As signs appear that the global economy is picking up, the markets would expect to see a move from bonds into equities. However, it’s early days and no-one is celebrating just yet. Mark Pelham reports.

The nascent upturn in the global economy appears to be reigniting investors’ risk appetite, which theoretically results in them moving from bonds to equities. While such a shift has obvious direct implications for those asset classes, it could also impact heavily on the currency markets.

Major portfolio flows toward any single area are most likely to affect the US dollar, but there are potential ramifications for a range of currencies. Consequently, FX traders are monitoring trends in portfolio flows closely.

The basic theory is that most of the major equity indices are at least 50% dollar-denominated but have relatively little yen and euro components, whereas bond indices have relatively fewer dollars and a lot more yen. So if there were a wholesale switch from bonds to equities, the first-round effect would be that portfolio managers would need to buy dollars and sell euros and yen.

Less straightforward

However, Rashid Hoosenally, head of client strategy and product innovation at Deutsche Bank, argues that it is no longer so straightforward: “There has been a trend away from government bond indices in the past year or two to aggregate bond indices, which have higher dollar and lower yen components. Therefore the effect of a switch from an aggregate index to an equity index would be less pronounced.”

Rashid Hoosenally: trend from government bond indices towards aggregate bond indices

Furthermore, the effect of bond-to-equity switching may not be exactly reflected in the currency markets. “The currency effect may be tempered by whether there is a move from one hedge ratio to another – it depends what the domestic currency is for those switching, as to what hedge ratio they need to have on. Overall, it’s very situation-dependent, but if you were going from a standard government bond index to a standard equity index and their hedge ratios were roughly the same, the major effect would be some dollar buying and some yen selling corresponding with the price action we have seen recently,” says Mr Hoosenally.

Another difficulty in analysing the trend is that, at the time of writing, portfolio flow data was only available up to the end of May. To that point, equity inflows to the US had increased over the year as a whole, but by far the biggest flow was still to bonds.

Fatih Yilmaz, G10 currency strategist at Bank of America Securities, says that since the beginning of June there has been some pick-up in equity markets, together with a significant positive move in exchange rate-equity market correlation. “We don’t yet have recent flow data but it’s not difficult to deduce from financial market experience and anecdotal evidence that switching from bonds to equities is the cause. The Fed [US Federal Reserve] is undoubtedly trying to engineer a switch from a carry culture to an equity culture, but it is evident that the carry culture still exists from the recent sell-off in treasuries,” he says.

Risk of negative impact

That sell-off in the first full week of August, means that the dollar is viewed as being at a crossroads. “Although there has been a sharp sell-off, bond markets must stabilise for this scenario to continue to unfold. There is a risk that if bond markets continue to decline at their current pace, yields will be pushed up to levels where they could have a negative impact on the US economy and equity markets once again,” says Ian Stannard, FX strategist at BNP Paribas.

If stabilisation is achieved, the outlook for the dollar is positive because the sell-off, combined with the recovery in equity markets, should trigger asset-switching back into equities, especially as risk appetite has started to return. “Risk indicators are showing that we are back to more normal levels of risk appetite, following the extreme levels of risk aversion that we saw at the turn of the year. The US equity market is very large compared with the European equity markets and will attract more flows,” he says.

He adds that the US is closer to a sustained recovery than Europe, and US corporations appear to have successfully restructured their businesses, so earnings growth should come through more quickly. This should make corporates and the US equity market better placed to take advantage of a recovery and increased demand. On this basis, the US equity market should attract more funds and begin supporting the dollar.

Growth factored in

While the dollar may be supported by such flows, its upside may be restricted because potential growth in the US over the short to medium-term has already been factored into FX pricing and it will take unexpectedly good numbers in future to boost the currency. Consequently, perhaps more of an effect will be seen in peripheral currencies if global growth continues, says Bilal Hafeez, FX strategist at Deutsche Bank.

Bilal Hafeez: bond market sell-off has led to a lot of adjustments to positions

He explains that the so-called commodity currencies – the Australian, New Zealand and Canadian dollar – are the currencies that theoretically do well in an economic upturn, whereas the Swiss franc and the Norwegian krone are both negatively correlated to global growth.

But, he says: “Over the past couple of weeks, we haven’t seen the dollar bloc currencies perform well, although they did earlier in the year. This is a repercussion of the quick turnaround in global growth expectations. The resultant bond market sell-off has led to a lot of adjustments to positions, which has impacted the currency markets as well. It led to trades, particularly carry trades, being unwound. It has been a tug of war between global growth expectations improving and risk aversion increasing because of the dynamics in the bond market.

“In a period of risk aversion, you tend to find dollar bloc currencies doing badly because they are the high interest rate currencies in carry trades, which are unwound. Eventually, once this short-term risk aversion subsides, and the bond market settles down, then the medium-term driver of improving global growth comes into play and should benefit those currencies.”

Another currency that looked set to benefit from an increase in risk appetite was the yen, with predictions of huge foreign inflows into the local equity markets. However, it appears that, as in the past, domestic economic policy is triumphing over external trends.

Japan still fragile

Mr Yilmaz says: “We have recently seen some pick-up in Japanese equity income flows but their sustainability is a concern; the situation is still fragile and Japanese investors’ appetite for foreign bonds continues. Furthermore, the Bank of Japan’s continued currency intervention to keep the yen weak is currently negating the inflows. In July, it spent $17bn in the FX market, bringing its total intervention to $60bn for the year, and because BoJ does this by buying US bonds, it translates into outflows.”

Elsewhere, Asia’s emerging markets have had significant inflows since the beginning of the year, causing their currencies to appreciate. But this is unlikely to continue, says Mr Yilmaz. “From the goods market side, because the pick-up in the global economy is likely to be a slow process, those economies are going to resist further currency appreciation and they are managing this very well from a political perspective.”


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