Myriad factors impact major currency pairs, says Gallo

What is your macro view?
In the current context it is important to keep in mind the importance of capital flows – where we have come from, where we are and where we could be heading.

The first thing in the currency arena that comes to mind is the concept of currency wars. I do not think the concept of currency wars is hyperbole. From that perspective it is important to understand what capital flows were like before the crisis, what they are like now and why we have seen the resultant moves in a number of currencies, particularly yen and sterling.

During the last decade global capital flows were so powerful that economies grew at abnormally high rates. Capital flows, particularly those from savings-surplus countries to deficit countries in the developed world, were responsible for the creation of huge amounts of leverage, securitisation and inflows into various western and developed asset markets. This drove growth rates high.

The 2008-09 financial crisis saw those capital flows diminish and in some cases disappear altogether. It has been much more difficult for developed economies to obtain a given level of output now those capital flows are not as abundant as they once were.

The best evidence to support this sharp decline in global capital flows is the fact that foreign exchange reserves in aggregate in the Bric countries (Brazil, Russia, India and China) were declining on an outright basis through the third quarter of last year.

From the policy perspective it has become every man, or every policy-maker, for himself because these capital flows have diminished. Domestic growth is so much more difficult to procure.

One example I like to use is the UK. Between the late 1990s and the end of 2007, the UK averaged quarter on quarter growth of about 1% and yet it was still able to cope with a currency that was extremely rich for a material portion of the last decade. Now, however, the level of the exchange rate matters immensely.

Essentially the currency is now an important avenue to securing a short-term boost to competitiveness from trading partners but also a way to boost nominal growth or reflate.

I would say these are not just currency tensions. They are in fact currency wars and I believe they are related to this global capital flows paradigm: what we had versus what we have now.

A final note on the global capital flows. China is very important because during the last two decades it was seen as the factory of the world. That paradigm is dying now because the middle class is growing in China, real incomes are rising and domestic demand as a share of GDP is slowly increasing. The savings glut is not as abundant and does not have the potential to grow as rapidly as it did during the last decade.

What does this mean in relation to what central banks are doing and what is the meaning behind the currency fluctuations and the commentary from various policy-makers?
As many central banks, excluding the European Central Bank, have become more entangled with their respective governments, what we are seeing from policy-makers is an attempt to replicate and fabricate the pre-crisis outcomes when it comes to capital flows: things like the global carry trade, asset price appreciation or simply boosting nominal growth.

In a way it is important to try to interpret the recent moves by the Bank of Japan (BoJ) and the Bank of England (BoE) as a way to try to replicate and fabricate asset price appreciation, growth and capital flows pretty much out of thin air.

Because Japan is still structurally a savings glut country, a lot of the move in the yen has been concurrent with money moving out of Japan into western asset markets. Also, policy-makers in the US probably recognise that as a beneficiary of capital being exported out of Japan, they are getting some asset-price appreciation.

If there were one currency you would buy now, what would it be and why?
In developed country currencies a lot of the bigger moves have occurred already. There is more two-way risk in the market than there was during the low-volatility, safe haven demand environment that was consistent with rising or high sovereign default risk in the eurozone.

Based on that perspective and on a number of cyclical factors we have observed, such as US growth being above the eurozone average, I would look to be buying the US dollar index on dips or above the 78 level for the time being.

Relative growth rates between the two largest reserve currencies currently argue for this being a rather supportive environment for the US dollar overall.

The US current account deficit, while not consistently improving, seems to have stabilised. The falling dependence of the US on energy imports is an important cyclical factor. I do not know whether it will be a structural factor for medium-term consideration but for now I would look at that monthly trade data as an important indicator for renewed strength or weakness in the US dollar.

It is not clear yet if the US is becoming a high or higher savings-driven economy, which is not dependent on foreign capital inflows and which can finance domestic investment purely through the level of domestic savings. If that is improving I would say it is worth becoming a bit of a medium-term dollar bull but I am not sold on this proposition just yet.

Overall, in this currency wars environment you need to look at what policy-makers are saying because they may want their currency weaker one day but if that starts to create problems for their monetary policy stance, that may change the next day.

It is difficult to say there is one currency I would be buying and continue to buy. This is still a very policy-driven environment.

What would you short?
The sterling trade is intriguing to me. It is a currency I am more medium-term bearish on than I have ever been. If you are looking at the next 12-18 months, aiming for sterling/US dollar closer to $1.40 or euro/sterling as high as £0.95, there may be some good value currently along these lines through options.

There is still more weakness to come in the pound. A lot of the quantitative easing (QE) and ultra-easy monetary policy in the UK has delayed or put off much of the necessary macroeconomic adjustment such a highly indebted country will ultimately need. The UK’s wide current account deficit is a major concern, and one way or another some major adjustments are likely to be needed over time.

The UK virtually has no engine of growth to offset private household sector deleveraging. I expect the BoE to use its new powers to try and influence consumption and borrowing if it can.

Failing success along these lines, the last resort option could be to allow the pound to fall further. In view of the loss of the AAA rating, it seems likely that safe haven flows into the pound will unwind more aggressively than they did previously when the eurozone crisis enters a lull period.

Where do you think the sterling/US dollar rate will end the year?
Currently between $1.45 and $1.53. Short term a lot of what is transpiring with policy in the UK is priced in already. The reasons I give leave a bit of downside risk embedded in that call is that I think the sterling/US dollar rate will weaken in tandem with the euro/US dollar.

If there are risks to stability or growth in Europe as a whole, I think the dollar will be a main beneficiary.

The second thing is independent of what goes on in the eurozone, if there is any central bank that is ultimately going to be the most Keynesian in trying to procure a politically acceptable level of growth, it will be the BoE.

The handover from Mervyn King to Mark Carney as governor is not going to change that, especially as the 2015 UK general election approaches. That means every time we have stability within the global financial system, every time we have indication of stabilising global growth, the BoE will be the first to try to bring global inflation pressures inward by allowing the currency to weaken either verbally with rhetoric about QE or by implementing QE itself.

Given the BoE’s new powers, QE will almost certainly become more synonymous with the desire to keep the currency weak as time goes on. When the euro crisis is in a lull period, anything the BoE says or does will be much more potent and have a much larger effect.

What about the euro/US dollar rate in 2013?
For the foreseeable future the euro/US dollar rate is going to tread water around the $1.30 mark, gravitating to this level from either side. Out of all the major central banks in the developed world, the ECB is still the least likely to use QE, interest rate cuts or the monetary channel to try to weaken the currency. What it may continue to do is use to its advantage the political, financial and/or sovereign debt tensions if they arise again in order to allow the markets to push the currency lower or at the very least keep it relatively weak.

On the top side you have the risk there is a protracted period of stability in the eurozone and reserve managers start increasing the share of euros in their trading portfolios If they demand euros rather than some other reserve currency for whatever reason, there is a risk the euro/US dollar moves towards $1.35.

At the same time more drags on sovereign debt markets – potentially Spain, Italy, even France – soft growth fundamentals and ongoing banking sector distress will bring it back down to $1.30 and below following periods of consolidation above that mark.

On the downside the ECB will be much more willing to intervene in some sovereign debt markets through OMTs [outright monetary transactions]. The request for an aid programme from one or more eurozone member state is likely to come when the euro/US dollar is closer to $1.20 than $1.30.

The result will be a euro that rallies, for instance from $1.20 or $1.22 to $1.30 when OMTs are activated rather than from $1.30 or $.1.35 to $1.40.

Those OMT bond buys in future will be a supportive factor for the euro, if not causing the euro to rally moderately or even aggressively.

If we get into a situation where a country accepts a bailout programme, the euro will most likely have been sold off fairly aggressively in the run-up to that request.

Will the euro experience weakness in 2012?
Any moderate to aggressive weakness in the euro will be fairly short-lived, based on the backstop the ECB provided last summer.

Another important factor for the eurozone is what the OMT and the promise of OMT achieves. The prospect of a country having its debt bought by the ECB if it agrees to macroeconomic reforms and macroeconomic adjustment will prevent something we have lived with since 2009 when the Greek crisis erupted: panic austerity.

Panic austerity has tended to erupt when a eurozone member state has implemented severe, growth-damaging austerity measures. Markets sell the sovereign debt aggressively because they think it is going to lead to a vicious cycle of increased borrowing and automatic stabilisers in order to avoid slower growth. In order to avoid further selling, governments have responded with additional austerity, which triggers more economic weakness and so on and so forth.

Now the OMT exists, if a country is in a macroeconomic adjustment programme and the ECB is standing there as a backstop, panic austerity is unlikely to occur. The government could continue to cut the deficit even though it will cut growth and the ECB will stand as a backstop to stop bond yields from rising above a certain point.

In theory, all things being equal, you can have an extremely slow economy, unemployment rates of 25%-30% and bond yields that do not rise. That provides governments with breathing space while the macroeconomic reforms, deficit reduction programmes and other adjustments fall into place.

What is your outlook for the eurozone? Is a break-up on the cards?
I do not think it will come to that. What we see on a month by month, quarter by quarter basis is a political, macroeconomic or financial game of chicken between various euro member states that are all gradually being integrated with one another with the ECB acting as a referee.

It is going to be messy but the future of the single market in Europe is at stake. The euro is the most critical element for making the single market function smoothly. No process of integration on this scale is going to be neat or happen quickly. When you are forcing countries to become more competitive and/or live within their means, there will be a lot of political and social tensions along the way.

From now until the end of the decade there will be many instances where we are faced with a potential euro break-up. It could be France in five years, it could be Italy next year; the latest hot topic was Cyprus.

It will be a recurring theme. There will always be a euro break-up discount for at least the next three to five years in the price of the euro against most other currencies.

Spain, Italy and France will all be in macroeconomic adjustment/OMT programmes by the end of this decade.

How will Abeconomics affect the yen?
Over the last decade, but more importantly in the last six to nine months, the level of entanglement between the BoJ and the government has increased 100-fold, making the BoJ a dependent central bank in all but name.

Japan, without proper macroeconomic reforms, is essentially like a car on a steep and very muddy incline with little or no traction. What the BoJ is essentially doing now is stopping the car from sliding down the incline but the car is not making any progress up the hill either.

The BoJ will continue to look for lulls in the euro crisis or windows of opportunity that it can use to force the yen lower without triggering tension from policy-makers in other countries.

Given the historically strong negative correlation between the yen and US interest rates, the BoJ’s efforts to weaken the yen may for the time being be able to achieve levels in the 100-108 range at most given that US growth is so highly dependent on rock-bottom interest rates. Anything above that range will be highly dependent on whether or not the BoJ is actually able to produce the type of inflation it is aiming for – the type that might ultimately seriously undermine Japanese government bonds, seriously erode the nation’s export competitiveness or both.

There are a number of upside factors for the yen. There will be bouts of instability in the eurozone going forward. For the BoJ’s policies to really drive the yen forward over the medium term, the euro/yen rate must be able to do a lot of the heavy lifting.

There could also be periods where central banks like the Fed or the BoE will once again move into various asset markets, print money and depress yields. That will be supportive for the yen, although perhaps not as significantly positive as it used to be.

Structurally not a lot has changed in Japan. It is still an export-driven economy and there is still a huge domestic savings glut, which continues to be underdeployed within the domestic economy.

The nation also holds huge pension fund and insurance assets that can be put to work overseas. My question for the yen over the long term has always been: what will happen to its value when those overseas earnings, hedged or unhedged, are repatriated in order to fund a rapidly ageing population?

What is the outlook for China and the yuan?
In 2012 China’s export growth was 7.5%-8%. That was below the government target of 10%. China is a mature export-oriented economy but this performance and other factors clearly show some evidence of rebalancing. So far the government has been able to manage this transition and deflate some sectors of the economy fairly successfully.

I do not expect China to crash. I do not buy into that view.

What we cannot seem to get to grips with in the developed world is that China is doing what we failed to do over the past decade in order to burst our own asset and credit bubbles.

Growth that misses expectations because of a cooling of certain sectors of the economy or a rebalancing of an economy to make it more sustainable in the longer term is frightening to Keynesians, policy-makers and investors in the west because we did not operate like that and now we are all paying the price.

China has two main medium-term challenges in my view: finding ways to boost aggregate demand sustainably and to develop new sectors of its economy and coming up with the right macro prudential toolkit to manage financial stability risks in an economy that is vastly different on a region-by-region basis.

For this reason, there will be disappointments from time to time with China. So far the evidence suggests the authorities are taking the right steps and are on the right track.

In this environment the yuan is no longer a simple one-way bet upwards as it was a couple of years ago. China does play into the currency wars theme and during this transition period for the economy, it will not want excessive strength in the currency.

Who is going to win the battle to become the largest centre for renminbi trading outside China?
I take a simple approach. The more centres for trading the yuan outside China, the less control the People’s Bank of China (PBC) will have over exchange rate movements.

The growth in offshore trading centres should move step-by-step with the desire for more flexibility in the currency by China. If it starts saying new things about the flexibility of the exchange rate, I expect new centres to pop up. You cannot have 15 trading centres for the yuan and a tightly controlled exchange rate.

Before the global financial crisis, Washington was always putting a lot of pressure on Beijing to make itself more market-oriented and develop western styles of running an economy rapidly. Once the global financial crisis happened Beijing said, ‘why should we do that?’ It is still in that mindset. Slowly it will have a flexible exchange rate and an open economy to a degree but it will not completely give up state capitalism. Rather, China will look to strike a balance between its version of state capitalism and a more laissez-faire approach.

What about emerging market currencies?
The euro/zloty is a currency pair I would look to sell on significant rallies. Poland is a solid economy that has benefited immensely from macroeconomic and structural reforms, its inclusion within the single market and its close ties with its main eurozone trading partners.

I expect Poland to outperform other EU countries in central and eastern Europe. If the euro crisis heals sooner than expected, domestic efforts in Poland to join the eurozone will speed up rather than slow down.

Inflows into South African equities tend to be highly correlated to increases in the size of the system open market account at the US Federal Reserve. When the Fed increases QE or ramps up QE, there tends to be unhedged flows into South African equity markets. So there is probably a QE trade there.

The market has swung back to thinking the Fed will tighten next. If they indicate they will tighten or wind down asset purchases or let mortgage rates rise above something like 4%, US dollar/South African rand pairing will be a decent buy in my opinion. If the US does the opposite, it is one of the currency pairs I would look to sell aggressively.

What do you see as a safe haven currency?
We have moved away from the safe haven paradigm. This will only tend to be relevant during bouts of rising sovereign default risk or loads of unwanted inflation.

If we get into a period where inflation is causing major complications for policy-makers in the developed world, people will seek out stores of value and hedges against inflation.

If we have a period of very low volatility ushered in by heavy central bank intervention – for example more Fed or more BoE QE in response to rising eurozone sovereign default risk or tension in the eurozone or even weakness in their own domestic economy – that would be a situation where investors, rather than seeking absolute return or outperformance, will look for capital preservation and the age-old safe havens will come back into play.

For the time being what has taken the place of the safe haven paradigm is the ‘return haven’ paradigm. The moves by the ECB and the BoJ this year and last year have allowed for an increase in volatility, therefore making this a more long gamma, long volatility-seeking environment. The best avenue for market participants in this, whether buying or selling a currency, is to be in the asset where return on capital is guaranteed or almost guaranteed. It is the asset class that everyone else is buying or selling at roughly the same time. That is the best place to be. The trend is your friend.

The key to this environment is to continue to look at the policy sphere for clues as to what is going to be the next trend that the markets pick up on or pile into. It is an environment that you can count on returns in because of that two-way risk and because of the eurozone sovereign debt crisis.

The lull or relative calm in Europe has allowed for more two-way risk in different currencies but you have to be nimble and quick because things can change on a dime. Policy-makers can say one thing one day and something completely different a week later depending on how moves in the currency and other asset prices develop.

What is your outlook for the Swiss franc, usually seen as a traditional safe haven currency?
There again the policy developments are key. Overall the Swiss franc for the time being, like the euro, is likely to tread water:  US dollar/Swiss franc rates not too far from parity or euro/Swiss franc in the €1.23 area.

One of two things is likely to happen. First, the eurozone sovereign debt crisis could increase again and the euro/Swiss franc rate will see some downside pressure or the US dollar/Swiss franc rate may initially see some upside pressure with the dollar being the preferred safe haven if capital flows out of Europe and into the US.

If another bout of sovereign debt/rising default risk in the eurozone triggers a round of QE from the Fed, the dollar may become much less loved. That is one thing that can happen: a rise in sovereign default risk in the eurozone.

On the other hand we may get a protracted lull in the eurozone sovereign debt crisis. That is a risk we have to be aware of. The Swiss National Bank could announce some type of move to raise the floor in euro/Swiss franc rates or to allow the euro to strengthen or the Swiss franc to weaken versus the euro.

Again it is very dependent on what happens in the policy sphere.

What about the commodity currencies this year?
Pretty much anywhere you look in the complex you are not seeing the type of gains in commodity prices that would be consistent with stable upward appreciation in the Canadian dollar for instance or the Australian dollar.

What I am more interested in at the moment for the commodity currencies is the relative strength or weakness of the housing market in places like Canada or Australia. There could be a value play between Canada and Australia depending on which housing market stabilises.

What we have seen recently is weakness in the Canadian housing market based on language that came from the Bank of Canada regarding monetary tightening. If the housing market in Canada stabilises, the Canadian dollar might become a good buy over the Australian dollar.

If the Australian housing market goes down the same route and slows down and the Reserve Bank of Australia promises not to cut rates any further, the Australian housing market may succumb to some of the same downside risk the Canadian market has had.

The housing market is important to these two markets because both have cut rates. For example, if you are looking at the Reserve Bank of Australia (RBA), it has cut rates in response to a slowdown in China. It has also cut rates because it tends to get very animated about the strength of the currency in this environment. That has caused a lot of headache for manufacturers and for competitiveness in general. In Australia they have a lot of policy traction.

Canada has low policy rates and has had a lot of traction with policy. You have seen asset prices appreciate in those economies.

A lot depends on whether or not policy-makers in Australia want to do something about the strength of the Australian housing market.

If we see some tentative or concrete signs of stabilisation in the Canadian housing market, it would be a good time to buy Canadian dollar on a relative value basis. If the RBA promises not to cut rates much further, the market would probably be surprised by that. I would expect the housing market to go up rather than down. We could see the Canadian dollar become a good buy versus the Australian dollar.

Domestic factors as trading signals are something to be looking at in both those economies for the time being.

Commodity currencies at present are not really commodity currencies because that area is not as exciting as it once was.

In developed country currencies a lot of the bigger moves have occurred already. There is more two-way risk in the market than there was during the low-volatility, safe haven demand environment that was consistent with rising or high sovereign default risk in the eurozone.