With FX markets range-bound in sideways summer trading, much of the focus and conversation has turned to September. Expectations for Fed tapering bond purchases has fueled treasury selling and can be seen by the sharp moves in US rates over the past 3 months. This movement has led to a significant number of discussions worrying about what these higher rates mean for the US recovery. Market participants have been reluctant to reallocate from bonds back into risk assets (such as equities) on fears that higher rates will lead to reduced economic activity. This concern has largely been overblown by talking heads generalizing economic principles without taking into context the corporate US position. There are major misconceptions and significant factors to consider when mapping the relationship tapering will have with broad US activity.
Tapering is Becoming the Posterboy for Bears:
The logic goes: "Increased rates will cause higher cost of capital for corporate borrowing. This will cause less economic investment, bringing about a decline in economic activity and job growth will stall."
While the premise is true (tapering => inc rates => higher cost of capital), the conclusion of this argument is false. The fact is, job growth has historically been positively correlated with treasury interest rates and we still are seeing a significant gap between the two as a result of the QE programs. The intuition behind this relationship is basic, corporate investment is based on expected market returns in the future being greater than current cost of borrowing. As a benchmark, treasuries are then used as the risk free expected rate of return.
This is also why we have been seeing record levels of corporate debt issuance while experiencing minimal re-investment flow. Cost of holding cash has been at historical lows while expected economic returns have been artificially depressed due to QE. This has essentially created a pocket of freely available corporate cash, which is just waiting for interest rates (and thus expected returns) to rise before being re-invested. This post-tapering corporate reinvestment flow will outweigh the decline in corporate borrowing from higher cost of capital. The reinvestment flows fuel a positive feedback loop of whereby increased economic activity (caused by the reinvestment flow) will be a catalyst for further expected increase in rates (increased returns in risk assets = less demand for sovereign FI/treasuries). Expected future increase in cost of capital stimulates rational borrowers to borrow in the moment rather than at higher rates in the future.
Likewise, we see that steepening of the yield curve has increased lending supply and will continue to steepen as debt yields increase. With the supply and demand for credit increasing, this is a very powerful potential tailwind to the economy over the next year or so. The fact that credit is more available, albeit at a higher price, will be more of a stimulus to the US economy than when the price of credit was cheaper but unavailable.
The Obvious Moves:
The bottom line here is tapering will lead to higher rates and as H2 begins to unfold, dollar strength trends will re-emerge. Across the board, the most attractive plays are still to be shorting EM (BRL, MYR, INR, SGD) currencies against the USD through end of year.
In G10, the most attractive USD longs are against the EUR, CHF, and JPY. Once tapering starts, the FX conversations will focus away from the Fed and back towards ECB with respect to Greek bailouts (rumor mill already spinning regarding early 2014 bailouts) and impact of Abe's 3rd arrow (including the debate over the 2014 sales tax hike). While summer doldrums continue to range, this is presenting very attractive prices above 1.325 (E/U), below 0.93 (U/CHF) and below 97.00 (U/J) to build core positions with EOY targets 1.22 (E/U), parity in CHF, and 105 (U/J).
As always, the preferred instrument for individual investors on these moves would likely be via OTC rolling spot positions. Although ETFs are an option (YCS, EUO, UUP, etc) I always suggest people take care when considering. They increase the carry cost of the position significantly by failing to efficiently realize carry differentials of rates (not as significant with EUR but is very much so non-trivial when shorting JPY) further penalizing holders through unnecessary expense ratios.
Additional disclosure: I hold medium term barrier option interest in long USD ag. EUR and JPY.