End of the USD downtrend? Michael Metcalfe Head of Global Macro Strategy

Transcription

1 End of the USD downtrend? Michael Metcalfe Head of Global Macro Strategy

2 End of the USD downtrend? Major USD index > Re-coupling global disinflation policy catch up did the USD overshoot? > Repatriation why it helps the dollar how it relates to market turbulence who is vulnerable? > Regret the USD5trn hedging question why US investors should follow their flows Jan-74 Jan-79 Jan-84 Jan-89 Jan-94 Jan-99 Jan-04 Jan-09 > Risks inflation who will buy Treasuries? crowding out 1 Source: Bloomberg

3 All down together And no recovery in 2009 Consensus for G7 growth 2008 Consensus for G7 growth USD EUR JPY GBP CAD USD EUR JPY GBP CAD Jan-07 Jul-07 Jan-08 Jul Jan-08 Mar-08 May-08 Jul-08 Sep-08 2 Source: Consensus Economics Inc

4 Policy is still expected to be tight Catch up will be uneven Where is policy expected to be restrictive? Output gap ULC yoy% (deviation from average) Nominal GDP (2009) Official rates today Expected yield (2009) Norges Bank SNB BoJ RBA 0 JPY CAD USD SEK CHF AUD EUR GBP NOK Riksbank 150 Easy Policy reversal and catch up Tight RBNZ ECB 0-50 BoE BoC Change in CB policy rate since July 07 Fed Change priced in the 4th IR contract USD CAD GBP NZD JPN EUR CHF AUD SEK NOK Source: State Street Global Markets, Datastream, Bloomberg

5 EM is sounder than before but is not immune Leveraged plays on growth will suffer 4.50 US corporates BBB EMBI 200 MSCI Developed Market Index (rebased) MSCI Emerging Market Index (rebased) Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 4 Source: MSCI, Bloomberg

6 Why is policy re-coupling important Relative yields have explained currency moves 8 Correlation btw USD moves and 2-yr yield differentials 2.50 EURUSD and 2 -yr yield differential Past 52 weeks Average ( ) Sig. level Aug-07 Dec-07 Apr-08 Aug-08 NZD CAD CHF GBP NOK AUD SEK EUR JPY Implied 2-yr yield differentials EURUSD rhs 5 Source: State Street Global Markets, Bloomberg

7 Repatriation fills the gap The USD is not so overbought > OLS regression on changes in yield and repatriation- past 52 weeks > Δ EUR/USD = (Δ Yield diff) rsq 33% > Δ EUR/USD = (Δ Yield diff) (Repat) rsq 42% Where Repat is a dummy variable that takes the value of 1 in weeks of falling cross-border equity flows 1.00 Dummy variable on equity flow repatriation 1.60 Not such a big EUR overshoot No repat 1.40 Jun-08 Jul-08 Aug-08 Sep Jan Mar May Aug Oct-08 EURUSD implied by yield differentials EURUSD implied by yield differential and repatriation variable EURUSD 6 Source: State Street Global Markets, Bloomberg

8 An odd safe haven Why does the dollar benefit from repatriation > Negative real rates, budget & current account deficits > Huge international deficit on fixed income securities > Is balanced by a surplus on equities If cross-border equity flows fall, there will be a net inflow into the US 2 15% US international investment position (% GDP) Equities Fixed income securities 3 25% US holdings abroad surge 1 5% 2 15% -5% % -2-25% 5% US holdings of non-us equity % market cap. Foreign holdings of US equities % mkt cap 7 Source: State Street Global Markets, Federal Reserve, US Treasury

9 Regime map Behaviour has been predicative Japan Asia Latam Eastern Europe Europe exuk US Commodity Countries UK Leverage crossborder EFI, percentiles 5 10 Commodity Countries Latam UK Asia US Eastern Europe Europe exuk Japan Liquidity Abounds crossborder EFI, percentiles 5 10 Mapping behaviour Think of a grid of intercity distances. A self organising map is a neural network that would locate each data point relative to all the others. In other words, from the grid of intercity distances it would draw an approximation of the geographical location of the cities. We do the same, but the grid is the pattern of equity flows observed each month. US Eastern Europe Japan UK Europe exuk Latam Commodity Countries Asia Riot Point crossborder EFI, percentiles 5 10 UK Europe exuk Commodity Countries US Eastern Europe Japan Asia Latam Safety First crossborder EFI, percentiles 5 10 Each reading in the individual hexagons represents a month of actual data. Months which appear in the same hexagon are ones in which the patterns were similar. Months which are located in hexagons that are widely spaced, showed very different flow patterns. 8 Source: State Street Global Markets

10 Measuring turbulent times Big and unusual moves > Methodology to capture large moves in assets & correlations Daily returns % (1997 -) Turbulence measure of equity and bond returns 3% 45 Turbulence index 2% Sept 15th 40 1 threshold US Bonds 1% -1% -2% Sept 19th Distance from multivariate mean % 0-12% -8% -4% 4% 8% 12% US equity Jul-97 Jul-99 Jul-01 Jul-03 Jul-05 Jul-07 9 Source: State Street Associates

11 Using sentiment to predict turbulence Safety first and riot point show higher risk of black swans > Safety first is a persistent regime from which investors typically remain defensive 18% Share of days which are turbulent in prices following a given flow regime 6 Probability of regime following a Safety First reading 16% 14% 5 12% 4 1 8% 3 6% 4% 2% 2 1 Leverage Liquidity abounds Neutral Safety First Riot point Leverage Liquidity Abounds Neutral Safety First Riot Point Risk seeking Risk Aversion Risk seeking Risk Aversion 10 Source: State Street Global Markets

12 Riot point has been met with policy response Institutional investors have been skeptical > Flows on 22 nd September saw a dramatic rise, but will they persist? 10 How institutional investor reacted to policy shifts, 20d DM cross border equity flows (percentile) 10 Developed market equity flows, 1d percentile 75% 75% % 25% GSE bailout 75bp intermeeting cut Co-ordinated liquidty add Bear bail out 01-Sep 03-Sep 05-Sep 09-Sep 11-Sep 15-Sep 17-Sep 19-Sep 23-Sep 11 Source: State Street Global Markets

13 Who is vulnerable to repatriation? Focus will be on emerging markets > Foreign demand for some EM equities peaked as early as US holdings of foreign equities (% free float market cap) 1400 Cumulative foreign demand for local equities since 1995, bps mkt cap PEN ARS CLP COP CNY ZAR CZK TW PKR MYR RUB KR HUF IDR SGD THB INR TRY HKD BRL MXN ISL PHP -400 Sep-94 Sep-97 Sep-00 Sep-03 Sep-06 KRW INR BRL ZAR 12 Source: State Street Global Markets, US Treasury

14 Is repatriation a temporary phenomenon? Returns, volatility & diversification > Consider two portfolios US only, 5 US, 5 EAFE+CAD > Returns are superior > Vol. & correl. are higher, particularly in bear markets 35% 3 25% 2 15% 1 5% -5% Rolling 5-yr returns -1 Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 US Portfolio (5 EAFE) Conditional correlation when US and EAFE move up and down together(1970-date) 2 Volatitility and correlation, rolling 5-yr periods % 7 16% % 5 12% % % % % % % 8% Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 US Portfolio (5 EAFE) Correlation - rhs Source: State Street Global Markets, Bloomberg

15 5 trillion dollar question Will US investors now hedge more? > Contribution of currency exposure Volatility Diversification > The Minimum Variance Hedge Ratio (MVHR) balances these two effects to eliminate uncompensated risk while maintaining beneficial diversification 6% Rolling 5-yr returns returns over US MSCI 9 Minimum variance hedge ratio for EAFE+CAD 3% 7-3% -6% -9% 5-12% Jan-95 Jan-98 Jan-01 Jan-04 Jan-07 Portfolio (5 EAFE) Portfolio (5 EAFE - hedged) 3 Mar-96 Mar-99 Mar-02 Mar-05 Mar Source: State Street Associates, Bloomberg

16 Tracking institutional investor hedge flows 6-mo USD hedging flows are in the 90 th percentile Forward USD buying Institutional investor hedging and USD moves corr=41% Forward USD selling -40 Jun-01 Jun-04 Jun-07 USD hedging indicator, 6m average DXY 6-mo % change Source: State Street Global Markets

17 A hedging strategy of following the flows If investors are buying USD forward, hedge EAFE +CAD Hedged returns (Jan 98=100) EAFE+CAD USD returns (Jan 98=100) Combination Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan Hedging flows Buy USD forward 0-10 Sell USD forward -20 Jan-98 Jan-00 Jan-02 Jan-04 Jan-06 Jan-08 MSCI EAFE + CAD Hedged MSCI EAFE USD returns EAFE+CAD flow based hedging Return (av. Ann) 3.68% 5.34% 5.6% Volatility (ann) 14.59% 14.91% 14.76% IR Source: State Street Global Markets

18 Risks to the USD view Inflation/money printing/foreigners selling Treasuries 2.70 US inflation expectations (%) lhs DXY rhs (rhs) US inflation expectations (%) lhs WTI oil spot price ($) rhs Aug-07 Feb-08 Aug Aug-07 Feb-08 Aug d rolling correlation changes in USD and oil Jan-07 Jul-07 Jan-08 Jul-08 On days when oil falls On days when oil rises 17 Source: Bloomberg

19 Risks to the USD view (II) Monitoring foreign demand for Treasuries will be key 120 Change in Fed custody holdings (3-mo sum, USD bn) Treasuries Agencies 10 DM cross-border bond flows Foreign demand for US bonds % % Jan-04 Jan-06 Jan-08 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Current and historical holdings of Treasuries 14% 12% 1 Historical average Current share of financial assets in Treasury securities 8% 6% 4% 2% Households Private pension funds Mutual funds Money market funds State pension funds 18 Source: State Street Global Markets, Bloomberg, Federal Reserve

20 End of the USD downtrend? > Re-coupling Growth will ease broadly Restrictive policy is not appropriate USD did overshoot > Repatriation US surplus on its international equity pos. Repatriation equals turbulence Trend in home bias > Regret USD hedging flows have been strong Best to follow these flows Major USD index > Risks Increased money supply but lower multiplier Domestic investors can buy Treasuries Treasury market is only 15% of mkt Jan-74 Jan-79 Jan-84 Jan-89 Jan-94 Jan-99 Jan-04 Jan Source: Bloomberg

21 State Street Global Markets is a registered trademark of State Street Corporation used for its financial markets businesses. The products and services outlined herein are offered to professional clients or eligible counterparties through State Street Global Markets International Limited, State Street Bank Europe Limited, State Street Bank and Trust Company, London branch authorised and regulated by the Financial Services Authority (FSA) in the United Kingdom (UK), and State Street Bank GmbH, London branch, authorised by the Bundesbank and German Financial Supervisory Authority (BaFin) and by the FSA; regulated by the FSA for the conduct of UK business, or another company within the group of companies owned by State Street Corporation Clients should be aware of the risks trading foreign exchange, equities, fixed income or derivative instruments or in investments in non-liquid or emerging markets. Derivatives generally involve leverage and are therefore more volatile than their underlying cash investments. The information provided does not constitute investment advice and is not a solicitation to buy or sell securities. It does not take into account any investor's particular investment objectives, strategies or tax status. All material has been obtained from sources believed to be reliable but we make no representation or warranty as to its accuracy and you should not place any reliance on this information. Past performance is no guarantee of future results. 20

22 Pattern of FX flows is still defensive > Value and trend had been the dominant factors in flows and price > Momentum signal has now disappointed 0.8 Correlation btw FX flows and currency style 0.8 Correlation btw FX flows and currency style Jan-08 May-08 Sep-08 Yield Price Momentum -0.8 Jan-08 May-08 Sep-08 Yield Current AC 21 Source: State Street Global Markets

23 Still following trend but preference for value returns. Institutional investor FX flows (20d Percent Rank) Yield Current Ac 24 September 2008 Competitiveness X-Border Equity Flows Price Momentum Strongest NZD % 22-13% 3 Strong Inflows 1 Neg Decreasing 14 USD % 18 3% 12 Neutral 15 Pos Decreasing 4 CHF % 3-2% 8 Neutral 10 Pos Decreasing 7 GBP % 16-7% 5 Strong Inflows 4 Pos Decreasing 3 SEK % 5 2% 10 Strong Inflows 3 Neg Decreasing 13 ZAR % 21-19% 1 Neutral 14 Neg Decreasing 18 MXN % 12 5% 13 Strong Outflows 19 Neg Decreasing 17 JPY % 6 5% 14 Strong Outflows 22 Pos Decreasing 2 NOK % 2 1% 9 Strong Outflows 20 Neg Decreasing 19 IDR % 7 12% 19 Strong Inflows 2 Neg Decreasing 12 EUR % 10 8% 15 Neutral 16 Neg Decreasing 9 TRY % 19 16% 20 Neutral 8 Neg Decreasing 21 AUD % 20-5% 6 Neutral 12 Neg Decreasing 15 CAD % 9-9% 4 Neutral 11 Pos Decreasing 6 SGD % 1 8% 16 Strong Outflows 18 Pos Decreasing 8 HUF Strong Inflows 5 Neg Decreasing 11 BRL % 11 11% 18 Neutral 13 Neg Decreasing 22 INR % 13-3% 7 Neutral 9 Neg Increasing 20 TWD % 4 2% 11 Neutral 17 Neg Decreasing 10 KRW % 8-15% 2 Strong Outflows 21 Neg Increasing 16 PLN % 15 21% 22 Strong Inflows 6 Pos Decreasing 5 CZK % 14 18% 21 Strong Inflows 7 Pos Decreasing 1 Weakest Spearman -2.99% -13.6% 38.1% 13.7% 5.3% Weekly Return Monthly Return 1.12% -3.36% -0.68% 0.61% % 1.58% 2.41% -2.79% -0.71% Three Month Return % 0.9% 1.7% Source: State Street Global Markets

24 Following preferences > Style switching continues to work well 1 Styles filtered by flows and effectiveness 9% 8% 7% 6% 5% 4% 3% 2% Start Date: 05-Jan-07 End Date: 05-Sep-08 Number of weeks (total) 88 Number of weeks traded 43 Hit Rate 7 Average Annual Return 5.66% Average Annual Volatility 3.51% IR 1.61 Biggest weekly loss -1.27% Cumulative Return 9.53% 1% -1% Jan-07 Jun-07 Nov-07 Mar-08 Aug-08 Yield Current account Competitiveness Price momentum X-EFI Cumulative portfolio returns 23 Source: State Street Global Markets

25 Which crosses have overshot yield changes XXX/USD = α + β(usd-xxx 2 yr yields)+ ε 15. Currency overshoots in the past 12-weeks AUDUSD EURUSD GBPUSD EURJPY EURCAD EURGBP AUDNZD AUDSEK AUDNOK JPYGBP EURSEK JPYCAD JPYAUD USDJPY EURAUD CADUSD CADSEK JPYSEK GBPSEK GBPNOK JPYCHF JPYNOK CADNOK GBPAUD USDCHF CADAUD USDSEK USDNOK Excess moves over implied rate differential moves in the past twelve weeks where there is a positive correlation (>23%) 24 Source: State Street Global Markets, Bloomberg