Every time it looks like we are heading back to a “regular” market environment we are reminded just how extraordinary an event we went through in 2008. Perhaps there is no going back — at least not for a long time. The key factor is that nearly all major currencies are wallowing in a near zero-interest rate environment and central banks across the globe are keeping a tight handle on monetary policy (see “Not much to trade over,” below). The result has been historic low volatility in currency markets.
“Obviously with monetary policy and yield differential being a big catalyst for currency direction the whole world seems to have come to a standstill,” says Interactive Brokers Chief Market Strategist Andrew Wilkinson. “Risk was set in neutral gear and nobody has a good handle on what comes next for the dollar.”
Or for anything else for that matter. An odd component of the recent low volatility environment is that it is happening with the world awash in geopolitical risk. We have the Russia/Ukraine situation, a hot war in the Gaza strip, the Islamic State of Iraq and Syria (ISIS) gaining a strong foothold in both those countries and an Ebola outbreak in Africa.
“I have never seen anything like it in terms of complacency,” says Marek Chelkowski, principal of advisor MDC Trading. “There are a lot of volcanos.”
“We are setting records for most narrow average daily ranges,” adds Michael Aronovitz, portfolio manager for Gables Capital Management. “The average euro range is 30 to 40 pips a day; we were used to seeing 120 pips a day a few years ago. That is not going to change until interest rates begin to rise in the United States and there is more variation between (rates in) G10 countries.”
The situation compounds itself because with most central banks wallowing between zero and 50 basis points there is not a wide range of potential moves. “In a normal environment people would be looking at a larger potential range in movement of interest rates, but with it frozen that range is 25-50 basis points instead of perhaps 400 basis points,” Aronovitz adds.
Dollar ready to soar?
There is a consensus that the dollar rally, which began in July, will continue, though the range of conviction is wide.
Dean Popplewell, director of currency analysis and research for Oanda, sees numerous factors supporting the dollar. The taper, set to be complete by Q4, low inflation and the current low volatility all are adding to dollar strength according to Popplewell.
He points out that the European Central Bank is concerned with deflation as the U.S. Federal Reserve argues over when to begin raising rates.
Wilkinson is also positive on the dollar but more by default, and is cautious. “We had a lot of false starts with the dollar,” he points out. “Currency traders have been tripped up by that so many times. Ultimately it left a lot of people nursing wounds and sitting on the sidelines.”
He points out that economic data is still tepid and while the Fed should be the first mover, it could take another year. “The problem is that at the moment that move is thought to be way off into 2015. And for the spot currency market that is a lifetime away,” Wilkinson says.
Erik Tatje, market strategist at RJO Futures, says, “We will see some weakness out of the Eurozone and a strengthening of the dollar by year end. I don’t foresee the fed changing anything. The dollar will continue to rally.”
Aronovitz is also bullish and cautious. “The dollar will continue to strengthen though there will be hiccups along the way,” he says. “We are at an historical low in currency volatility and that is the bigger story. Dollar strengthening is expected but the pace of the move is historically very slow.”
Expectations for the dollar range from slightly higher, following a correction, to testing the 2013 highs.
The summer rally took out some short-term resistance and the greenback faces a series of resistance areas in the narrowing ranges of the last few years (see “Squeezing the dollar,” below).
“What we are seeing now is a bit of a fear trade where people want to be long the dollar because stock markets are looking vulnerable to correction,” Wilkinson says. “And for the first time in a long while we are seeing the dollar feed off of those. The dollar is looking clever at this point in time but as [summer turns to fall] once again the same fears that are driving the dollar higher may end up receding.”
Popplewell sees the dollar breaking out of its narrow range and eventually testing 85. However, there is close-in resistance that must be challenged first.
“The first [resistance] level is 81.75, which was a 161.8 Fibonacci retracement from a previous zone,” says Tatje. “We really started to break above some key technical levels (in August); 81.50 to 82 will see a little resistance. If we can break above 82, I don’t see a whole lot of resistance. The next level of real resistance is 82.80-83.”
Wilkinson is less confident. “It might try and break through 82, but I see it between 82-81 for the remainder of the year,” he says. “I am not really looking for a substantial move in either direction. If we go off, we don’t go too far and if the dollar comes back, it won’t turn into a dollar rout.”
Chelkowski says, “I would buy the dollar but at a little better level because there is some pain coming.”
Tatje adds, “The dollar just looks the strongest relative to other currencies at this point. We are seeing a shift in strength to the dollar and that momentum will persist. By October, the market may test [the 2013 high]. We could see 83 anywhere from October to November. The key is when the market starts to trade above 82, because there will not only be near-term profit taking from this most recent rally but also longer-term resistance.”
Euro/yen
The euro is not looking nearly as strong as the dollar and that has folks cautious as well. “When it looks too easy it is usually the wrong trade,” Chelkowski says. “Everyone hates the euro here. Everyone is short the euro, but I am a contrarian at heart.” He notes that the euro may make a comeback, but adds, “If euro prints 135, I would be a seller.”
“The euro is weakening because of the geographic proximity (to Russia) and the likely impact on Germany (from sanctions) and therefore the Eurozone as a whole,” Wilkinson says. “But I don’t think the euro will continue to slip. I can see 132 by September but I would not predict anything much lower.”
At that point, Wilkinson would turn bullish. “You can make the argument that the euro would be quite attractive at that point. On the other side of the financial crisis the euro could probably go to 150 but I would not put a time on that.”
Popplewell says it should be an intriguing end to the year. “The equity correction at the beginning of August provided some well-needed volatility and holds out hope for a more normal market. The euro will underperform the dollar and the dollar will outperform the yen.” Popplewell targets 131-129 for the euro.
Where things could get very interesting, judging from our experts, is with the Japanese yen. That is where we have seen the widest variance in opinion.
“There is nothing to cheer for in the yen,” Chelkowski says. “But markets don’t work like that. I would buy yen against Aussie.”
And he is not alone. Popplewell says the low volatility has pushed more traders to the carry trade, which he says is oversubscribed already. “The Aussie and kiwi (New Zealand dollar) benefit from the low rate environment. Those trades are overcrowded [and] will come under pressure by the end of the year.”
Specifically he is talking about a lot of traders long the Aussie and New Zealand dollars and short the yen.
While Popplewell sees an unwinding in the carry trade, Chelkowski has more ominous reasons for supporting the yen.
“I would sell risk, that means you sell the Aussie, you sell the kiwi and you buy yen and you have to buy the dollar,” Chelkowski adds.
He says the problems with the Chinese economy are not over, despite the rhetoric from Chinese leaders and that the correction in equities this August may just be the beginning. “I don’t believe in a global economic recovery. I am bearish on the stock market. We are in a serious scenario. I say 95 on dollar yen.”
“The yen is interesting,” acknowledges Wilkinson. “There was a view that things were getting better—the sales tax had created a whiff of inflation and the economy was staring to move. It was starting to act like a better risk arbiter than the dollar. It even was advancing against the euro, and now it seems to be [under pressure]. It may be ready to resume a march to 105 or 110 on concerns the Eurozone [problems] will roll over to the United States.”
The China wildcard
One of the reasons analysts have varying opinions on the yen, particularly vs. the Aussie, is because that trade is highly dependent on China (see “Wide breadth,” below).
China appears to have weathered its recent economic storm but like all things Chinese, the details are sparse.
“The Chinese economy seems to have turned the corner, which is good for the Aussie,” Wilkinson says. “It is difficult to predict that [the Aussie] is going to suffer when its biggest customer continues to grow at 7% to 7.5%.”
That is if you believe those numbers. “Six to nine months ago everybody was talking about how China was falling apart, now you are hearing that China is turning the corner,” Chelkowski says. “I don’t believe the Chinese numbers; the worst is yet to come. Obviously you would want to sell the Australian dollar.”
Aronovitz agrees that the Chinese data is questionable. “We expect our GDP to come out at 4% and it is flat—they expect GDP at 7.5% and it comes out at 7.5%.”
The larger question is if China will move further to float the yuan.
“The Chinese economy has suffered at the hand of a strengthening exchange rate,” Wilkinson says. “It is a long journey to bring it in line with where it should be. They just don’t want to do that too quickly. Perhaps in an era of stronger global growth they make that transition faster but we are still not clear of the financial recession.”
It’s all about rates
What is clear in the forex world is that there is very little volatility and that is not likely to change until interest rates change, which is why everyone has their eyes on the Fed. “It is really difficult to make currency projections because conventional monetary policy is perhaps dead,” Wilkinson says. “Even though interest rate increases appear on the horizon, there are a lot of “ifs” on the way that [could] actually provoke the fed into tightening. I’m quite concerned that we are going to be in an era of unconventional monetary policy going forward.”
Aronovitz says the one thing that can change expectations is if the economy begins to fail or we see an uptick in inflation. “Inflation is what central banks are paying attention to,” he says.
And after six years of a zero-rate environment it is unclear what tightening will bring or look like.
“The very action of pulling interest rates up will retard economic growth significantly. We have eight years since [U.S.] monetary policy was last tightened, so I don’t know how the economy is going to respond to it,” Wilkinson says. “The traditional catalysts for currency movements are almost redundant because we keep on getting these pushes in yields and we end up pushing back.”
It is unclear how quickly the Fed will move when they do move sometime in 2015. Tatje expects any move to be gradual. “It will be a slow gradual increase in the rates as opposed to a big jump of a whole percent.”
Judging by the Fed fund futures, it will be slow and not come until the end of the third quarter (see “The long wait,” below). It is important to remember that this unwinding has been continuously pushed back. “The long wait,” shows that a year ago Fed fund futures had priced in an interest rate of roughly 1.75% by the first quarter of 2016, now it indicates a rate of less than 1% for that period.
Of course those expectations can accelerate, particularly if the economy improves at a faster pace and if inflation spikes. Nothing lasts forever and that will hold true for the low volatility currency environment.
“The forex market had been handcuffed by the central banks,” Popplewell says. “When the market is quiet for a number of years, there tends to be an upshot in volatility and opportunity. Something we have been craving for a long time.”
While change is inevitable, the question on everyone’s mind is when.
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