He begins by noting that the current environment is characterised by weak, but stabilising global growth (as better momentum in China and the US compensates for continued weakness in the Eurozone) and receding funding risk in the Eurozone, driven by various forms of ECB intervention, most lately the OMT program.
He believes that the second factor, receding funding risk, has been important in driving changes in volatility and correlation structures with FX and global markets more generally. He writes, “Moreover, better growth,coupled with upside inflation risk, should lead to lower volatility and USD weakness in some crosses.”
He continues to explain that tail-risks are real and varied in nature. He believes that the eurozone situation could deteriorate again, although an application for aid from Spain would likely provide some near-term relief. In the US, the situation around the fiscal cliff creates a risk, but our base case assumption is that a solution will be found (albeit one that probably kicks the can).
In China, In China, it appears that the risk of a hard-landing scenario is diminishing as data is starting to improve. The change in views about China often is reflected in commodity prices, especially iron ore. The price of iron ore fell sharply over the summer on fear of a China hard landing, but prices have since rebounded, retracing about 50% of their decline. However, prices remain about 20% lower than they were last spring, as investors have pared down their growth expectations. Our Asia economics team still assigns a one-in-three likelihood of a hard-landing in China (defined as growth averaging 5% or less over four consecutive quarters).
He writes, “If we are right about these assumptions, then we will remain in an unusual environment of “stable low growth‟ and reduced concern about tail risk stemming from systemic tension in the eurozone.
Consistent with this outlook, he expects volatility to remain lower and 'FX beta' (in EM and higher yielding G10 currencies) to play out too, as carry to volatility ratios remain relatively attractive. He explains, “In parallel with the overall macro environment, the flow picture is also supportive of this concept. There is evidence that EM flows are improving (although not sufficiently to generate strong intervention dynamics), and recent flow data suggest that EM flows have been resilient, even in the face of S&P weakness. This is a further sign of de-correlation between global risk assets, in our view.”
Concerning global intervention trends, he maintains the view that EM intervention is unlikely to return to levels seen in H1 2011 and pre-crisis. This is based upon the trends observed in recent months and on the fact that EM current account surpluses are smaller now than just a few years previous. Additionally he notes that the much reduced Chinese intervention feeds into this view. This implies that EM FX support provided by decent inflows, and better fundamentals, do not translate into any dominant pressure on reserve currencies (from a diversification perspective).
He believes that this is important for EUR/USD, which he does not expect to be as well supported as it has been in recent times and sees a better risk environment for risk assets. In terms of global growth outlook, he sees potential for some degree of growth decoupling in EM relative to developed markets. This is a function of better balance sheets in selected emerging market countries, including banking systems better able to generate credit in EM space. Moreover, easing eurozone funding tensions means less spillover effects through the financial sector, although real effects, through trade with the eurozone, will remain in play.
Looking ahead in conclusion, Nordvig writes, “Overall, we believe that there are opportunities to be selectively long EM FX and that differentiation trades also makes sense in this environment. That is, after many years in which relative value trades were the victims of global shocks and indiscriminate risk-off moves, we think there will be room to position for such themes in 2013.”