Exciting times for currencies ahead

Global currencies are set to remain in increasingly frustrating ranges over the next month but the probability of a breakout is rising. Importantly, ANZ Research has identified the factor expected to drive the break – liquidity.

Policy tides are shifting and the unwind of the US Federal Reserves’ balance sheet, together with a cautious beginning to normalisation in Europe, will represent a key turning point for ANZ’s liquidity indicator which predicts by the end of 2018 official liquidity will be approaching zero.

As a result ANZ Research has flattened its forecasts for the $A and $NZ and now expects a touch more weakness in both. For now, the $US outlook remains clouded as valuation is no longer providing a compelling signal, growth is slowing but is expected to recover, and liquidity is high but expected to peak.

On the growth front, ANZ’s Global Economic Advanced Reading (GEAR) suggests growth re-accelerates as we move into the third quarter, while similarly global order-to-inventory ratios are not suggesting there has been excess supply in this cycle.

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" The carry trade is now becoming akin to picking up the last few pennies in front of a slow moving steam roller."

As such, the slowdown in growth is likely relatively temporary.

Seismic shifts

On the liquidity front we are increasingly convinced that we have reached the cycle peak. In the near term, this may not have much impact on markets but in the background some potentially seismic shifts are beginning to take place. As such, ANZ Research now believes that the carry trade is now becoming akin to picking up the last few pennies in front of a slow moving steam roller.

Of particular note will be what happens as the Fed begins to wind down its balance sheet, and on this front there are two different elements to consider.

First, whether the announcement effect means there is some imminent threat to sentiment and second what the liquidity indicator says about the pace and severity of the reversal in liquidity to come.

At the time of the ‘taper tantrum’, the announcement had as much impact on markets and FX as the actual act of tapering. However this time this is less likely as there are a few important differences.

Firstly global growth is stronger and broader, and indeed the market has already been able to see the beginning of a tightening cycle and remained resilient. In 2013 there was a real fear that any tightening would be disastrous.

Second, markets have arguably decoupled somewhat from simply being a liquidity trade. Today there is far more diversity in positioning and cross-market correlations are significantly lower. This implies contagion risks are significantly lower, and as such the risk of a systemic sell-off is lower for now.

Third, misalignments across both markets and economies are lower today than they were in 2013. Valuation extremes are not as large, current account positions have significantly improved and, more broadly, the economies vulnerable to a sharp reversal of flows looks more resilient.

Liquidity is coming

ANZ’s Liquidity Indicator projects the direction of liquid based on assumptions of various factors - namely the Fed reduce its balance sheet by $US10 billion per meeting and the Bank of Japan being unchanged on rates throughout calendar 2017, among others.

As the below figure shows, the impact of these changes is somewhat gentle, but it is also persistent, and by the end of 2018 official liquidity will be approaching zero.

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In past cycles there have been times when during the decline in official liquidity the funding markets have picked up the slack as bank lending accelerates into the end of the cycle.

What has been unusual in this cycle is the primary funding vehicle has been the market, rather than the banks. While there may be some time for this to change, it is unlikely banks are about to aggressively change their lending behaviour.

Further, the leverage starting point together with the nature of what finance was used for in this cycle (engineering balance sheets via debt to equity swaps, rather than actual capex) suggests lending is not about to explode higher.

This is important. It means funding liquidity was primarily generated via narrowing spreads and so there will be a tighter relationship between the fate of official liquidity and funding liquidity. While the degree of widening is not alarming, the trajectory, when combined with tighter liquidity, ensures that the momentum of liquidity has peaked.

As we look towards the back end of 2017 and into 2018, market volatility is almost certain to rise; and the $US will once again find its footing – but for a different reason. Not because of strong growth and exceptional policy divergence but rather because of a rise in risk aversion.

This will drive a different sort of $US rally. Against the Euro and the Yen policy dynamics will still matter, and the risk is that the $US comes under some pressure. Against the $A, the $NZ and cyclical Asian currencies the USD will continue to advance.

Daniel Been is Head of FX strategy at ANZ 

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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