Currencies face uncertain August amid central bank normalisation

August tends to be a lax month for currency investors, but occasionally it can be fraught. Two years ago, traders were rushing back from the beach to cope with a market fright over China’s economy, before spending the rest of the year trying to minimise losses.

August 2016 was the opposite, a sterile month influenced by Federal Reserve caution on the economic recovery. Reviewing the trading ideas of strategists and investors suggests that this year may reside somewhere in between.

Foreign exchange markets are currently dominated by the weakness of a dollar that has dropped a tenth against a basket of trading partner currencies, but also sub-plots related to the question of monetary policy normalisation.

After years of pumping stimulus into economies threatened by deflation, the world’s central bankers have started to discuss when and how they might start to remove programmes of bond buying, or even follow the Fed’s lead in raising interest rates.

Typically such tighter monetary policy might be expected to prompt a currency to strengthen, as it reflects economic growth and the attraction of higher bond yields.

Yet the collective movement in that direction means that the relative pace of change matters. So many expect the big market-moving event to be the annual Jackson Hole symposium in Wyoming, a venue used in the past to signal policy shifts. In 2012, for instance, then Fed chair Ben Bernanke foreshadowed a third programme of quantitative easing.

This year the star turn is Mario Draghi, president of the European Central Bank. With some expecting the institution to announce a tapering of bond purchases as soon as September, any thoughts on policy normalisation will be lapped up by traders.

The euro has risen 6 per cent against the dollar since Mr Draghi spoke at a similar gathering in Portugal in June, when his focus on economic growth roiled markets. The US event “has the potential to underscore the renaissance we are seeing in the euro”, says JPMorgan’s Paul Meggyesi.

Still, there are arguments for a rethink. ING’s Viraj Patel warns that central banks may decide markets have run too far, meaning “greater verbal intervention” may hold back the euro. This is particularly as a firmer currency acts as a brake on export growth and inflation.

Some investors are also looking for ways to play monetary policy normalisation trades in Sweden and Norway.

As at many central banks, the debate both among policymakers and in the markets is about the risks attached to keeping monetary policy too loose for too long. Sweden’s Riksbank and the Norges Bank both face strong economic growth data butting up against subdued inflation pressures.

The market has been betting that the tide is in favour of higher rates, hence strong performances by the two krona currencies since May. But the case for buying them by selling euros has been complicated by the ECB’s discussion of future policy.

As an alternative, Kit Juckes at Société Générale advocates selling sterling against the two Scandies. While the UK currency has gained against the dollar in recent months, as the politics of Brexit have appeared to soften, it has drifted lower in Swedish Krona terms.

Kamal Sharma at Bank of America Merrill Lynch, meanwhile, prefers taking exposure to volatility in the euro/Swedish krona market. Given the possibilities for central banks surprising traders, it might be considered odd that the degree of movement in the two currencies is nearing 2014 lows.

BNP Paribas looks further afield, to the Indian rupee. It has gained on the dollar by more than 6 per cent cent this year, and this week climbed to a two-year peak as the currency rallied after the Reserve Bank of India cut borrowing costs.

One trend in July was to buy the Australian dollar against its US counterpart, but Deutsche Bank now thinks that the better trade is to sell the Aussie against the yen.

There is no interest rate upside in Australia, where the central bank is on hold for now, says strategist Tim Baker, while the yen could strengthen if prime minister Shinzo Abe comes under polling pressure, creating the possibility of a change in direction.

Data from derivatives markets also suggest that many investors are positioned the other way, buying the Aussie and selling the yen, meaning that the currencies are vulnerable to shifting sentiment.

For a more esoteric trade idea, consider Venezuela. If troubles there worsen, investors should look out for an impact on the country’s supply of crude, which would spur higher oil prices.

That, along with North Korean tensions, should favour oil-dependent currencies, and RBC Capital Markets singles out the Colombian peso because it has underperformed other Latin American currencies.

Chief among the better performers of late is the Chilean peso. RBC’s recommendation is to sell the Chilean peso against its Colombian cousin as the former faces pressure from expectations of a possible rate cut.

Finally, the Swiss franc kept analysts busy at the end of July, being the only big currency to fall against a weak dollar, and registering its biggest monthly drop against the euro in six years.

A hawkish ECB and a continually dovish Swiss National Bank makes the case for further Swissie declines against the euro, causing the likes of Crédit Agricole to revise lower their end-of-year forecasts.

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