IG Markets, Afternoon Thoughts

Across Asia, regional markets are mixed despite the positive leads from the US and sharply stronger-than-expected private-sector jobs data. The Nikkei 225 is the standout performer, gaining 1.2% to hit another the highest level in nearly 8 months. Elsewhere, the Hang Seng added 0.2% while on the downside, the Kospi and Shanghai composite are 0.1% and 0.4% lower.

Locally, it’s been another disappointing session for the domestic market as it continues to grapple with uncertainties over the economic impact of the devastating Qld floods. The ASX 200 briefly opened higher before once again slipping into negative territory, where it remains. Its currently 0.1% lower at 4709, just off session lows of 4696.2.

Weakness among material and financial names are doing the bulk of the damage while we’re also seeing red across consumer staple and healthcare sectors. On the upside, modest gains among the energy, industrial and consumer discretionary sectors are helping to pare further falls.

With little new driving equity markets, we’ve chosen to talk about likely themes affecting currency markets in the coming year.

Themes affecting the US dollar in 2011 and subsequent effects on other majors

Moves in the US dollar have a big impact on other asset classes. We take a look at potential drivers of the world’s reserve currency and, given some of the lingering macro issues, how it may trade in 2011.

Firstly, it is worth pointing out that we could see a fundamental shift in the way the currency is traded. Last year, the primary driver of USD appreciation was certainly risk aversion, with traders looking for safe-haven assets when either negative news or poor global economic data arose. This could change this year with the greenback not only trading in line with risk sentiment, but also as a growth currency. And with further signs of an improving economy pushing up treasury yields, we could see subsequent USD inflows. We have already seen signs of improvement in US manufacturing and initial jobless claims have been heading lower. With QE2 and the Bush era tax-cut extension still much on the cards, potential plays in the USDJPY and USDCHF may be very interesting at these low levels. These could be the pairs to look out for in 2011.

Historical US dollar moves in January

January is probably a good month to be leveraged to the USD, if historical data is anything to go by. According to research by UBS, since 1980, the USD index (DXY) has tended to outperform in January. Rising an average of 1.51%, it makes this the best month to be holding US dollars. Looking at two major currencies, the euro and Swiss franc they have both lost ground during January versus the greenback in seven of the last ten years. There are quite a few reasons behind this, but put simply, traders are positioning themselves for US growth expectations. Foreign investors are also initiating positions at the start of the year, before repatriating these funds back to their homeland (hence the strength in the JPY, AUD, CHF and EUR in December).

Interestingly, whilst January has actually been a reasonable month for the AUD, February has not been so positive. Our dollar has lost 0.7% on average against the greenback since 1980. This is something to bear in mind, if trading on the long side with the AUDUSD near 1.02.

Technically, you could make a good argument for the AUD, NZD and JPY being over-extended to the upside in the short term. This could possibly lead to some profit taking, as valuations become further stretched and net-long-futures positions are wound back.

Three key themes for 2011 for currencies

The Chinese economy
A slowdown in China would certainly be a key driver for risk and may have the biggest impact on commodity currencies. With its central bank orchestrating cooling measures to curb inflationary pressures, we are likely to see more moderate growth of around 9% in 2011 for the region. With six reserve ratio requirement hikes and two interest rate moves last year, the market is concerned that China could be headed for a hard landing. More than 65% of all Australian exports are destined for this region; this will invariably be the major risk to a significant pullback in the AUD. Our dollar could be vulnerable to downside pressure anyhow, given its 17% gain versus the euro and 12% against the greenback in 2010.

A good way to play the strength in commodities via currencies could be with the Canadian dollar. It has a high reliance on the US economy and underperformed in 2010 compared to the AUD. With 70% of Canada’s exports going to the US, it does not have anywhere near the same dependence that the AUD has on China.

Eurozone debt concerns
Eurozone worries will no doubt be another key driver for risk assets in 2011. Spain is crucial, and making sure the fixed income market does not attack yields by selling its bonds too aggressively, is important. If bond yields undergo the same treatment that plagued Ireland and Greece, we could easily see the USD being bid up, plus the euro and commodity currencies (notably the AUD) may come under serious selling pressure.

As it stands, of the 37 analysts surveyed by Bloomberg, the median estimate for the EURUSD is 1.30 for year end. Interestingly, net-short positions from futures traders have risen of late, indicating a bearish view. On the flip side, if the Eurozone comes up with a comprehensive and cohesive plan to unify the region and the market is convinced it will work, the recent positive price action could catch the currency forecasters off guard (like they did in 2010!).

An improving US economy
US economic growth is certainly key to the USD. The Fed is under serious pressure to keep to its mandate of price stability and to lower the unemployment rate from around 10%. Given the stringent measures that have taken place, we should in theory start to really see some traction going into the second half of 2011. As it stands, the treasury market is pricing in signs of growth in the US, and this more forward looking asset class may be testament to a rise in the USD.

Merrill Lynch’s analysts recently suggested the US economy will grow by roughly 2.8%, with it set to pick up through the year. Capital expenditure and corporate spending will be stronger than the consumer spending, which will suffer with the unemployment rate not much lower than it is today. They are bullish the US dollar and believe it will strengthen against the euro (to 1.20) and the Japanese yen.

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