We have scaled back some of our risk exposure, taking profits on EUR/USD and EUR/GBP long positions. Weak EMU data, signs of complacency among European politicians and lingering US fiscal-cliff concerns stand in sharp contrast to signs of better US consumer demand, stronger Asian trade and returning capital flows to Asia. Repeated HKMA intervention, rising local currency reserves and onshore USD/CNY reaching the lower end of its band indicate investors have moved back into Asia, providing a positive backdrop for local currencies and risk appetite.
Conflicting signals require us to differentiate our risk investments. Signs that EMU politicians are becoming complacent have increased the tail risk that the OMT will not be activated to intervene in Spanish bond markets by the end of the year. We think it is likely that Cyprus, Greece, and Slovenia all ask for financial assistance in the first week of November. Should Spain not request aid at the same time, the EUR may come under significant selling pressure. For now, we believe this tail risk is too high to justify the reward, explaining our more cautious EUR approach. The strong UK Q3 GDP report convinced us to close our EUR/GBP long position.
JPY trends lower. Our bearish JPY call based on the assumption of a more aggressively anti-deflation BoJ seems to be working out. The latest weekly security-flow data showed continued JPY weakening outflows. The weakening JPY should provide a further boost to global liquidity as we expect funds leaving the JPY to seek higher returns elsewhere.
Current Account Balances and FX. We look at the impact current account shifts have on currencies. While EM currencies tend to move in line with current account swings, DM FX markets’ reaction to current account swings is more complex due to the dominance of financial transactions. As EM markets lack depth and liquidity, official exchange rate policies and commercial transactions reflected in the current account still dominate the direction of FX. In DM, the impact of current account shifts on FX is largely via their effect on relative yield and capital return expectations.