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Asia Open: FX and Gold | Investors exit fiat currencies, Central banks’ worrisome balance sheet drives gold

Market Analysis / 7 Min Read
Stephen Innes / 18 May 2020

 Gold Markets 

As we transition from a world where central banks' primary function was inflation control to the new world order where their primary purpose is to finance government spending, many investors are logically exiting all forms of fiat currency.

Central banks’ worrisome balance sheet expansion is unequivocally one of gold's primary drivers, and hedging against an escalation in US trade tensions also seems like a great idea. With interest rates near 0%, the global opportunity cost of owning gold remains alternatively attractive to currency hedges as the path of the US-China trade war could be paving the way higher with gold bars. 

Precious metal call options are bid skywards with gold grinding higher and silver rallying through $16. With gold prices closing above $1,735 on Friday, from a technical perspective, fast money names are likely to chase new topside moves on gold on any further rally.

Gold rallied despite modest risk-on investor sentiment; In Asia, Chinese data showed a pickup in production, but Germany's economy fell into recession in Q1.

Gold again made its big move in US trading. Neel Kashkari, President of the Minneapolis Fed, said a V-shaped recovery is "off the table" (Bloomberg). Out of all the possible recovery scenarios, a V-shaped recovery would likely hold the most bearish implications for gold, as it would imply a robust recovery.

A raft of horrible data supported gold. According to the Commerce Department, US April retail sales contracted -16.4% m/m with core sales down -4.6%. April Industrial production fell -11.2%, according to the Commerce Department. The data show that industrial output fell the fastest in 100 years.

The market pushed above the year-to-date high of USD1,746/oz. The recent run of weak data is not surprising, but when the official numbers are released the low or negative data provides a stark reminder of how bad things are and punches golds ticket higher. The negative data highlights a contracting global economy, a contracting economy kills investment opportunities, gold's status improves and money on the sidelines finds its way into bullion.

Surging oil prices are also helping with the inflationary side of the Gold trade and pressuring real interest rates lower.

Currency Markets 

For the summer months, four main drivers will dominate the FX macro; One, the divergence and relative success of lockdown 'exit strategies'; Two, Central Banks sub-zero interest rate policies; Three, Trump says he likes a strong dollar; Four, how far down the trade war slope the combination of US election risk and blame game on coronavirus leads us.

G-10 Currencies

The central scenario is now a U-shaped recovery. Still, if a V shape happens you need to remain pliable. The apparent winners would be the traditionally "risk-on" currencies that have weakened the most in recent months; NOK, AUD, NZD, CAD, SEK and GBP would all likely fare very well in the initial stages, at the expense of the USD, JPY and CHF.

At this stage, a V shape recovery is an unlikely scenario that opens the following trades.

The Japanese Yen

The abnormally sizeable Japanese capital outflows were supporting USDJPY even though US interest rates have plunged close to Japan's levels. The Yen now has a favorable balance between a currency that’s cheap on most metrics but doesn’t have a cost of carrying disadvantage acting as an anvil on its back. 

The closer we get to 105, which is widely seen as the low end of the current range, the higher the chance for Japanese hedge ratios to increase on USD assets. This will drive the USDJPY lower as, in this complex chain of events, it will result in a virtuous circle for the Yen.

The New Zealand Dollar 

In a full-blown risk-off scenario the list of losers could be huge, but currency frailties exposed by central bank policy means the Kiwi could very well be the biggest loser and possibly the most attractive short. 

The RBNZ Governor Orr is keeping an "open mind" to debt monetization, challenging what he has described as a "taboo" in central banking circles while seemingly intent on delivering a lower currency to aid the economic recovery. That should be strong enough signal to send the NZD back into the mid 50's. Current NZD levels do not look overly attractive for fresh shorts, so in the near-term we could look for opportunities to sell on rallies. But in the second half, if the global economy continues to struggle, it’s bound to see AUD/NZD quickly rises above 1.10 and NZD/USD shifts to the low-50s.

Asia FX

The slope of the Trade War is best played out via USDASIA, particularly USDCNH which remains the principal trade war barometer. Outside of the Yuan, which will move tangentially to the ebb and flow of President Trump's trade war bluster, USDASIA spot moves have been relatively contained and vols have come off across the board. Interest has been muted, but the bias is still to own USDASIA topside. 

The Malaysia Ringgit 

With traders concerned that the US and China's worsening relationship will morph into a "knock ‘em down, drag em out affair," the Ringgit has been trading with a negative skew, despite soaring oil prices. This is as clear of a signal that Asia investors are getting concerned about trade war as the MYR correlation with the weakening Yuan falls back into the light. There’s a growing preference for long USDCNH in the market which could hamper the MYR recovery, despite Brent oil trading at 32.50 per barrel (+60 %) from the sub $ 20 per barrel lows April 22.

The Philippine Peso 

PHP's outperformance continues to stick out, even though it has implemented some of the most rigid mobility restrictions in the world. The outperformance likely boils down to a few factors: the shallow participation of foreign investors in the Philippines' capital markets means fewer outflows when trade issues bubble, modest current account improvement, and a slump in oil prices that’s lifted current account surplus by 1.2%. In contrast, weak domestic demand has hit imports, which also boosts the current account balance – these two factors make up for the decline in overseas remittances.

The Thai Baht

The surge in gold prices should be a short-term boon for a THB hobbled by tourism woes, which will be a continued source of medium-term weakness. Tourism revenues fell 40.4% yoy in Q1 vs. +1.9% in Q4. Worse still, lockdowns around the world point to an even more tremendous external demand shock in Q2, likely resulting in two consecutive quarters of contraction in GDP, despite a phased removal of its lockdown. Although Thailand will emerge from the recession in 2H, its path to full recovery will be a long and bumpy one given that the development of effective antiviral drugs and vaccines against Covid-19 will be the things that allow for a more confident rebound in tourism and other related activities.

The THB has a positive correlation to gold. When gold prices rise locals sell gold to make a profit, and in these trying times of economic downturn they’re trying to get cash. This will then exert downward pressure on USD/THB as local gold dealers offload their gold inventory in the international market and convert proceeds into THB.

President Trump and the Dollar

You can read President Trump's latest comment on “a great time to have a strong dollar” in two ways. On the one side, the US Administration wants to portray dollar strength as a clear sign that they’re open for business and that US assets and US exceptionalism is running high.

On the fiscal side, the US deficits need financing now, so a healthy or more stable US dollar is probably in the US administration's best interest. On the speculative side, the market has to buy into the idea that the Fed's action does not carry a significant inflation threat, thereby debasing the Greenback. 

Of course, this narrative can and will likely change. When calmer times return, President Trump would probably revert to a pushback against the USD's strength, hoping this would boost net exports. 

These are odd times, and one needs to look before jumping as currency levels typically need to be relevant as far as boosting trade, but at the same time the administration doesn't want to give off any ringing endorsement of inflation, especially with a substantial deficit to finance.

Will it change the way I trade the dollar next month? Probably not. But it will make me think twice for a couple of weeks if I decide to go hog wild shorting the dollar. 

The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

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