RMG Wealth Management

RMG Investment Bulletins

 

By Howard Jones on 09/09/18 | Category - Currencies

After a superb run of weekly commentaries, my colleague Stewart Richardson has called time on the treadmill of finding fresh insights every seven days. Let me start by saying that effort is not one I, or my fellow fund manager, Ciaran Mulhall, will try to measure up to. Instead as times change, so do we and recognise that depth of research, in a world of so many opinions, is fighting for too few eyeballs. No, my aim is far more to inspire thought, provoke reaction, and to be brief. I will trouble you but once a month (Ciaran will do likewise on macro themes), but I hope I will also disturb you to.         

So, where goes the Pound?

It has become a focus of attention, with the exchange rate being taken by many as a barometer for the future prospects of the UK post Brexit (if indeed Brexit occurs).

"Pound down is bad, Pound up is good" so goes the logic. And on each and every coiffured utterance from Barnier, we get in a frenzy.

Let's face it, Brexit is probably the single most important political issue to face the UK since 1945. You can have a sound economy, you can have revered legal and financial institutions, a dominant international language and favourable time zone, but politics can override it all. Especially if the perception (or reality) is one of institutional paralysis or failure.

The UK has had a current account deficit more or less throughout my adult lifetime. Call it 40 years. Now basic economics tells us, on that basis the exchange rate should adjust downwards, until at least we get somewhere close to an equilibrium level.

The historical effective exchange rate index has traded roughly between 140-90 in that time, and we sit close to the bottom now.

Sterling is weak, and actually it should be. It's been trending that way for decades, with the occasional period of exuberance.

That long term trend is unlikely to change, unless we see a post Brexit supply side revolution.

But there are legitimate reasons to be concerned about a Brexit characterised by UK institutional failings. By that I mean inept government and the inability, or unwillingness, of institutions of government, to do as instructed by the British people.

Wherever you sit on the Brexit debate, no sensible person should want to see the apparatus of government so undermined. Yet that is the real and present danger to Sterling. If that trust is lost, then it will be incredibly hard to re-establish it.

In such circumstances, Sterling will fall hard, and that drop would be sustained.

An organised and visionary Brexit may well also see a fall in Sterling, but I suspect it would be short lived. An open and flexible UK economy, perhaps with significantly lower corporate tax rates, and an immigration policy open to all with the required talents, could be the kind of supply side reform that markets embrace.

But a fudge just won't do. It will lead to increased uncertainty, and prolonged government bickering, further undermining our institutions of government.

One of the eternal conundrums of foreign exchange is after identifying the liability currency, you then have to find the asset currency. In other words, you may think the pound falls, but against what?

In a messy exit lacking vision, Sterling will fall against most things. But let's not kid ourselves that the Euro is some kind of safe haven. The election of Macron was viewed by some as the dawning of a European Renaissance. However, I would suggest that it is more like the apogee, than the start of "more Europe".

Markets adapt to economics in a relatively orderly manner, but when the big picture politics go awry, all bets are off.

And the politics of Europe are changing. This is no localised short-term protest movement, but rather widespread and deep held convictions that somehow Europe or the Euro isn't working for great swathes of people. Both right and left of the political spectrum are seeing a surge in support, and I suspect too many people in Berlin and Brussels are viewing this as just another minor irritant, rather than a groundswell of opposition.

And unlike Greece, Italy is going to be no pushover for either the EU or the ECB this time around. Debt levels are unsustainable, the buyer of last resort that has kept European bond markets so buoyant, will be no longer be present, the demand for infrastructural spending, post the bridge collapse in Genoa and the introductions of minimum incomes and lower taxes, will simply blow the EU budget rules out of the water. And the ECB and Germany are on the hook, big time.

Italians are fed up with internal devaluations forced upon them by Berlin and Brussels.

And the Euro is viewed as the major millstone around their necks.

This has the makings for one heck of a showdown.

So I'd suggest that selling Sterling against the Euro is at best a very short term proposition. An existential threat to the Euro is raising its head, and the beast could easily display hydra like qualities.

The dollar is still the best asset currency to hold against Sterling, although from an historical point of view, anywhere approaching 1.10 dollars to the pound is "cheap".

There is much already priced in to the exchange rate, and some hold the view that markets are already too pessimistic and Sterling offers value. That may be true, but only on a short to medium term economic basis.

The outlook is not dependent on Brexit, but on the health of our political institutions and the vision or leadership when Brexit occurs. If the perception grows of institutional ineptness or indeed deliberate thwarting of long held democratic principles here in the UK, then the pound will fall hard and deservedly so.

By Stewart Richardson on 28/01/18 | Category - Currencies

To view a PDF of this report, click here.

We've all seen charts similar to the chart below, showing US bond yields, and the extraordinarily orderly decline in yields over the last 30 years or so. On the chart, we have marked the trend channel that has contained all price action for at least 25 years, and the red horizontal line illustrates some chart resistance at current levels. At the risk of stating the obvious, within the confines of a multi-decade trend that has shaped the performance of all financial markets globally, we are near a tipping point that should be resolved within the next 9 months.

Chart 1 - Weekly chart of US 10 year bond yield

 

We have made the case recently that higher interest rates could easily impact global financial markets, and although equity markets are seemingly ignoring this as they melt up, there is a potential coming together of macro factors that really could change the world as we know it.

Since the end of WWII and the signing of the Bretton Woods agreement, there has been one major change to the global financial system. Between 1944 and 1971, most currencies were fixed against the US Dollar, and with the Dollar convertible to gold at a fixed price of $35, there was a backstop against US profligacy. So long as the world had faith in the Dollar, and decided against converting Dollars to gold, everything would be fine.

However, the fiscal strains for the US began to show in the 1960s, and in August 1971 the US ended the convertibility of Dollars into gold, and the world order shifted from an effective Gold Standard to a US Dollar Standard.

For decades, the Dollar standard has worked incredibly well. Credit creation, untethered from gold and controlled by commercial and central banks, has led to strong global growth and rising asset prices. The dark side of the Dollar Standard is that it has also led to an unparalleled growth in debt in virtually every country and every sector. The economic outcome is that rather than the economic cycle being mostly about inventory cycles, it is now much more sensitive to boom and bust cycles in the financial markets.

But so long as everyone played to the rules of the Dollar Standard, things would generally be ok. What we don't know is what would be the impact on the global economy and global financial markets if the global system shifts away from the Dollar Standard.

In just the last few weeks, we have the following dynamics to consider;

1.Trump slapping tariffs on selected items with more to come

2.China hinting that they would hold fewer reserves in US Dollars

3.Other central banks admitting that they are already holding more reserves in Yuan, and that they expect the amount to be higher in the future

4.US Treasury secretary publicly saying a weak Dollar is good because it will help the US trade position

5.The passing of US tax legislation that is likely to lead to a much larger budget deficit

6.The beginning of quantitative tightening that will see the Fed's balance sheet reduced by $450 billion in 2018 and likely more in 2019

These dynamics, together with Trump's more isolationist agenda, are threatening the Dollar standard. So the big picture questions are 1) will the Dollar standard remain in the years ahead and 2) if it changes, how and what will the new system look like and 3) what will happen to the global economy and markets during any transition?

These are such big issues that we won't be able to answer them in one commentary. What we can see is that if global investors begin to lose confidence in the Dollar at a time when US inflation is rising, bond yields are rising, the Dollar is weakening, the budget deficit is set to increase dramatically and the US central bank is draining Dollars from the system, there is a case to be made that the future may not be quite as bright as many pundits are currently claiming.

But these dynamics change relatively slowly, and financial markets are currently in no mood to think negative thoughts. 

We would like to add just a couple more thoughts in the big picture. First, the US consumer may be running on fumes. The household savings rate has collapsed, and as a result growth remains reasonable. At the same time, consumer debt is increasingly dramatically just at the point when interest rates are rising. There is a strong case to make that unless households can find a new source of income, rising interest rates and inflation will impact both consumer spending and therefore the economy.

The second thought is on oil. At $65 on US WTI, this represents an increased burden for the US consumer compared to a year or two ago, and a potential boom for US shale. If the US consumer begins to retrench at a time when US policy is becoming more isolationist and the US continues its shift towards energy self sufficiency, this will reduce the US current account deficit, adding a further strain to the Dollar standard that has been in place since 1971.

All of these thoughts need to be fleshed out, and we will attempt to do so in the weeks ahead. However, as we sit here watching equity markets melt up, retail investors piling in at record levels and reliable valuation measures at levels comparable to 2000 and 1929, we begin to worry that a collapse or large shift to the Dollar standard would come as a huge shock to the global system. We are watching the rise in US bond yields, the decline in the US Dollar and the policy shifts occurring on the global stage, and wonder whether these are indeed major warning signs that investors are ignoring simply because the equity market party feels like a great place to be and there is a huge inertia and fear of missing out.

We are also acutely aware that either our concerns may be mis-placed, and that it could take a long time for them to matter even if we are correct to be concerned. So, for the moment, our concerns remain focused on bonds and the US Dollar, and even in the short term, we wonder whether the Dollar in particular is oversold and due some sort of relief rally. However, with market valuations so stretched, we do think that equity investors need to have their exit plans at the ready. So far in 2018, we have seen volatility inch up across the major assets, and with everything else noted above, we wonder aloud whether an increase in market volatility could be the harbinger of greater change in the months ahead. 


By Stewart Richardson on 26/11/17 | Category - Currencies

To view a PDF copy of this report, click here.

My colleagues have been urging me to write a weekly commentary on Bitcoin/Cryptocurrencies. However, although my interest in the sector is growing, I am not sure that I am nowhere near close enough to the action to comment. I will continue to read as much as I can about this new phenomena, but in the meantime, we will stick with traditional fiat currencies. So here goes.

The US Dollar, having enjoyed a reasonable bounce from the mid-September lows, is struggling to maintain its balance as we head towards the end of the year. The weakness is apparent even though interest rate differentials appear to be supportive. The most obvious explanation for the Dollar weakness seems to be that investors and traders continue to expect the Fed to be more dovish than their forecasts suggest. 

Frankly, we can build both bullish and bearish Dollar scenarios at the current time, and with price suggesting the Dollar is struggling a bit, we will err on the cautious side in the short term until proven otherwise. But we are not sure that any upcoming Dollar weakness, if seen, will be as broad and persistent as it was between April and September. Let's jump in and have a look at a few charts to develop our thinking here.

First up, the Euro seems to be leading the charge against the Dollar. Why so? Well, economic data shows that the Eurozone is performing pretty well and perhaps signs that Germany may not have to have another election help. But it could also simply be that if traders want to sell the Dollar, they will first buy the most liquid alternative, and that's the Euro. It could also be more structural, as the Dollar's reserve status seems to being chipped away constantly. In chart 1 below, we can see that the Euro rose strongly between April and September, and that the recent downward price action broadly found support at the previous highs of the last few years. From the most simple of technical perspectives, we think that the recent move lower from about 1.21 to near 1.15 looks more corrective in nature, and that the Euro has to at least trade back to the September high of around 1.2100. 

Chart 1 - EUR/USD weekly price graph with 21 week moving average

Drilling down to a shorter time frame, in chart 2 we have shown the daily price graph. We have shown two resistance lines on the chart. One being a downward sloping trend line (in white) drawn off the high in September, and also a horizontal line (in red) drawn from the high in mid-October. On Tuesday of last week, having already broken the downward sloping trend line, EUR/USD appears to have tested the same downward sloping trend line from above and reversed higher. On Friday, EUR/USD moved higher and traded above the highs seen in mid-October. 

Chart 2 - EUR/USD daily price graph with 21 day moving average

From a purely trading perspective, as noted, we should really now expect EUR/USD to carry on higher and at least trade to the 1.21 area. If this level is exceeded, price may even extend towards the 1.25 area (although we are less sure about this at this stage). First support is in the 1.17 area, and for the bullish Euro thesis to remain valid, price has to remain above 1.15 area.

Moving onto Sterling, the situation does not look quite as robust as the Euro. Chart 3 shows the daily movements of Sterling versus the Dollar, and we think the most important technical feature at the moment is the gently rising channel shown. If this interpretation is correct, then we should look at this sideways type movement since late September as a correction of the decline from 1.3650 to nearly 1.30, which should at some point lead to a test of 1.30 and below.

The price action on Friday just may be of interest as well. Sterling did rise against the Dollar, but the advance was a lot less robust that the Euro's advance, indicating perhaps some underlying relative weakness in Sterling. Furthermore, price traded right up to the top of the channel during Friday, but began to fade away into the close. The way we are looking at this is that Sterling may be close to a short term peak against the Dollar, and we will hold a bearish trading bias so long as price remains below 1.3380 area on a closing basis.

Chart 3 - GBP/USD daily chart

Let's quickly take a look at two more currencies; the Aussie Dollar and Japanese Yen. The Aussie Dollar has been amongst the weakest of the majors during the Dollar rally that began mid-September. We in fact highlighted the Aussie Dollar a couple of times in recent months as potentially a weaker currency play, and our view remains bearish. Chart 4 shows that price remains in a steady downtrend, and we are looking for the rally in the last week to fail around about current levels, or if the Dollar is weaker than expected, we could see a rally up to the 0.7700/30 area. We have highlighted before how the Reserve Bank of Australia remains quite dovish, and this is still the case. We also harbour big worries over the level of household mortgage debt and the Australian property market, but we'll leave that story for another time.

Chart 4 - AUD/USD daily price graph with 21 (gold) & 50 (purple) day moving averages

The Japanese Yen may be the most unpredictable major currency at the moment. Aside from stories that the Bank of Japan continue to play around in the market, price itself is smack bang in the middle of a 108 to 115 trading range, as can be seen in chart 5. When we analyse market positioning, the Yen is the only currency where speculators are holding a large short position. The net speculative short position is large enough to make us worried about selling the Yen.

There is also a growing feeling that the Bank of Japan is laying the groundwork for a subtle shift in policy next year. Subtle perhaps being the word, as when policy is as extreme as it is in Japan today, and with the knowledge that any major reversal could have seriously negative consequences for Japanese financial markets, the Bank of Japan are in a dark corner that they don't know how to get out of. But there is talk that they may shift their yield curve control policy, and instead of targeting the 10 year yield at zero per cent, they will shift that to the 5 year yield. This would allow the 10 year yield to trade more freely, and presumably with an upside bias which, all other things being equal, would be positive for the Yen.

Chart 5 - USD/JPY weekly price chart

So, at the moment, we are somewhat agnostic on the Yen, but with a bias to look for opportunities to buy as speculators may have to cover their short at some point, especially if the market perceives that the Fed will be more on the dovish side of the ledger, and/or risk assets ever have a period of corrective price action.

Looking at some of the major currencies, we get the overall picture is a mixture of themes, without one dominant one. When we see this sort of backdrop, we think we need to be careful not to become married to any one theme, and that we should maintain a flexible and more tactical approach as the market may switch focus very quickly.

As we see it, the Euro is currently the strongest of the major currencies, followed by the Yen. The Antipodean currencies are at the bottom of the pack, and the US Dollar is somewhere in the middle. We think the factors that the market is focusing on for the Dollar can change quite quickly, although tax reform seems to be taking a little longer than the White House would want. The UK did not have a great week in our opinion, with growth estimates reduced and borrowing expectations increased in the Autumn Statement. Despite being a relatively cheap currency, the UK has a monstrous task ahead, and we think that Sterling can sit near the bottom of the pack.

With Central Banks trying hard not to rock the boat, or make any obvious policy errors, we doubt that we see any major moves in the FX markets between now and year end. Yet, after such a long period of calm in global financial markets, we have to suspect that volatility will increase at some point soon. By maintaining a flexible and tactical approach in the short term, we think that we will have the opportunity to identify future changes in the early stages of their development. 


By Stewart Richardson on 23/10/16 | Category - Currencies
To view a PDF copy of this report, click here 
 
There is no doubt that big swings in the value of the US Dollar have a big impact on global economic growth and also financial markets performances. Between June 2014 and January 2016, as the Dollar rose by over 20%, global equity markets struggled (Emerging Markets suffering the most), commodity prices plunged and deflationary concerns moved front and centre. After the Dollar topped in late January, everything has turned around. The Dollar has traded sideways, financial markets have performed pretty well overall and economic concerns have abated. Although it cannot all be about the Dollar, we need to recognise that the Dollar is extremely important for both financial markets and the global economy.

So, it is with growing interest that we see momentum gaining in the US Dollar. In chart 1 below, we show the US Broad Trade Weighted Index which has gained nearly 3% in the last two months and is trading at its highest in nearly eight months. Although this recent Dollar strength may turn out to be nothing more than short term "noise" within a larger consolidation, there are reasons to believe that further Dollar strength lies ahead.

Chart 1 - The US Dollar Broad Trade Weighted Index
 
From a central bank divergence standpoint, the Dollar appears to be attractive. The Fed continue to guide market expectations towards a gradual normalisation of policy, whereas the Bank of Japan and European Central Bank remain in full on emergency mode and other central banks continue to discuss more easing. Although policy divergence is not the only currency driver, it should remain important.

Another development that is beginning to capture some headlines is the persistent weakness in the Chinese Yuan. Chart 2 below shows the US Dollar versus Chinese Yuan exchange rate. Within a larger Dollar bull market, gains appear to be accelerating in the last couple of weeks. In August 2015 and January 2016, accelerating Dollar gains led to losses and higher volatility across global risk assets.

Chart 2 - The US Dollar/Chinese Yuan Exchange Rate
 
Understanding Chinese currency policy is not always straight forward, however, the underlying story here is one of continuing capital outflows. Chart 3 below (courtesy of Goldman Sachs) shows Chinese capital flows. As can be seen, although capital began to leak out of China in late 2014, there was a marked increase Summer 2015, coinciding with the mini devaluation, and again around the turn of the year. It would appear that capital outflows are increasing again which we believe is a negative for the Yuan, and potentially a bearish portent for global risk assets.

Chart 3 - China Capital Flows
 
Now, there is no doubt that Dollar bulls have been disappointed in recent months as the Fed actively moved away from the four rate rises promised in January by vice chair Stanley Fischer. However, the Dollar strength in recent weeks has the feel of something bigger developing. One asset that is not confirming our thesis however is the price of oil. Chart four below shows the performance of the Dollar and WTI Oil. The correlation over the last three years is clear, and future US Dollar strength should surely impact the price of oil. 

Chart 4 - The US Dollar v. the Oil price
 
However, the correlation has gone awry in recent weeks. The prospect of some sort of deal at the upcoming OPEC meeting is supporting the oil price. However, with Opec output continuing to rise and global inventories still way above average, we suspect a freeze will simply not be enough. If we are right on this point, and the price of oil begins to decline back towards $40 this will have quite large consequences for global assets and for the global economy (there will be winners and losers but psychology is still that lower oil is deflationary).

In such a scenario, Emerging Markets, especially those reliant on commodities could suffer and hot capital would likely switch to actively selling EM assets. Commodities generally would lose value which could easily weigh on global equity markets. If the oil price were to fall far enough, then the bond market could well move yields lower despite the potential for higher inflation in the next few months.

So to try and wrap up this week. There remain a number of important macro factors that could influence markets, however a number of them just don't seem to matter in a world of extraordinary Central Bank largesse. What is really grabbing our attention because it could be very important is the recent strength in the US Dollar. Yes, there will be corrections along the way, but we do believe that the recent Dollar gains are the start of something bigger. Recent gains are occurring despite no dramatic shift in central banking policies, and illustrate that there is a growing shortage of Dollars in the global system, and that growing shortage could easily be the oil that lubricates any future Dollar strength.

Global investors and policymakers have learned the hard way in recent quarters how important the Dollar really is. Another period of Dollar strength would be damaging to both financial markets and the global economy. Amongst many important factors that investors need to be aware of, the Dollar is the most important, and could well be signalling an impending end to the recent calm that has prevailed.


By Stewart Richardson on 07/05/16 | Category - Currencies
For no obvious reason, the US Dollar turned higher on Tuesday and barely looked back all week. As suspected, with a stronger Dollar came weaker equities along with commodities and high yield bonds. In short, a classic risk off week.
 
When we say there was no obvious reason for the Dollar's recovery, we had actually been looking for this to happen for a couple of weeks or so, and so it was not a huge surprise. There really has been no fundamental improvement in any of the big macro concerns that have been plaguing markets for what seems like years now. The decline in the Dollar since January was in conjunction with yet another centrally ordained risk rally driven by more easy money. Unsupported by improving fundamentals, we believe these risk-on rallies are doomed to failure; it's simply a question of trying to spot the turning points, and we continue to believe that the Dollar's performance is key in this regard.
 
Furthermore, shorter term traders had definitely shifted to quite aggressive short positions in the Dollar especially against commodity currencies, and the anecdotal evidence suggests that some investors had increased exposure to emerging markets FX as well. The initial stages of a rally in any asset will be when shorts get squeezed as price rallies, and the Dollar certainly rallied after an attempt early in the week to break below significant support levels. We have shown this in chart 1 below, suggesting that the pattern seen last week in the Dollar is a solid reversal pattern, i.e. one that we believe has an excellent chance of holding true.
 
Chart 1 - Weekly candlestick chart of the US Dollar Index
 
What we think is impressive is that the Dollar closed very near the high of the week, and was easily able to shrug off some temporary weakness immediately after a slightly softer than expected US employment report. Any asset that can rally in the face of any type of disappointing news (although the US employment report was not that bad at all) is an asset that is in demand. 
 
Of course, the Dollar index shown above is a broad index, and the Dollar was strongest against commodity and emerging market currencies. However, it was able to register minor gains against the Euro and Yen despite the general risk off environment - another sign that the Dollar is turning higher. We think that this performance sets the tone to the period ahead and we will be looking to focus our attention on being long the Dollar against the commodity and EM currencies. Of course, nothing moves in a straight line, and so we would prefer to buy the Dollar on any pullbacks, but if the big trend in the Dollar has turned higher, we do want to be involved, especially in the recently launched RMG FX Strategy UCITS fund.
 
We also noted a potential reversal pattern in US bonds at the end of last week. Although we don't think the reversal in bonds is as strong a signal as the one in the Dollar, it is clearly an early warning that US bond prices may be headed lower (yields higher).
 
Chart 2 - The continuous futures contract on 10 year US Bond
 
We have been on record quite a few times in recent quarters arguing that US recession risks are a lot higher than many believe. We think that the risk in the next few quarters is for a strong whiff of stagflation as growth remains at stall speed and inflation picks up. Any decline in bond prices is likely a reflection of this stagflationary potential. As we made clear in our earlier recession risks commentaries, a recession is likely to occur after equities have entered a bear market, which we have not seen yet!
 
We came across the chart below illustrating what should happen to inflation in selected countries, assuming oil stays at US$45 a barrel. As can be seen, we are a month or so away from the next low in inflation, before a decent pick up into year end.
 
Chart 3 - Potential CPI assuming oil remains at $45
 
 
Very shortly, the Fed will have little choice but to admit that they have met their primary objectives on employment and growth. Assuming no new global worries or financial events, they will have a huge amount of explaining to do as to why they are not raising rates. It is this outcome that gives the fundamental support to a strong US Dollar.

Will the Fed actually raise rates? We are not so sure they will, but if they do, we think they will regret it later. If they don't, they will continue to see their credibility being publicly questioned. As we outlined with Japan last week, it is possible that the Fed will be damned if they do and damned if they don't. If they do raise rates, the strength in the Dollar will hurt the economy and if they don't raise rates, they lose credibility and financial markets decline anyway

And this brings us onto the equity markets, where it's been a pretty rough week for some. Emerging markets fell by 4.1%, Europe by 2.9%, Japan by 3.4% and the US by 0.4%. It feels very similar to recent periods where declines are being led by emerging markets and the US holds up for longer. Of course, last August and again at the start of the year, the US eventually played catch up on the downside. Frankly, we think that global equity markets are vulnerable to another sell off at some point in the not too distant future.

Chart 4 - MSCI World Index appears vulnerable to another sharp correction
 
It's early days in terms of the next leg in the US Dollar's big bull market, but it would appear that the correction is now over. A strong Dollar will be a negative for both the global economy and global financial markets. As has been the case in recent quarters, emerging markets are leading the way, both equities and currencies. European and Japanese equities continue to be moribund at best, despite negative interest rates and QE, and the US continues to outperform despite stratospheric valuations. If sentiment deteriorates far enough, then we expect all risk assets to drop sharply, as has happened twice in the last 9 months. It's time to prepare for more volatility.
  

By Stewart Richardson on 08/11/15 | Category - Currencies
With the Fed nudging investors in recent weeks to expect the first rate rise in December, the strong jobs report on Friday now has everyone convinced that a December hike is inevitable. In our opinion, the best way to position for Fed rate hikes is to be long the US Dollar. Initially, we think the US Dollar will be strong across the board. Moving in to 2016, we think the Dollar will be strongest against selected Emerging Market currencies.
 
Two weeks ago post the ECB meeting, we said that we felt that the Euro/US Dollar exchange rate had entered a new bearish phase. Having closed that week around 1.10 we said that we felt the 1.05 area would be tested and ultimately we would see a move to parity. With the Euro now just above 1.07 our forecast appears to be on track.
 
 
It's not that hard to be bearish of Euros at the moment, with Mario Draghi hell bent on weakening his currency. That said, one of the main drivers of the recent weakness against the US Dollar is the widening rates differential in favour of the US. In the chart below, we show how the Euro/Dollar FX rate has been tracking interest rate differentials as measured by the difference between the respective 5 year Government bonds. To be clear, the red line depicting the rate differentials is inverted and illustrating that 5 year US Treasuries yield about 1.7% more than German 5 year bonds.
 
 
As well as being bullish the US Dollar against some of the major currencies such as the Euro, our preferred structural bullish Dollar trade is against selected Emerging Market currencies. We have laid out the bearish EM scenario quite a few times in the last year or so, and a strong US Dollar on the back of Fed rate rises will potentially just make matters worse. Commodity sensitive currencies continue to struggle with most commodity prices remaining depressed and supply still expected to exceed demand for some time to come. However, many commodity sensitive currencies have already depreciated markedly in the last two years. Our focus remains on mercantile Asian currencies which we believe are likely to weaken their currencies especially if the Euro and Yen continue to depreciate on the back of ultra easy monetary policies.
 
The chart below shows selected EM currencies (and Japan) against the US Dollar over the last 5 years. It is clear that North Asian mercantile currencies have held up incredibly well compared to other EM especially those exposed to commodities. With Japan having depreciated significantly over the period, mercantile Asia is struggling to compete and in a world where currencies have become an active tool for policymakers, we believe that Asian currencies will be managed lower over the next 12 months.
 
 
Quickly looking elsewhere. In the current environment of policy divergence between US and Europe, and a strong Dollar, we expect European equities to outperform the US. We would also expect continued underperformance of EM equities.
 
In fixed income, markets are pricing in a series of rate rises in the US over the next couple of years. We still believe that the Fed will only be able to raise rates a couple of times in this cycle. If we are correct in this, then the longer end of the interest rate curve (the Dec '17 to Dec '18 EuroDollar contracts) is beginning to offer some value. As for US Bonds, they have suffered another tough week, and may continue to trade poorly as investors position for the start of a rate rising cycle and reserve managers remain forced sellers. However, relative to core European Government bonds, a pick-up of 1.7% in the 5 year and 1.6% in the 10 year actually looks quite attractive to us.
 
We will cover equity and bond markets in more detail next week, however we think the potential in these markets is more nuanced than a simple bullish or bearish forecast for the next few months. Relative value trades appear to have better risk reward potential with European equities preferred to EM and US and US bonds preferred to German bonds. The message in currencies is simpler. We expect the Dollar to remain strong against most currencies with EM being the weakest over the next few quarters.

 

Page: 1 of 3

Recent Posts



Categories



Archive

Disclaimer
RMG Wealth Management LLP is authorised and regulated by the Financial Conduct Authority (FCA). These reports are for general information purposes only and do not take into account the specific financial objectives, financial situation or particular needs of any particular person. It is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it. This report is based upon public information that RMG considers reliable but RMG does not represent that the information contained herein is accurate or complete. The price and value of investments mentioned in this report and income arising from them may fluctuate. Past performance is not a guide to future performance and future returns are not guaranteed.