AMERICAS TRADING The first sign that this era of easy USD funding was drawing to a close came on May 10, 2013, in a speech given by then Fed Chair Ben Bernanke. He stated that "in light of the current low-interest rate environment, we are watching particularly closely for instances of 'reaching for yield' and other forms of excessive risk-taking." He added that such activity "may affect asset prices and their relationships with fundamentals." As we noted at the time, by highlighting the link between ultra-loose monetary policy settings and asset bubbles he was also (albeit indirectly) calling time on the policy of "benign neglect" towards the USD. A sign of what was to come came in the summer of 2013 (even before the Federal Reserve had begun tapering its asset purchases), as the currencies and markets of a number of developing nations with significant current account deficits (the "fragile five") came under pressure in anticipation of the drying up of inflows from the USD. However, it was in the summer of 2014 that a real shift in the environment began to emerge. Ironically, the catalyst for the sharp appreciation in the USD from June 2014 onwards was not a change in US monetary policy (the Fed had been reigning back its asset purchases since the start of the year) but, rather, the European Central Bank's (ECB) decision to introduce a negative deposit rate for the euro (EUR). Within days of its implementation, a rally began that subsequently saw the USD index gain close to 25%. The most telling impact of the postsummer 2014 USD rally was not felt in the mainstream currency markets (other than a sharp rise in volatility) but, instead, in those commodities and emerging market currencies that had particularly benefitted from the USD funded bubble formed over the previous 12 years. Perhaps the most eye-catching turnaround came in oil prices with Brent crude losing over 75% since June 20, 2014. By November of 2014, the collapse in oil prices had forced Russia's central bank to allow the ruble (RUB) to free float rather than continue to see the massive drain on its FX reserves it was suffering (having fallen by USD 95 Bn since the start of 2014). Although Russia's FX reserves sustained a further USD 64 Bn decline over the next five months, the numbers began to stabilise from May of 2015 at around the USD 300 Bn figure. Tellingly, although the RUB continued to suffer (particularly from October/November
of last year as it became increasingly clear what both the Fed and the ECB were likely to do), local markets have performed relatively well since then. Most notably the Moscow Interbank Currency Exchange (MICEX) continues to trade at roughly the same levels as it has for the past 12 months. Similar to what the UK discovered back in 1992 when it left the Exchange Rate Mechanism, Russia has been able to encourage a degree of welcome stability in local markets by letting its currency take the strain.
While Russia might have decided that discretion was the better part of valour when dealing with the radical shift in the financial environment seen since the summer of 2014, others chose to continue defending their currencies. Most notably China (having seen a stock market bubble of its own formed during the first half of 2015 that was eerily reminiscent of that seen in late 2006/early 2007) began to see increasingly dramatic draws on its FX reserves. Last August, China saw a USD 93 Bn decline while December saw an astonishing USD 107.9 Bn drop.
In January 2016, the Shanghai Composite fell to more than 40% from its peak in June of last year. The reason why this matters is simple enough. Rather than being (relatively) unrelated market shocks both the downward pressure on oil prices and the turmoil in Chinese currency markets can be seen as a function of the radical shift witnessed in the broader market environment since the summer of 2014. This matters, as it indicates that while China might succeed temporarily in stabilising the Chinese yuan (CNY) and its local markets (much as it did in September 2015), or oil might find some temporary updrafts, the key issue will remain relative to demand for the USD. With the Fed is still signalling that it intends to further tighten policy, and other developed world central banks are increasingly erring on the dovish side (most notably the ECB), a reasonable argument can be made that the USD will remain in demand for some time to come. If true, this leaves those nations still defending their currencies with an uncomfortable choice at some point: either follow Russia's decision to stop throwing good money after bad (this, essentially, was President Putin's criticism of the Russian central bank at the end of 2014) and allow their currencies to take the strain, or face the potential prospect of continued hefty draws on their FX reserves. 2016 is therefore already shaping up to be one of the more interesting years for the currency markets in quite some time.
Even the quieter months saw sharp outflows with USD 71 Bn being wiped off the value of the nation's holdings in March and a further USD 87 Bn in November. While the overall decline in the value of China's FX reserves since the summer of 2014 peak may only have been 16% and may partially be accounted for by valuation shifts, this still represents a decline of over USD 660 Bn. This is roughly three times the size of China's reserves at the start of 2002 and twice the size of Russia's at the end of December of last year. If there is any one symbol (other than the decline in oil prices to the kind of levels last seen back in 2002/2003) of the astonishing change in the financial environment since the summer of 2014, this number is it. It is also worth highlighting that China's stock markets continue to suffer.
Simon Derrick Chief Currency Strategist BNY Mellon The views in this article are those of the author only, do not constitute investment advice, and may not reflect the views of BNY Mellon.
Issue 3
87