Feb 08 2012
The most recent CFTC Commitments of Traders (COT) Report (close January 31, 2012) showed that large speculators (non-commercials) have fallen to 154,000 contracts net short the Euro from an all-time record net short position of 171K.
Some of the many factors pressuring the Euro include high cost of financing the debt of the PIIGS, tightness of credit in the Eurozone requiring the EU to ease monetary policy and to increase the supply of capital, and then the cultural differences between northern and southern European nations trying to agree on a structural solution to the crisis. Policymakers continue to buy time for fiscal adjustments and ending the crisis depends on finding political resolutions that will not be forthcoming for much of 2012. Ultimately a tighter fiscal union needs to emerge.
Weakness in the Euro translates to USD strength. This is indeed the wildcard as we begin 2012; will this correlation continue, or will we see such a huge magnitude crisis in confidence that the aggressive monetary policies pursued by both the U.S. and Europe prove to be bearish for both currencies? If the USD strengthens materially, it could have significant bearish implications for the commodity markets across the board. Look for the inverse relationship between the USD and the Euro to continue in 2012, but non-U.S. and non-Eurozone currencies will benefit from easing of monetary policies in both economies.
The U.S. Dollar
Periods of risk aversion have done little to bolster the greenback except versus the commodity currencies in 2011. Valuations for the dollar remain extremely low versus the Australian dollar, the New Zealand dollar, the Norwegian krone, the Canadian dollar, the safe-haven Swiss franc, and, to a lesser extent, the euro. As the dollar alternative, the euro continues to beneﬁt from intervention-driven reserve diversiﬁcation by emerging-market central banks, despite its inherent structural ﬂaws and the risk that contagion will move from fear to reality. However, as we begin 2102, further weakness in the Euro will likely prove bullish for the greenback because of flight to quality/safety stemming from uncertainty in the Eurozone debt crisis. Dollar strength then would likely prove bearish for commodity markets. However, as we move through the year, we expect the USD to resume its weakening trend. This is predicated on a significant policy response in Europe as well as a third round of quantitative easing in the US.
Japanese Yen and Swiss Franc
The USD remains the preferred world reserve currency. But other currencies have benefitted more from the uncertainty coming out of the Eurozone, namely the Swiss franc and the Japanese yen. Both of these currencies made all-time highs against the USD dollar in 2011. Looking forward however, the only currency that is likely to keep pace is the Japanese Yen (JPY). Although the Bank of Japan (BoJ) could further intervene to weaken the currency, we do not think it will take a similar form to that of the Swiss National Bank (SNB). Additionally, intervention is likely to prove short-lived and ineffective. Despite the JPY looking overvalued in nominal terms relative to the USD, it looks much better value in real terms on a trade-weighted basis (confirmed by BoJ Governor Shirakawa in his October, 31 2011 speech). With respect to the Swissie, the effective exchange rate of the CHF reached a record high since the mid-1970s and the Swiss Franc (CHF) is significantly overvalued because of the significant risk associated with the euro area peripheral crisis. On a PPP basis, the CHF is 10% overvalued against EUR and 17% overvalued against the GBP. In the near-term, we think the EUR/CHF 1.20 floor will work - the SNB wants a weaker CHF and it can print as much money as it wants to make the peg hold.
The British Pound
With respect to the UK, recent data showed weak underlying demand and suggested that the rebalancing of the economy is off track. The Bank of England’s (BoE) November Inflation Report saw the Monetary Policy Committee (MPC) make significant downgrades to its near-term growth outlook and project that inflation will fall below target in the fourth quarter of 2012. The November MPC meeting minutes indicated risks to the inflation outlook have shifted to the downside, and we expect the Committee to announce further gilt purchases in February. UK output is forecasted to accelerate modestly during the second half of 2012, but the poor hand off from the start of the year suggests that annual growth will be limited to only 1.0%. Since both GBP/USD and EUR/USD have been highly correlated historically, we expect the GBP to depreciate along with the EUR against the USD. Despite this, the pound sterling should find support relative to the Euro and USD based on its AAA rating from the major credit rating agencies. UK economic strength versus the Eurozone nations should also prove supportive to the currency in 2012. The most recent COT Report data showed large speculators net short 26.2K contracts in sterling (close Jan 31, 2012).
Canadian Dollar and Australian Dollar
A year ago, stronger Canadian and Australian currencies were to be expected due to demand for commodity resources there. This expectation remains unchanged into 2012. Canada is seeing sustained international investment from portfolio diversification as an alternative to U.S. or Eurozone debt risk. In addition, Canada is a significant net exporter of petroleum, and with crude oil prices expected to remain strong in 2012, the currency should remain strong in 2012. Australia’s economy is closely tied to exports to China, and Australia has significant gold exports. These factors, when combined with the significant yield advantage against other major currencies, make the Aussie dollar an expensive short. In fact, according to COT Reports throughout most of 2011, large speculators’ net long positions in currencies were the highest in the Australian dollar. The most recent COT Report showed large speculators net long 25,742 contracts of the Aussie and net short 26,868 contracts of the Canadian.
We believe holding overweight positions in Gold is appropriate as this asset will continue to act as a store of value whilst governments print money in an attempt to deal with ongoing financial and economic uncertainties. Another reason is that China has indicated it seeks to put the Yuan currency on the international stage to compete with the USD and the Euro. However, in order for that to become a reality, they are committed to raising their gold reserves to be on par with the United States. Chinese officials have stated that China would build its gold reserves to 10,000 metric tons over the next decade. Worldwide tensions are not ebbing away, either, and can be supportive of gold. There continues to be unrest in Syria; investors are profoundly concerned that Iran’s continued defiance and their desire to harvest nuclear capability can spur wider geopolitical tensions. Yet, over the short-term, the movements in the gold price correlate closely with those of other “risk assets.” Leveraged investors, such as fund managers and speculators, use the futures market and ETFs. These instruments are typically traded on margin. Consequently, if equity markets experience a sell-off, there is usually a rush to liquidate all margined positions to raise cash and limit future losses. Both gold and silver have been caught up in these sell-offs before, and it’s probable that they will suffer again. As we have seen this year, the buy-side of the gold trade can get overcrowded; a small piece of negative news can result in a rout and heavy losses for longs, especially if over-leveraged. However, Gold should be bought ahead of QE3 and sell-offs provide buy-back opportunities with demand pent-up at around the $1600 level. Overall, natural disasters or geopolitical crises that disrupt oil supplies put upward price pressure on precious metals and inflation hedge buying of both gold and silver will continue. In an environment of QE and other unconventional reflationary measures, we believe gold still looks good value even at current elevated levels.