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