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Morgan Stanley FX Morning – April 11

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Morgan Stanley FX Morning

 

Why JPY has further upside: We expect further flows from various market participants to continue to support JPY. First, Friday’s reluctance for JPY to weaken (indicating de-risking ahead of the weekend) suggests that ‘the Street’ has not traded JPY long in significant amounts last week. Note that CFTC data showed the most net long positions building in the first four weeks of the year. Instead our client conversations focusing on the BoJ and its ability to weaken JPY are suggesting to us that the market has not fully adopted our view, suggesting JPY strength staying with us for even longer. Second, Japan’s retail accounts may still need to wind down their JPY-funded carry trades, suggesting more of this ‘P&L’ driven JPY buying in store. Third, pension funds and financial institutions’ foreign assets relative to total assets are near historical highs and most importantly still hugely currency-unhedged. The GPIF had allocated 36% of its portfolio to foreign assets at the end of December 2015.

The BoJ’s ability to weaken JPY remains limited, as we highlighted on Friday. Sovereign bond purchase-focused QE can no longer rely on the JGB yield curve acting as a transmission mechanism. Negative interest rates seem to undermine banks and monetary velocity, hence strengthening and not weakening JPY. The BoJ’s tool box appears to be limited to the purchase of private assets such as ETFs. The JPY-weakening impact of such BoJ equity purchases should be limited. The mechanism of JPY weakness in this scenario would be limited to the de-FX-hedging of equity portfolios, where many global equity investors have used JPY as a ‘quasi’ hedge for equity risk. Alternatively, the focus on increasing fiscal spending would require equity market investors to have more faith that Abenomics is going to work in order for JPY to weaken significantly. Bloomberg is reporting that foreign traders have sold Japanese equities for 13 straight weeks, the longest stretch since 1998. This ‘outflow’ from Japan has not weakened JPY as it has been met with a larger inflow from domestic investors.

The likelihood JPY resumes its appreciation is high, but the higher JPY moves, the bigger are the carry trade liquidation pressures. Here we under line our thoughts again. The second-round effects of JPY strength would terminate the US D downward correction, especially against liquid high-yielding currencies with the EM spectrum. Within the DM world it might be AUD suffering most. China’ s CPI remaining steady at 2. 3%Y puts focus on this this week’s trade and GDP data. China’s 1Q GDP will be released on Friday, with a high likelihood of seeing a positive surprise. The Chinese economy seems to be under going a cyclical rebound, while structural issues such as over capacity, low debt and investment multipliers have not been addressed yet. The question is how much of the good cyclical news has been priced in. Should AUD fail to rally following the anticipated strong 1Q GDP report then AUDUSD should have traded its corrective top to near 0. 7730. Within our strategic portfolio we sell AUDUSD near 0. 7650 and we recommend selling AUDNOK as our ‘trade of the week’.

The Fed-JPY link: We put special focus on AUDJPY, which offer s significant downside potential from here should JPY-based investors pile out of carry trades. Another interesting factor driving AUDJPY down comes via the Fed and risk appetite. USDJPY-bearish performance may remind Fed Chair Yellen that there aren’t just winners from a lower USD. Abenomics and the ECB’s Draghi’s “Whatever it takes” approach are the losers. Sure, lower inventories, negative net trade and the weak US manufacturing sector have pushed the Atlanta Fed ‘Nowcast’ GDP indicator to 0. 1%, but this week’s release of March retail sales should provide a timely reminder that US domestic demand conditions have remained growth-supportive. Markets currently under price our call for the Fed hiking rates in December. In addition, 1Q earnings will start to be released in the US today. Actual releases tend to surprise under whelming expectations. Market projections are for an aggregate 6. 9%Y decline of S&P500 listed company profits. Should positive surprises disappoint relative to previous quarters then risk appetite may get hit. If not, it might be rising rate expectations that limit the equity mar ket upside anyway. Whatever the outcome, AUDJPY should receive little support from the risk appetite side of matters.

EURGBP’ s next target is 0.85: The press is reporting that the ‘Save Dave’ political reaction to the release of the ‘Panama papers’ may suggest promoting Justice Secretary Gove to Deputy Prime Minister and allocating a prominent cabinet post to Boris Johnson after the referendum. Some may say this is part of the plan to bring the Conservative party back together but for FX trading it suggests two leading figures of the Brexit campaign increasing their political relevance ahead of the June 23 vote, increasing volatility in GBP. The economic fundamentals are not looking good either with the 7% current account deficit, the 4% budget gap and the UK household sector reporting a 2. 3% decline of its net savings in 4Q, leaving us firmly within the sterling bearish camp. Our favoured way to play this week is to be long EURGBP.

Trades of the week:

G10 – Sell AUDNOK

Our structural bearish view on AUD, based on weak nominal growth, a poor terms of trade outlook and a slowing housing market, is likely to lead to 50bp of cuts by the RBA by year-end. We propose selling AUDUSD on rallies but prefer to sell AUDNOK today. NOK has been fairly shielded during the ups and downs in the oil price recently because of the sovereign wealth fund, and the ability for the government to ramp up fiscal spending if needed may limit the negative impact on the economy relative to other commodity producers.

Despite AUD depreciation over the last few years, Australia’s nominal trade deficit and current account remain near post-crisis wides. China’s rebalancing away from investment, particularly the steel capacity cuts announced in recent months, as well as the excess real estate inventory in Tier 3 cities pose large downside risks to iron ore prices. Furthermore, domestic demand has mainly been supported by the housing boom, which we expect to reverse. With the RBA’s inclusion of negative language on AUD in the most recent statement, we believe that too strong an AUD rally from here increases risks of an RBA cut in the near term, and we expect weaker data in the future. Both would support the trade.

The main risk for the NOK side this week is the lead-up to the OPEC meeting on April 17, with the probability of an agreement to cut production looking low for now. NOK’s correlation with oil is much lower than that of CAD.

We like to sell AUDNOK at market with a target of 6.0800 and a stop at 6.2950.

EM – Buy EURTRY

Evidence suggests that positioning in the Turkish lira has built up meaningfully since the rally in EM currencies started in late January. Lower oil prices, stronger-than-expected growth in 4Q15, which was further emphasised in last week’s better-than-expected IP data, and lower inflation have all contributed to a stronger fundamental footing for Turkish assets recently. One concern is the considerable uncertainty over monetary policy in light of the upcoming appointment of the central bank governor , which could come as soon as this week. The presidency of Turkey does not hide the fact that it would like to see interest rate cuts, and it’s quite likely that TRY will weaken a little ahead of the announcement, but we will only really know the stance of monetary policy once the new governor concludes the first meeting on April 20.

The main risk to the trade would be for the CBT’s initial communications to sound purposefully conservative, given the above considerations, as has been the case in Poland following changes to the MPC earlier in the year. Today will see February current account data released, and the expectation is for just over a US $2.2 billion deficit.

We like to buy EURTRY at market with a target of 3.35 and stop of 3.20.

 

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