2017: USD Rally or EUR Reversal?

A lot of top fund houses are talking about the US Dollar strengthening theme in 2017 and after the Trump trade this appears to set a major trading theme. So let us explore the scope for such a dollar rally theme. The US dollar rally that has started after the conclusion of US presidential election has not yet shown any signs of subsiding. Looking back, we saw a great sell-off in crude and this set much of the moods prevailing in the world economy covering all asset classes. This slowly traced back to dollar in 2015, partly through the surprise CNY depreciation, and later through Fed rate hike expectations. US dollar has again appeared as a dominating risk factor keeping aside all the noises around Brexit etc. We had seen a similar setup earlier in 2013 as well but this time it is more focused to set the market sentiments. 

Looking at the fundamental drivers, a large part of the recent dollar strength can be attributed to the expectation of US policy change of a possible fiscal stimulus. The basic rationale is that a fiscal stimulus, coupled with a budget deficit will increase interest rates and hence the exchange rate. The impact of increasing budget deficit affects interest rates and lead to a higher exchange rate as demand for higher interest assets goes up among foreign investors. Also, the increased budget deficit can increase the long term inflation expectations and hence expectation of future dollar depreciation. The other important part of policy is trade which is putting a tightening pressure on the US current account deficit (if and only if Trump follows what he promised). For the US, the current account in recent past has been largely driven by demand for financial assets from overseas investors. This implies that a tightening current account will have to be balanced by a reduced demand for US financial assets by foreign investors, resulting in a currency depreciation now. So an increase in interest rates may make US assets attractive among foreign investors, but without matching trades the flows in to those assets will be difficult to sustain. To talk about some other drivers, while inflation in US has been steady, including wage growth, we have seen some early signs of a come back of inflation in the Euro area as well. Hence it is important to watch out the pick up in Euro credit growth.

The ambiguity in the impact of trump policy, and the fact that trade weighted dollar (NEER) has a little head room left to reach an all time high (achieved in 2002), it does not look like the dollar rally theme can make further strides. With the ECB's decision of continuing QE in Europe till Dec 2017 and yesterday's Fed hike decision (which was priced in already to a large extent) will definitely hinder further upside in this rally. 

It is interesting to see the recent dollar rally as risk-off from Emerging Markets point of view but it is an altogether different story for Euro area as Euro sold off drastically. Fed policy always matters for emerging markets because U.S. monetary policy helps to set tone for EM financial conditions, especially through the availability of USD liquidity. The biggest risk to EM, would come later in 2017 if the new Trump administration works with Congress to pass large tax cuts and loosen fiscal policy significantly. Although that would boost growth in the short-term, including in EM, it would also be inflationary and make it more difficult for the Fed to withdraw policy accommodation gradually, increasing the risk of larger capital outflows from EM economies. It is a different story for Euro area because it has accumulated a huge current account surplus in its glut for savings in the post-crisis period. A substantial change in trade relationship with the US may start to unravel that. If you are positioning for the consensus Euro dollar parity, think again. 2017 may see a major reversal in Euro instead dollar.

Trading around the barriers: Forces at work in Spot market

This is an interesting bit on trading barrier options which has come out of my interaction with some option traders. The breadth of FX exotic products traded these days is considerable and one of the most commonly traded exotic option is a knock out option- this is a vanilla option but with an additional feature where it disappears if a given in the money barrier is crossed at any point during the life of the option. This is popular because this feature reduces the price of this option.

Consider a very realistic situation where a market maker would be selling this KO call option to an investor which results in a short position for the market maker. The delta hedging requirement for such an option would vary across spot and time. The market maker has a gamma position similar to a vanilla option near to strike which makes him short on gamma and hence needs to buy spot as it rises.

The interesting thing is that as the spot approaches barrier, the curvature reverses and the trader gets long gamma as a result of being long the barrier and short on the call. As the delta exposure becomes increasingly positive, the trader hedges this by selling large amounts of spot as it approaches the barrier which exerts a downward pressure on spot and hence preventing it from hitting the barrier. A similar dynamics is realized for the vega exposure on this trade which is being short near the Strike but long near to the barrier. This will again result in the selling of short dated options and hence suppressing the volatility levels. This makes the spot sticky.

Option delta profile a day before expiry (K=1.4850; KO=1.5500; delta in Euros)

Whenever the barrier is breached, the option gets knocked out and hence the hedges would need an unwound which will result in buying back the spot and options to square this position which can result in a higher gap in spot and the spot is said to be slippy. 

Global Economic Highlights

It has been quite a busy period of central banks' policy stances and we have heard a bit from ECB, Fed and BoJ recently. The ECB talked about corporate bond purchasing program with the general feeling that it exceeded expectations. The Fed made some changes to its language obviating the external risks but the market response remained mostly unconvinced pertaining to the next tightening move. Finally, while the investors were expecting some action from BoJ, the market's reaction was an obvious disappointment. This can be portrayed as a case of mismanagement of expectations.

After the BoJ's announcement, markets were eyeing on the US data and particularly the Q1 GDP result. The growth number of +0.5% qoq was disappointing as the expectations were at +0.7%. This is due to the reduction in business fixed investments. The inflation data released gave an upside to USD strength and the Treasury yields. The Q1 Core PCE came out at +2.1% qoq which is the highest level achieved in last 4 years. It can be inferred that any near term strength in core inflation is going to be temporary because the residential rents' growth and the rate of health care spending is slowing which forms a large chunk of the core PCE deflator.

The Employee Cost Index (ECI) released earlier this week showed a mildness in worker compensation. This is a good enough evidence of a very little relationship between unemployment rate and wage growth. The Phillips curve is in doubts again!

Oil Story: Would production freeze be an effective move?

If oil producers had agreed to freeze oil supply at a January level until October 2016, this wouldn't have much meaning for market fundamentals because the prospective agreement would have excluded both Iran and Libya which are the only countries with a production growth potential in the short term. Let us see the positioning and rationale below.

Iranian production averaged 3.30 mmb/d in March, up from 2.91 mmb/d in December 2015. The government believes that the production level of 4.00 mmb/d can be achieved by March 2017 but the growth may be limited by primary US sanctions which still holds their place. These US sanctions are meant to target Iran's support for terrorism, creation of weapons of mass destruction, the avoidance of human rights in both Iran and Syria. They restrict US companies and individuals to transact with Iranian financial institutions which results in marginal dampening of exports from Iran.

Another major development that will potentially pave a way for enhanced joint venture investments with local companies in Iran is the revised formulation of Iran Petroleum Contract (IPC). The revised terms of the IPC appears to be improved as it includes no capex ceiling and the cost overruns are no longer to be suffered entirely by the participating International company. Also, the remuneration will be floating based on oil price, and will allow the international company to participate in any excess production over and above the agreed target level. The duration of contract has also been revised to over 20 years. These revised terms would be beneficial to attract both foreign capital and technology to successfully exploit the upstream oil and gas projects.

The production in Libya is at its 12 months low of 340 kb/d down from a level of 1.4 mmb/d. There has a huge damage to oil exporting and transportation infrastructure which in turn has affected its capacity. The further production outlook for Libya depends on government's success in restoring peace and order which right now appears to be more remote.

The rift between Saudi Arabia and Iran turned a potentially positive event into a negative creating a suspicious outlook for any potential agreement in June's meeting. While the oil producers were meeting in Doha, there had been an open ended strike of oil workers in Kuwait over the issues of salaries and benefits which has resulted in a significant reduction in oil production. This level of reduction could neutralize the bearish impact of the failure of meeting in Doha if at all it could last long enough.

Last week's US petroleum statistics were positive for the market as the supply fell just below 9mmb/d level for the first time since October 2014. For the last two weeks, the change in Brent positioning has been driven more by an increase in long positions rather than a reduction in shorts. The heightened long positioning and the likelihood of a floating storage unwind threaten to pressure prices in near term.

Pending drawdown could pressure prices lower; Source: Bloomberg