Weekly Update: Interactive Brokers, 12th November 2008

publication date: Nov 13, 2008

IB FX View
A race to zero
 

Wednesday November 12, 2008

We know that the Chinese economy has allegedly been growing at a double-digit clip for several years now. The greatest shadow of doubt that lurks over the statistics appeared at the start of the week when we heard news of a gigantic $586 billion economic stimulus package for the Chinese economy. For sure that’s great news, but hot on the heels of 9% growth makes one wonder, “why?” The vigor with which the stock market began the session quickly folded and before investors could regain their footing, indices were once again in freefall. Two currencies remain investor favorites in this groundhog day era with one weak report following another from month to month, while the repetitious story of weakness in company earnings is feeding on the external environment well beyond a joke. The dollar and the yen remain currencies in chief. The fact that monetary policy in both nations stands at practically zero creates an unusual deflection, which runs counter to the typical yield argument.

The added sense of urgency to slashing rates at the Bank of England underscored the messy macro environment. Not since sterling’s ejection from the exchange rate mechanism in 1992 did the Bank of England or the government get so aggressive with rates. A series of 1% reductions was the cure and even then rates began falling from a higher base.

So the current environment whereby the major western and Asian economies have hit rock bottom at the same time is a first since the Second World War. We know that the safe haven argument currently favors both dollar and yen but it’s increasingly apparent that higher yields are being punished because those nations will inevitably take longer to heal. In a sense there is a real rush to zero for global interest rates. The light is no longer blinding the dollar because no matter how ugly it is, its problems are turning up elsewhere around the world where central banks still haven’t quite grappled with the regime of unfortunately overly tight monetary strings.

There has possibly been more attention paid to dire British data than last week’s shocking US employment report. So it’s no surprise to see that the dollar took further lumps out of the pound following several news releases so far this week. Estate agents (or local realtors) last month sold the fewest homes since records began in 1978. Homebuilder Taylor Wimpey said its order book fell 40% from one year ago while the quarterly pace of growth deteriorated recently from no growth to a slippage of a half a per cent. The British Retail Consortium said that retail sales slumped 2.2% in its latest report. We should expect the pound to continue sliding against the dollar until the yield advantage the pound has over the dollar has been eroded.

Likewise the dollar is continuing to shine against the euro currency, where ECB credibility is being severely tested. The ECB’s reduction in its repo rate last week paled into insignificance against the Bank of England’s reduction and while the ECB is now on the right path, one wonders when they will try to derail the market by warning over inflation fears or crying over a decline in the value of its currency.

We noted recently how the Swiss franc had lost its allure as a safe haven and that effect continues to play out. While the euro continues to decline against the dollar the relationship is not the same between the euro and the Swiss franc, where monetary policy is getting pretty close to zero following a half point interest rate reduction last week. The Swiss is still weaker against the dollar now above $1.18 and against the euro it fails to command the same safe haven strength that it would had its banking heartthrobs not been tarnished in the credit crunch.

With the race to zero a reality for some nations others are struggling from capital outflows and ever-weaker data. The Russian central bank has given up trying to stop the rot after defending its currency through intervention and raising interest rates. The capital outflow is just too great and is causing dislocated equity markets, a weaker rouble and slower growth prospects. So for anyone who had predicted this sorry cycle six months ago, the reality of this downwards spiral would now need to be rethought. The actuality of this scenario playing out is creating a fresh set of problems and arguably makes the prospects even worse.

The Mexican peso too is intolerably weaker against the dollar. The fallout from the American slowdown is taking its toll on growth prospects. The US imports more from Mexico than any other nation and so when you consider the impact on the Mexican trade balance from a decline in the price of the oil it pipes to America, you might get a sense of the mess the economy is getting into. So bad is this mess that Fitch Ratings just downgraded Mexico’s internal and external currency debt to ‘negative.’ The Mexican central bank has given up defending its currency having spent $13.5 billion in providing dollar liquidity and demand for pesos.

Such central bank measures to support local currencies are proving as ineffective as measures aimed at propping up each economy.

According to CME open interest data investors appeared to exit futures positions in the Australian dollar (-2%), the British pound (-5%) and the Canadian dollar (-7%) during the last week. November options expiration muddles the picture and we can’t tell much from the put/call ratios this week. Open interest in the euro, the yen and the Swiss franc increased marginally.

We noted the lull in currency market implied volatility last week, but this has proved to be short-lived with only yen and Swiss franc option volatility lower than one week ago. The largest rise was in pound currency options where volatility gained by one-third. On Canadian options implied volatility rose by more than one quarter. On Tuesday there was a large appetite for Canadian dollar puts via the PHLX World Currency Options, where almost 20,000 puts were bought at the 82 strike. The Canadian dollar today broke into the money as it dropped 1.5 to 81.45. On the week the Canadian dollar has slipped from 86.58 as broadly weaker commodity prices reflect weaker demand and therefore growth.

Bearish sentiment appears to be growing on the euro according to the growth over the last week of 29% in bearish put options on the PHLX. There are now 87,000 puts in play on the euro, which has now forced the put/call ratio above one for the first time in a month. The euro was last at $1.2500 having lost 3.5 cents on the week.