Currencies: Risk Trades Under Pressure

There can be no doubt now that risk aversion has forcibly made its way back into the market's psyche. Government bonds, the US dollar and the Japanese yen have gained more ground over recent days against the background of higher risk aversion.

Following a tough week in which global equity markets slumped, oil fell below $60 per barrel and risk currencies including many emerging market currencies weakened, the immediate outlook does not look particularly promising.

Data releases are not giving much for markets to be inspired. Even the upgrade to economic growth forecasts by the IMF proved insufficient to boost sentiment, especially as it came alongside a cautious outlook. US trade data revealed a bigger than expected narrowing in the deficit in May whilst US consumer confidence fell more than expected in July as rising unemployment took its toll on sentiment. There was also some disappointment towards the end of the week as the Bank of England did not announce an increase in its asset purchase facility despite much speculation that it would do so.

Rising risk aversion is manifesting itself in the usual manner in currency markets. The Japanese yen is grinding higher and having failed to weaken over recent months when risk appetite was improving it is exhibiting an asymmetric reaction by strengthening when risk appetite is declining. Its more recent positive reaction to higher risk aversion should come as no surprise as it has been the most sensitive and positively correlated currency with risk aversion since the financial crisis began.

Nonetheless, the Japanese authorities will likely step up their rhetoric attempting to direct the yen lower before its strength inflicts too much damage on recovery prospects. The urgency to do so was made clear from another drop in domestic machinery orders last week as well as a poor performance from Japanese equities.

The US dollar is also benefiting from higher risk aversion and is likely to continue to grind higher in the current environment. Risk currencies such as the Canadian, Australian and New Zealand dollars, will be most vulnerable to a further sell off but will probably lose most ground against the yen over the coming days. These currencies are facing a double whammy of pressure from both higher risk aversion and a sharp drop in commodity prices. Sterling and the euro look less vulnerable but will remain under pressure too.

There are some data releases that could provide direction this week in the US such as retail sales, housing starts, Empire and Philly Fed manufacturing surveys. In addition there is an interest rate decision in Japan, and inflation data in various countries. The main direction for currencies will come from equity markets and Q2 earnings reports, however.

So far the rise in risk aversion has not prompted big breaks out of recent ranges in FX markets. However, unless earnings reports and perhaps more importantly guidance for the months ahead are particularly upbeat, there is likely to be more downside for risk currencies against the dollar but in particular against yen crosses where most of the FX action is set to take place.

Comments

[Traffic:]

Risk aversion or suicidal tendencies?

Jul 12 09:51 AM

[nobby73:]

Risk aversion - I am beginning to hate the phrase. The gorilla in the room is the US Dollar, unless I am being brainwashed by the Chinese and Russians. But we are told that buying Dollars is what the street does, so any bad US data sees everyone pile back into the old greenback.

If the kids are outside and it starts raining, mom comes to the step and says, "come on kids, back into the house." The thing is, it's not raining outside, rather the damn house is on fire.

Jul 12 11:45 AM

[DWStein:]

Excellent article! I agree with everything except the causal relationship between equities and currencies.

While sometimes, in the short run, various liquid markets can take their cues from another market, they are generally driven by the same underlying macro fundamentals.

I think equities, currencies, and commodities are reacting more and more to government action. As governments have tried (or not) to stimulate growth and/or counter receding credit, the markets have reacted.

Recent press suggesting the US fiscal stimulus is failing and/or a second package may not arrive has roiled markets significantly. The only thing last week that countered that move was the better-than-expected weekly jobless number.

New lows in risk assets (along with new high's in Yen and new lows in EUR) could be on the way if the US government proves unable (or unwilling) to provide more stimulus; or print enough money, for that matter!

Jul 12 11:47 AM

[Thomas MacLeod:]

But the USD Index has barely moved since the 1st of June! Not exactly risk averse behavior as we have got used to over the last 12 months

Jul 12 06:35 PM

[Matt Stone:]

EURJPY & AUDUSD have both had minor reversals of their recent trends & this is inline with your view. Short term this may continue, although we do see long term value in these positions.

Jul 13 01:30 AM

[Moon Kil Woong:]

There is no way Japan can compete with the US with regards to embracing reckless currency depreciating policies. Poor Japan. In this market the strongest currencies get punished and the weakest companies get bailed out. No wonder the capitalist system in under so much strain. Punishment and reward have been turned on their heads.

Jul 13 04:14 AM