USD seems less lustre in September

What was interesting during the recent global stock rout is that there was no clear catalyst driving the tumble from US, to Europe, and across Asia. 

Fed
Source: Bloomberg

Analysts have pointed towards several factors for the bearish move, ranging from slowing global growth, lower commodity prices, to deflation risks due to China’s slowdown. None really stands out as the spark, since they have existed for a while now.

The lack of clarity probably push fears to the precipice of panic. S&P 500 plunged below the pivotal 2000 level, losing 210 points, or 10% in just four sessions between 18th and 24th August 2015.

The DAX plummeted almost 12% in the same period. Several markets in Asia entered bear territory, defined by a 20%, or more, drop from the previous high. The Hang Seng Index dropped over 1000 points on Monday 24 August. The index has lost over 7000 points, or more than 25%, from the peaks during April and May.

There is no doubt that investors are very fearful of what is really going on in the world equity markets. The VIX index spiked to a four-year high above 40. Naturally, in times of great uncertainty, a flight to safety ensued. Clearly, you have your usual demand for sovereign bonds and even gold. It is in the currency markets where clear reasons are behind the moves.

The appreciation of the Swiss franc and Japanese yen was expected because of its safe haven status, and the US dollar retreated as expectations surrounding a September rate move was unlikely to progress. Interestingly, the euro made large strides amid the massive volatility.

At first glance, there seems to be no reason for that as the Euro is typically not seen as a currency to hold during periods of risk aversion. Moreover, the euro usually rallies when European shares go up. However, what I feel was the key factor behind the euro resurgence was the unwinding of the carry trade.

A carry trade is a trading strategy where an investor borrows money at a low interest rate to purchase another asset that could provide a higher rate of return. This strategy is particularly common in the foreign exchange market. Investors have been using the euro as a funding currency to buy another due to its low interest rates and current quantitative easing programme.

They have been using it to buy risky assets. However, when the other markets are not providing an attractive return, such as the decline in global equities for the past few months, there is no longer a reason to buy cheap currencies. Therefore, investors begin to liquidate their carry trade and buy back euros.

Another reason is that concerns over the Grexit situation had receded, with debt rescheduling currently under way, after the country secured a new €86 billion low-cost bailout package. It suggests that euro is a neutral currency to hold, given its lack of big headlines.

In the FX space, what is the outlook for September? For one, it is quite likely that the dollar may not gain further strength as a Fed rate move seems increasingly unlikely now. This means euro and yen may be quite attractive. However, the QE programmes and ultra-low interest rates in Europe and Japan meant that we are not going to see outsized moves from these two major currencies.

Commodity currencies would continue under pressure, as the view on raw materials remains dim. Going short on these currencies, particularly CAD, may yield decent returns, but be wary of key support levels. This is especially true for antipodean pairs, which has formidable barriers at 0.70 for AUD and 0.60 for NZD.

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