A climate of low yields and expansive central bank balance sheets has naturally complicated the pursuit of trades that can generate an expected annual return of ~20%. For this reason, we have been banging the proverbial drum regarding the opportunity for investors to be short-USD/ARS. This trade is a direct beneficiary of the Argentinian government implementing – outside the auspices of the IMF – a classic stabilisation plan, one that requires monetary policy to be tightened such that it stabilises and strengthens an exchange rate following the ending of an unsustainable FX peg. The long history of EM financial crisis suggests that when a country implements this policy framework and as long as there is sufficient political will to absorb the hit to economic growth – which there is in Argentina – then investors can harvest the outsized risk premia that is usually embedded in FX forward curves. They can also often expect capital gains from currency appreciation. The market’s scepticism towards the ARS is fading and the currency is experiencing growing investor focus. While the subsequent appreciation of the ARS and leftward shift in the USD/ARS NDF curve has reduced the attractiveness of entry positions, a short-USD/ARS position still has the potential to deliver 15-20% returns over the coming 12 months.
USD/ARS spot and forward curve
The USD has not reacted well to the early days of a Trump Presidency. Hopes for a pivot to the political centre have receded into the rear view mirror as Trump has started enacting his policy pledges. As controversial as these policies have been, the nature of the implementation process has been an additional source of concern: a lack of planning, coordination and prioritisation has inflated concerns that Trump and his team are not ready for administrative Prime Time. However, to adapt a sporting phrase – when looking at the longer-term impact of Trump on the USD and US assets one has to try and follow the ball rather than just the man. We still believe that Trump’s economic policies have the potential to create a sugar rush period of stronger economic growth in the US and lay the foundation for a USD overshoot. This does not mean that the experiment with Trumponomics is likely to end well. His policies are expected to ultimately exacerbate the slow burning growth and income crisis that laid the foundations for his election victory. Trump rode a populist wave but he is no populist. This feeds into our view that the US interest rate market is reaching levels where investors can look to buy-USTs/ receive IRS. Nonetheless, over the coming months the current correction lower in the USD is likely to provide a compelling buying opportunity, particularly against the currencies of Asia ex-Japan where Trump poses a substantial threat to the region’s already struggling growth model. Meanwhile, his policy platform and his administration’s decision-making process both reinforce our view that the global markets have moved to a new and higher volatility regime.
Between mince pies, frenetic excursions for last minute presents, and family rows, the Christmas period can see noteworthy news slip past the gaze of many investors. One such development may have occurred in Argentina where USD/ARS has spiked over the past fortnight in response to the resignation of the country’s Finance Minister, Alfonso Prat-Gay, who was the most public face of Argentina’s attempt to return to the path of economic orthodoxy. The natural concern is that president Macri’s decision to ask for Prat-Gay’s resignation heralds a return to populism. Our preference for a short-USD/ARS position rests on the assumption that the Argentinian government will implement a well thumbed and battle-tested economic stabilisation plan, a central pillar of which is a tight monetary policy aimed at stabilising the ARS and limiting second round inflation effects of the December 2015 maxi-devaluation. However, while Prat-Gay was a critical visible face of the reform era, the broad-based support for orthodox economic policies in Macri’s administration is expected to ensure policy continuity. In fact, Prat-Gay’s departure may increase the likelihood of tight monetary policy being sustained. The ARS sell-off appears overdone, and the rightward shift in the FX forward curve provides an appealing opportunity to establish short-USD positions, and thereby place a non-correlated trade into an investment portfolio.
Hopes have been building that the ineffective global policy response to the slow-burning global growth crisis would be transformed, that belatedly policy would be coordinated across reflationary levers and there would be reduced reliance on monetary easing. The election victory of Donald Trump embodied this hope given his commitment to a fiscal stimulus. However, while the expected combination of looser fiscal policy, tighter monetary policy and faster growth in the US into 2017 has underpinned a surge in the USD, hopes for a broader global reflation are likely to be disappointed. Outside of the US, much of the G10 remains overly reliant on monetary stimulus. The latest example was the UK and the government’s Autumn Statement, or mini budget. We believe that the coming Brexit-related downside risk to growth requires a 2% of GDP fiscal stimulus, to augment the Bank of England’s August policy ease. In contrast, the government announced a tightening of fiscal policy over the coming 5 years and austerity remains it’s political leitmotif. This adds downside risk to UK economic growth and to the GBP which we still expect to hear towards parity vs. the USD, while Gilts could be poised for a recovery. More broadly, the increasingly divergent policy mix of the US compared to other G10 economies is likely to help spur further USD appreciation against major currencies into 2017. It will also maintain a trend of weakening emerging market currencies. Continue reading
In the 6-months since we first undertook a detailed analysis of the Saudi Arabian economy, little has happened to change our conviction that the 30-year old USD/SAR peg is inconsistent with a world where the price of oil is increasingly inelastic to the policies of OPEC. Despite the recent pick-up in oil prices, Saudi Arabia is still faced with the challenge of a widening current account deficit and declining FX reserves, while the need to limit the hit to GDP of lower oil revenues has resulted in a 21.6% of GDP budget deficit. Some optimism has been generated by the government’s plan to fund a Sovereign Wealth Fund by selling part of Saudi Aramco. However, establishing a SWF aimed at generating non-oil income may in part be inconsistent with the SAR-peg in the current climate: the much mooted sale of a 5% stake in Aramco over the next 18 months would likely generate funds that are equivalent to the decline in Saudi FX reserves over the past 12 months. Long-USD/SAR positions in the FX forwards continue to be attractive, as a larger risk premium needs to be attached to the SAR-peg, while the carry cost of such a position continues to represent a small price for adding convexity to an investor’s portfolio
The compelling economic challenge in most major economies is for an improved coordination of policy across reflationary levers, so that policy-makers can tackle the slow burning global growth crisis. The extreme degree of policy coordination – Helicopter money – may be a desired end-state for many economies. There is of course a dark side to such a policy of “inflationary” deficit financing. Emerging markets are replete with examples of central banks under-writing fiscal spending in a manner that has spurred economic dislocation and undermined investment returns. The damage these policies have reaped on various emerging markets stems from the fact that, unlike candidates for helicopter money, many emerging market central banks have monetised fiscal debt at a time when there is no zero bound problem for monetary policy and when the key economic challenges are not insufficient demand and downside risks to inflation. Argentina provides a prime example of the problems of inappropriate inflationary deficit financing. A decade of populist rule left the new President with a legacy of unsustainable budget deficits, high inflation, weak economic growth and an unpredictable regulatory regime. In contrast to many key leading economies, Argentina’s challenge is to disentangle monetary and fiscal policy and thereby return to economic orthodoxy. Reining in the budget deficit is a critical success criterion for the government’s stabilisation plan. While the government faces a daunting economic challenge, the market has expressed confidence in President Macri by maintaining long positions in the country’s Eurobond debt. By contrast, following a maxi-devaluation, sentiment in the ARS remains weak. However, we think that the risk premia on the ARS priced into the FX forward curve is too high since a tight monetary policy and a more stable ARS could be crucial components of a stabilisation plan over the next 12-months. We see value in establishing short-USD/ARS positions, which can potentially bring to investor portfolios a high return trade that is uncorrelated to prevailing market beta.
The ARS risk premium priced into the FX forward curve seems to high: opportunity to short-USD/ARS
One of our core medium-term investment themes has been for the emergence of a cyclically and secularly weak CNY, and we continue to hold to this view. The Chinese authorities’ current embrace of a weak-CNY is expected to persist, with the pace of CNY depreciation continuing to out-strip that priced into the FX forward curve. We also continue to favour positioning for CNY weakness via the NDF curve rather than the CNH offshore forward market, and accept paying wider forward points in return for reduced fixing risk. The method that the authorities have deployed to weaken the CNY has allowed the sizable depreciation seen over the past few quarters to go somewhat below the market’s radar screen. Nonetheless, continued CNY weakness may increasingly influence the performance of currencies and markets in Asia ex-Japan. The current liquidity driven rally in emerging markets may therefore provide attractive opportunities to short Asian currencies such as KRW and SGD, and also initiate some interest rate trades such as recieving KRW IRS and implementing SGD IRS curve flatteners. An additional appeal of a long-USD/CNY position is that the position contains an embedded long convexity component. There are growing non-linear economic risks associated with China’s economic slowdown given the combination of surplus industrial capacity, an increasingly inefficient allocation of capital and exceptionally high corporate leverage. These risk will increasingly require ultra-accomodative monetary settings to help limit the rise of credit risk and NPLs, and such a policy is consistent with a faster pace of CNY weakness. The unprecedented recent stability of the CNY IRS curve reflects the current policy stasis: PBoC is trying to strike a balance between supporting economic growth with low rates and limiting the rise in USD-demand; ultimately, as growth continues to slow the need for lower interest rates will prevail and the CNY IRS 2s5s spread is likely to steepen sharply as the fixing rate is allowed to decline.
The USD/CNY NDF curve continues to under-price the depreciation potential for the CNY
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In light of the Bank of Korea’s surprise policy rate cut in June, and the more recent rise in global risk premia folllowing the Brexit vote, it appears timely to expand on one of our long-running themes – that Korea is on a medium-term path to a zero interest rate regime. This reflects a number of external and domestic economic trends, which are reducing economic growth potential and maintaining a medium-term disinflationary path, which has the potential to become a deflationary one. We retain our bullish view on the Korea’s interest rate market, and also see the opportunity for forward starting curve steepeners to provide a cost effective way to add convexity into a portfolio. The post-Brexit slide in risk appetite has also accelerated what we expect to be an emerging trend – KRW weakness.
KRW IRS curve – 2s5s spot and 1yr forward.
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It has rarely been timelier for investors to embed a convex strategy within their portfolios, whether this be positioning for or hedging against out-sized, non-linear moves and trend changes within markets. The list of potential shocks grows ever longer and includes issues such as: a world economy struggling to sustain acceptable growth rates; the growing awareness of the downside risks to inflation in major economies; many policy-makers implementing ever more unorthodox monetary policies; the growing fear that the Fed has repeated the past policy errors of the BOJ and ECB in tightening monetary policy too soon. An additional risk factor, which will likely grow in importance, is the credit risk and secondary market implications of the collapse in commodity prices. Of particular focus for this note is the tension between the Saudi Arabian currency peg and the changed dynamics in the oil market where, firstly, the price of crude has become increasingly exogenous to OPEC members and, secondly, where Saudi Arabia appears to have changed supply policy in favour of preserving market share rather than the price of oil. For all the focus on Saudi Arabia’s current austerity programme designed to respond to the slide in oil prices, it is difficult to see fiscal policy being sufficient to remove the increased FX risk premium attached to the SAR-peg. Continue reading
We live in exceptional times, with many financial market prices and central bank policy settings at hitherto undreamed of levels. For many policy-makers trying to navigate their way through a persistently sluggish global economy, the conduct of monetary policy is complicated by their choice of prevailing exchange rate regime. Some significant trading opportunities can emerge from yield curve gyrations that are driven by FX policy, particularly during times of crisis, with Singapore and Korea providing two contrasting examples. These opportunities may be magnified by the prevailing strong-USD climate. The FX and yield curve relationship is also worth considering in the context of the perennial criticisms that are levelled at the crisis response policies proposed by the “Washington Consensus”, policies which so often attract complaints of a asymmetry between the options offered to developed and emerging market economies. Continue reading