Market Economics | Interest Rate Strategy - BNP PARIBAS ...

markets to slide, reminding us of the adage: ‘Sell in
May and go away’. This means following a risk-off
strategy for currency markets, favouring the USD,
CHF and JPY in that order.
EURUSD and equities: The correlation will return
Should equity and other risky asset markets decline,
the EUR will be a victim. This finding might surprise
given that the correlation between EURUSD and the
performance of share markets has collapsed over
recent months. However, the correlation has
collapsed due to inflows into the EMU bond market
weakening at a faster pace than the inflows into
European share markets. Financial account data
show that the 12-month sum of inflows into European
bond markets has collapsed from EUR 285bn to
EUR 20bn within the course of a year. But during the
same period, foreign investors kept on buying shares
and short-dated money market instruments, keeping
total portfolio inflows at a reasonably strong EUR
320bn. The combination of weak bond and strong
equity inflows led the EURUSD-capital market
correlation to decline. However, should the equity
markets lose their upward momentum or even turn
south, EURUSD will trade sharply lower.
The Aussie case
Should global liquidity decline, putting risky assets
out of favour, we see commodity currencies coming
under selling pressure too. Of course, changes to
Asian liquidity most notably via China increasing
domestic interest rates will impact commodity
currencies more compared to liquidity declines due to
(i) difficulties within the European banking system
developing on the back of the Greek or more broadly
speaking European peripheral crisis or (ii) the US
introducing tough financial sector reforms. However,
once equity markets turn down, investors will not ask
what caused the decline. People will just take profits
on commodity- and high-yielding currencies. The
exposure within this FX market segment is
significant, suggesting the first wave of a sell-off
would be sharp.
Sterling undervalued? Dream on
Last not least, we turn again to sterling. A
Conservative-led government would no doubt be less
damaging to capital markets than another Labour
government, but the Institute for Fiscal Studies
suggested that all main three party elections
manifestos were showing significant budget gaps.
These range from GBP 38bn in the case of the
Liberal Democrats to more than GBP 52bn for the
Conservatives. We cannot repeat often enough that
the over-leveraged British economy will find it difficult
to grow out of its problems (leverage is always
deflationary in a country unless debt is monetised)
suggesting the government will either have a higher
tax take or lower revenues. The Sunday Times
newspaper reported that BoE chief Mervyn King
Chart 7: EUR: Net Financial including Bond
flows have collapsed
Source: Reuters EcoWin Pro, BNP Paribas
Chart 8: There is no yield in core Euroland
Source: Reuters EcoWin Pro, BNP Paribas
privately admitted that sterling rates will have to stay
low for several years, implying that the sterling
forward curve is wrongly priced. Whichever way we
look at it, sterling remains a clear sell. Either it will
trade lower as investors lose trust in the country’s
ability to reduce its debt and deficit levels or it will
decline due to the impact of budget consolidation on
growth. One could argue that budget consolidation
gives greater scope for the private sector to invest as
rates and yields should fall due to lower public
borrowing, creating a ‘crowding-in’ effect.
Unfortunately, it will not work this way in the UK.
Money market rates are already low and the
crowding-in effect will not develop: there was no
crowding-out effect when UK deficits were rising as
the BoE counterbalanced any possible effect through
its quantitative easing policy. The BoE has stopped
buying gilts, at least for now, suggesting that the
deficit may have to be completely funded via the
capital market. This means that 2010 and 2011 will
see more net capital demand from the public sector
than 2009 – even if the deficit reduction process
turns out to be successful. Hence, crowding in is not
going to happen. Sterling is the only variable the UK
can manipulate to create the positive growth impulse
that will sorely be needed to compensate for the loss
of public demand.
Hans Redeker 7 May 2010
Market Mover, Non-Objective Research Section
64
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