Mitul Kotecha's  Instablog

Dubai’s bolt out of the blue is hitting markets globally, with the aftershock made worse by the thin liquidity conditions in the wake of the US Thanksgiving holiday and Eid holidays in the Middle East.  Estimates of exposure to Dubai companies vary considerably, with European banks estimated to have around $40 billion in exposure though what part of this is at risk is another question. 

The lack of information surrounding the Dubai announcement made matters worse.  The aftermath is likely to continue to be felt over the short term, with further selling of risk assets likely.  Indeed, there is still a lot of uncertainty surrounding international exposure to Dubai or what risk there is to this exposure and until there is further clarity stocks look likely to face another drubbing.

The most sensitive currencies with risk aversion over the past month have been the JPY, and USD index, which benefit from rising risk aversion whilst on the other side of the coin, most Asian currencies especially the THB and KRW as well as the ZAR, and AUD look vulnerable to any rise in risk aversion.  JPY crosses look to be under most pressure, with the likes of AUD/JPY dropping sharply and these currencies are likely to drop further amidst rising risk aversion. 

The rise in the JPY has been particularly dramatic and has prompted a wave of comments from Japanese officials attempting to talk the JPY lower including comments by Finance Minister Fujii that he “will contact US and Europe on currencies if needed”.  So far, these comments have had little effect, with USD/JPY falling briefly through the key psychological level of 85.00, marking a major rally in the JPY from a high of 89.19 at the beginning of the week.  Unless markets believe there is a real threat of FX intervention by Japan the official comments will continue to be ignored.

It’s not all about risk aversion for the JPY, with interest rate differential playing a key role in the downward move in USD/JPY over recent weeks.  USD/JPY has had a high 0.79 correlation with interest rate differentials over the past month.  The US / Japan rate differential narrowed sharply (ie lower US rate premium to Japan) to just around 4.5bps from around 100bps at the beginning of August.  With both interest rate differentials and risk aversion playing for a stronger JPY the strong JPY bias is set to continue over the short term.

Is this the beginning of a new rout in global markets?  It is more likely another bump on the road to recovery, with the impact all the larger due to the surprise factor of Duba's announcement as it was widely thought that Dubai was on the road to recovery.  The fact that the news took place on a US holiday made matters worse whilst the weight of long risk trades suggests an exaggerated fall out over the short term.

Risk appetite is failing to show much improvement this week and sharply weaker than forecast US housing data dampened sentiment further following other soft data over recent days including the Empire manufacturing survey, industrial production and retail sales less autos.  The data will add to concerns about the pace and magnitude of growth in the months ahead.

A sub-par recovery and benign inflation outlook are the two main reasons why the Fed will not hike rates for a long while yet.  This was echoed by St. Louis Fed President Bullard - a voting member of the FOMC - who gave a little more colour on the Fed’s “extended period” statement.  He highlighted the probability that US interest rates will not be raised until the first half of 2012. 

Bullard noted that following the past two recessions the Fed did not raise rates until two and half to three years after recession ended.  This is accurate given that in 2001 the Fed did not begin to hike rates until around 2 ½ years after the end of the recession whilst in 1990-91 rates did not go up until close to 3 years after recession ended.  This recession just passed was arguably worse than both of the past two, so why should rates rise any earlier?
 
One factor that could trigger an earlier rate hike is the risks from the massive global liquidity fuelled carry trade fuelled by Fed policy.  Bullard highlighted that the risks of creating an asset bubble from keeping rates “too low for too long” may prompt an earlier tightening.  What will be important is that the Fed gets the exit strategy right and the risk that delaying any reduction in the Fed’s balance sheet and asset purchases could turn out to be inflationary which in turn would be negative for the USD and hit confidence in US assets. 

The Fed is very likely to adjust the level of quantitative easing well before contemplating raising interest rates. The market is pricing in around 50bps of rate hikes in the next 12 months but even this looks to aggressive and as has been the case of recent months the market is likely to push back the timing of expected rate hikes.  The consequences for the USD are negative at least until the market becomes more aggressive in pricing in US interest rate hikes or believes the Fed is serious about its exit strategy.