What To Expect From Forex In 2H Of 2013

 |  Includes: FXB, FXC, FXE, FXY, UDN, UUP
by: Dean Popplewell

Will “tapering off” be the most important driver of the currency markets in the back half of 2013?

Most likely Yes. There are many problems associated with the Federal Reserve’s impending exit of quantitative easing (QE) or what’s now known as “Fed tapering”. An anticipated U.S. equity market drop caused by investor exuberance could lead to a significant point drop. This would create a negative spillover effect impacting other countries’ bourses. Just look to the emerging economies where the positive QE3 premium is currently in the process of being revalued. Monetary easing has created a stock bubble as cheap and free money hunts for returns. Central bankers will have their work cut out for them as they attempt to manage investor over-exuberance.

Central bankers’ language at the Fed, the Bank of Japan (BoJ), and the European Central Bank (ECB) has been largely ambiguous and unhelpful. The only fresh theme has been the U.S. dollar as it gained influence and directed other currencies over the past two months.

June and July’s stronger U.S. jobs report has the Fed on track for a potential rollback of stimulus as early as next month. The market is now moving from theory to real possibility pricing, expressed by a surge in the dollar and a move in interest rates. Investors are now expecting the EUR to remain in the "underperformance category" as the U.S. yield advantage is set to trump the persistently low ECB rate environment. Continued weakness in the commodity market will dampen investor appetite for commodity sensitivity currencies like the CAD and the AUD.

In the emerging market stratosphere, expect a further uptick in money flows out of those regions and into the greenback. The problem for the Fed is that its message about tapering and eventually ending QE by mid-2014 continues to see the market price in a “higher path for the Fed Funds rate.” Despite a plethora of Fed speakers telling the market that they have got their Federal Funds rate predictions wrong, the market seems to be clinging to the idea that the Fed is still focused on ending QE. Currently, the Fed is not interested in adding further stimulus despite it missing on its mandates (price stability, long-term interest rates and employment).

The market inherently knows that the Fed cannot keep its “foot on the gas when it recognizes it has to apply the brakes some ways away.” It’s a fine balancing act – the Fed has to be forward-looking and it knows it needs to convince the market to think the same way.

Nonfarm payrolls (NFP) report watching will be a rather contentious economic event for the remainder of the year.

“Lower for longer” in both EUR and GBP rates have been a recurring theme. The new Governor at the Bank of England (BoE), Mark Carney, launched his term issuing a statement along with the BoE decision. It was an uncommon move when there is no policy change to report, but it was somewhat consistent with his actions when he was running the Bank of Canada (BoC). This was followed by the ECB’s announcement. ECB President Mario Draghi and Carney both provided rate “guidance” for the first time last week. In short, they reassured markets that they would continue to provide stimulus well into the future. This is in stark contrast to Bernanke’s comments concerning the possibility that the Fed would consider tapering its monthly bond purchases. Of the remaining G4 members, that leaves the BoJ in unknown territory.

The market was initially confident about Japanese Prime Minister Shinzo Abe’s and the BoJ’s bold rhetoric at the beginning of the year. But a recent, disappointing policy meeting that provided no changes sapped all the goodwill that BoJ Governor Haruhiko Kuroda and Abe had enjoyed. Now the fate of Abenomics rests within the economic indicator Abe is so intently focused on: inflation. His three arrows – monetary policy, government spending, and structural reforms – have lost their edge and his quiver is empty.

What factors should allow emerging market currencies to reverse their latest slide against the dollar?

There are a number of factors that would change the dynamic for emerging market currencies. Chief among them is China. In recent months, we’ve seen disappointing economic figures from the world’s second-largest economy. For instance, in late June Chinese data showed that the private debt/gross domestic product (GDP) ratio has soared by +50 percentage points in just four years. This has markedly outstripped other emerging economies. In fact, it’s bigger than the U.S. and European regions combined in the six years prior to the start of the sub-prime debt problems. From an economic perspective, a rapid rise in a country’s private debt/GDP ratio tends to be followed by economic weakness and balance sheet vulnerabilities among that nation’s banks.

Other points to consider include whether or not the ECB’s Draghi changes his tune and fails to support euro bears and/or a sudden reversal of dovish talk by the ECB and other central banks.

Speaking of central banks, if the Fed changes its monetary policy or if the USD weakens considerably by prolonging QE, more exotic currencies could see a reversal of fortune versus the greenback. Moreover, a collapse of the U.S. equity market could make trading emerging market currencies instantly more attractive to investors.

Does the lack of negative reaction to going over the Fiscal Cliff mean that the "Grand Bargain" negotiations aren’t as important to the market as they were a year ago?

In general, all interested parties appear to be quite happy to continue to kick the can further down the road. Despite the gloomy forecast of economic havoc once the U.S. went over the fiscal cliff, consumers kept spending and businesses continued to hire after budget sequestration took effect last March.

According to International Monetary Fund (IMF) Managing Director Christine Lagarde, the U.S. federal budget cuts made to date are inadequate and the ramifications will continue to weigh on potential economic growth. She is urging Washington to present “credible” fiscal plans.

The market is largely focused on the actions of the BoJ and on Abenomics; understandable with important Japanese parliamentary elections slated for next month. Following the July Federal Open Market Committee (FOMC) meeting, the market will turn its attention back to Abenomics and wonder if it will actually work.

With only three more years to try to persuade the U.S. Congress to see it his way, President Barack Obama is in tough to resolve America’s budget issues. If he fails, it is probable that U.S. stocks will fall, possibly resulting in further USD gains.