Is FX moving from 'Risk Bucketing' to 'Economic Differentiation'?

“Greed is good” – Gordon Gecko

Headlines this week have been varied and emotive. The sentiment following on from last Friday’s disappointing US employment report (at least in terms of the headline payroll number) saw equities lower into that start of the week. Concerns over the public finances and their sustainability in light of a potentially faltering economic backdrop put Spain back at the forefront of global market concern. Comments from the Bank Of Spain governor that “Spain is not likely to see a strong recovery soon” and that Spanish “banks may need more capital if the economy deteriorates” gave the market doomsayers the upper hand… albeit briefly.

Throughout this year I have remained firmly in the ‘glass half full’ camp.  I remain of the view that selectively equities are cheap, particularly in the UK, and that the prospects for the global economy (and more particularly the US and UK) are much more positive than the general consensus. A general consensus that has been battered lower over the past 4 years as successive global crises have drained the life out of a once common trait of global finances, optimism or even greed. In fact history would suggest that financial markets are driven by fear and greed, but of late fear has been by far the dominant partner.

From 'risk bucketing" to 'economic differentiation."

So where does this leave us now?  Despite the ‘risk wobble’ at the start of this week all major currencies are within around 100 points of where they were prior to the US employment report, in fact the S&P is only 10pts away. In my view however the frustration of a lack of movement in currencies is a function of a regime change in the underlying dynamic. For years now the dominant driving force behind currency markets has been the ‘risk weighting’ or correlation of a particular currency to the risk appetite of the market.  In this instance AUD for example (a risk positive currency) would rise in a risk positive world and fall in a risk negative world. The difficulty that the market is having now is that I feel we are in a transition period between ‘risk bucketing’ and ‘economic differentiation’ where currencies are evaluated on the relative economic fundamentals or growth differentials.  

The main difficulty here is highlighted by the AUD. In the old regime, a risk positive backdrop would drive AUD higher as a more positive world would seek a higher yield, particularly if the world was more positive due to a more positive view on global growth (positive for China and thus AUD by further default). In the new world, however, (particularly as the dynamic of the US stance on interest rates at the current zero bound has been weakened to a central expectation from a mandated commitment) a risk positive backdrop would likely put upward pressure on US rates and thus narrow the interest rate differential between the US and Australia.

The broad weakness in some parts (non resources) of the Australian economy complicate this further but herein lies the problem.  While there is still a fear that the world may return to the fragilities it faced prior to the ECB LTRO’s the implications for currency are conflicting dependent on which regime you feel we are in. As a result currencies have continued to move in a frustratingly narrow range!

Lasting recovery in UK?

The OECD said yesterday that the UK may be building momentum for a lasting recovery. I would agree.  It has been frustratingly slow but as I see things some clarity to the deficit plans in Spain and the calming of concerns towards the eurozone will see GBP and USD outperform and some significant relative value normalisation occur.