MARKET MOVER - BNP PARIBAS - Investment Services India

Liquidity-Driven FX Markets
• Global asset markets are set to overshoot as
G4 central banks increase excessive reserves
while local market monetary authorities try to
control the pace at which their currencies
appreciate.
• Consequently, liquidity is seeking out
investment opportunities.
• Meanwhile, global rebalancing remains a
theme. China has become the trend setter for
successful rebalancing, with its improving
domestic demand conditions offering export
opportunities for the country’s trading partners
• Commodity currencies will remain strong.
The EUR will sail in the slipstream of the sharply
rising AUD.
• The CAD will rally should markets convert
the theme of ‘Japanisation’ into a bullish asset
theme.
• GBPSEK shorts are a conservative way to
trade the bullish China story as the UK’s trading
relationship with China is less developed than
Sweden’s.
US money market outflows will keep the USD
under selling pressure
The USD is likely to remain under selling pressure for
the rest of this year as cheap USD liquidity finds its
way into higher-yielding asset classes. Money market
outflows into local market funds have reduced money
market holdings, but with US rates set to stay low in
the years ahead, there will be little incentive to keep
funds in USD-denominated debt. The rebalancing of
the global economy will keep return expectations for
local markets high, but the highly leveraged
economies in the West will have to save in order to
bring down debt ratios. These savings will be partly
stashed in domestic financial instruments, keeping
bond yields low and reducing the attractiveness of
these assets to foreign investors. Reduced inflows
from abroad will put the USD under selling pressure.
Risk of confidence crisis in US assets is small
Hence, the long-term trend of the USD seems locked
to the downside. However, the real effective
exchange rate of the USD has already fallen by 20%
over the past decade. Nonetheless, an undervalued
exchange rate can become even more undervalued
in extreme situations and an extreme situation could
arise should the US face a buyers’ strike with regard
Chart 1: US Private Entities Deposit and Money
Market Fund Holdings (USD trn)
Source: Reuters EcoWin Pro
to funding its external liability position. 10-year
Treasury yields trading near 2.5% do not look
appealing to investors given that their portfolios of
expiring US bonds often provide nominal bond yields
of around 5%. The USD has been the world’s
number-one reserve currency and hence US bond
market dynamics should not be compared to those of
Greece or Ireland; vigilance will nonetheless still be
required. For instance, a clear indication that a
confidence crisis concerning the US debt position
has hit the US would be if bond yields increased at
the time as US shares were selling off and the USD
losing value in FX markets. This is not our main
scenario but we do not ignore this risk.
Risk appetite assessment remains the decisive
factor for the USD trend
The other factor capable of driving the USD for
several months is the USD’s funding currency status.
It is unusual to see a current account deficit currency
used as a funding currency, as deficit countries tend
to show higher yield and rates compared to those
running surpluses. However, this has not been the
case in the US. The US has run current account
deficits since 1994, but as the current account deficit
was widening, foreign investors were keen to buy US
assets even at relatively low yields. This paradox
developed on the back of the Asian crisis. Following
that crisis, Asian central banks kept a tight grip on
their capital accounts, leaving currencies
undervalued even as their current account surpluses
went through the roof. Closed capital accounts
suggested that the recycling of Asia’s current
account surpluses had to occur through currency
reserve managers happily investing in USDdenominated
debt. The liquidity and depth of the US
Hans Redeker 23 September 2010
Market Mover, Non-Objective Research Section
44
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