160728 fx watch cyclical bond flows support usd

FX Watch

Group Economics Macro & Financial Markets Research

28 July 2016

Cyclical bond flows support USD Georgette Boele Co-ordinator FX & Precious Metals Strategy Tel: +31 20 629 7789 georgette.boele@nl.abnamro.com

• Currently the US dollar is behaving like a cyclical currency…

• …meaning that relative economic growth performance…

• …and Fed rate hike expectations are key • Net cyclical bond flows have strongly supported the dollar…

• …and we expect this to continue during our forecast period • Meanwhile, net equity outflows have been a major headwind • US dollar could also behave as a safe haven currency…

• …then the relationship with cyclical US assets is negative Introduction In this FX watch we look into the importance of net inflows into US securities for the US dollar. We take into account how these flows behave and the character of the US dollar.

Since September 2012, the US dollar has mainly been driven by cyclical factors (with the exception of February to May of this year). This means that the US dollar is sensitive to expectations about Fed interest rate hikes and relative economic growth performance. In such an environment, in general, higher rate hike expectations and higher US equities support the US dollar.

Net US equity flows gave strong support to USD… 12M average

US dollar

Source: ABN AMRO Group Economics, Thomson Reuters Datastream, TIC data, Bloomberg

…but cyclical bond flows have taken over in H2 2014 12M average

US dollar

Source: ABN AMRO Group Economics, Thomson Reuters Datastream, TIC data, Bloomberg

Insights.abnamro.nl/en

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FX Watch - Cyclical bond flows support USD - 28 July 2016

Confirmed by flow data?

Given the cyclical nature of the US dollar over recent years it would be expected that foreigners would have bought US cyclical assets like US corporate bonds and /or US equities. Has this been the case? The graphs above confirm that this has been the case.

The start of the US dollar rally in H2 2012 was mainly driven by foreigners buying into US equities (graph on the left). Two years later, the US dollar received a major boost from foreigners buying into US cyclical bonds. This was mainly driven by expectations of higher yield pick-up in US bonds compared to other non US assets (see graph below).

Yield pick-up gave a strong boost to the US dollar 12M average

130

3

120 2 110 100

1

90 0 80 70

-1 90 92 94 96 98 00 02 04 06 08 10 12 14 16 US dollar (lhs)

10y US-GE yield spread (rhs)

Source: ABN AMRO Group Economics, Bloomberg

Cyclical US dollar for now…

As stated above, the US dollar behaves like a cyclical currency. This means that prospects about US economic growth and the Fed remain the main driving forces. We expect US growth to be moderate and the Fed to remain on hold this year and to hike in total 75bp next year. We expect the 10y US-GE yield spread to remain roughly stable around these high levels as German yields gradually move up from their lows. As a result, foreigners will likely continue to buy US cyclical bonds.

Since Nov 2013 net-outflows of US equities …

12M average flows dollar

…while US equities have rallied US

12M average flows

Dow Jones

20,000

20,000

15,000 15,000

10,000 5,000

10,000

0 -5,000

5,000

-10,000 -15,000

0 92

96

00

04

12M average Equities (lhs) Source: ABN AMRO Group Economics, Thomson Reuters Datastream, TIC data, Bloomberg

08

12

16

Dow Jones

Source: ABN AMRO Group Economics, Thomson Reuters Datastream, TIC data, Bloomberg

However, equity flows are not supportive at all. Since Q1 2013 they have declined and since the end of 2013 the US has even experienced equity outflows, despite the fact that US equity indices have risen to new all-time highs. The rise in US stocks has been possible because of the buying of domestic investors. The equity net outflows have

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FX Watch - Cyclical bond flows support USD - 28 July 2016

resulted in a major headwind for the US dollar. With US equity markets at these high levels, it remains to be seen if foreigner investors will return to buying US stocks.

‌but the US dollar can also behave as safe haven currency What makes the US dollar difficult to analyse is that it can also behave as a safe haven currency. This is because the US dollar is the most liquid currency and US markets are the deepest and the most liquid. In periods of severe stress, investors search for the most liquid assets such as the US dollar, the Japanese yen, US Treasuries and German Bunds.

The graph and the table below show the periods in which the US dollar behaved as safe haven (red circles) and as cyclical currency (green circles).

Net flows into US securities 12M average flows

US dollar

Source: ABN AMRO Group Economics, Thomson Reuters Datastream, TIC data, Bloomberg

If investors flee to the US dollar because of panic it is likely that they will keep it on account/in cash and this will not be captured in the flow data. However, what is visible is the lower demand for the more risky US assets such as equities and corporate bonds.

Therefore, in periods of risk aversion, when the US dollar behaves as a safe haven currency, the US dollar will rise while flows into US equities, corporate and agency bonds will slow down. While if sentiment improves the US dollar will move lower and these flows will pick up.

US dollar’s dual character Character and drivers per period

Driver

Crisis

Jan 1995 - Dec 1999 Rally (20%) followed by sell-off (-9%) Cyclical

Direction

Character

US stocks

Asia, Brazil , Russia, LTCM

Dec 1999 - May 2001 Rally (13.5%)

VIX

DotCom Bubble, Argentina crisis

Safe haven

May 2001 - July 2002 Rally (5%) followed by sell-off (-10%) Cyclical

US stocks

July 2002 - Jan 2006 Sell-off (-13%)

Safe haven

VIX

Jan 2006 - May 2008 Sell-off (-16%)

Cyclical

Interest rate spread

May 2008 - Sep 2012 Spikes higher (19%), sell-off (-19%) Safe haven

VIX

Sep 2012 - Feb 2016 Rally (32%)

Cyclical

US stocks, Fed rate hike expectations

Feb 2016 - May 2016 Sell-off (-6%)

Safe haven

VIX

Cyclical

US stocks, Fed rate hike expectations Brexit vote

May 2016 - Now

Sideways (+2.5%)

Global Financial Crisis, Eurozone crisis

Source: ABN AMRO Group Economics, based on Bloomberg data

This year there was a short period from February 2016 to May 2016 in which the US dollar behaved as a safe haven currency. Will the US dollar behave like a safe haven currency in the future again? This is likely if risk aversion would develop into severe stress in

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FX Watch - Cyclical bond flows support USD - 28 July 2016

financial markets. As the US dollar is now more driven by cyclical drivers, some deterioration in investor sentiment will initially weigh on the US dollar. If investor sentiment continues to deteriorate at some point in time investors will prefer liquidity over yield pickup. So the US dollar will increasingly receive support from safe haven demand until the crisis develops into a climax. From that moment on, the US dollar will decline, also if investor sentiment improves, until the moment that investors believe that US assets will outperform non-US assets.

ABN AMRO major currency forecasts Changes in red/bold

EUR/USD USD/JPY EUR/JPY GBP/USD EUR/GBP USD/CHF EUR/CHF AUD/USD EUR/AUD NZD/USD EUR/NZD USD/CAD EUR/CAD USD/SEK EUR/SEK EUR/NOK USD/NOK EUR/DKK

28-Jul 1.1111 104.76 116.39 1.3210 0.8411 0.9833 1.0925 0.7545 1.4728 0.71 1.5638 1.3128 1.4587 8.5835 9.5371 9.4439 8.4996 7.4398

Q3 2016 1.10 100 110 1.27 0.87 0.98 1.08 0.72 1.53 0.70 1.57 1.27 1.40 8.64 9.50 9.40 8.55 7.46

Q4 2016 1.10 103 113 1.20 0.92 0.99 1.09 0.74 1.49 0.70 1.57 1.27 1.40 8.64 9.50 9.25 8.41 7.46

Q1 2017 1.10 103 113 1.20 0.92 1.00 1.10 0.75 1.47 0.70 1.57 1.27 1.40 8.64 9.50 9.00 8.18 7.46

Q2 2017 1.10 105 116 1.25 0.88 1.00 1.10 0.75 1.47 0.70 1.57 1.27 1.40 8.64 9.50 9.00 8.18 7.46

Q3 2017 1.10 108 119 1.30 0.85 1.01 1.11 0.75 1.47 0.72 1.53 1.25 1.38 8.41 9.25 8.75 7.95 7.46

Q4 2017 1.10 110 121 1.35 0.81 1.02 1.12 0.75 1.47 0.75 1.47 1.20 1.32 8.18 9.00 8.50 7.73 7.46

Q1 2017 6.85 6.88 70.0 1,180 1.42 35.50 33.50 13,500 64.00 3.05 15.25 4.50 27.20 320.00 3.40 18.50 680

Q2 2017 6.90 6.93 70.0 1,180 1.42 35.50 33.50 13,500 64.00 3.10 15.50 4.50 27.25 320.00 3.50 18.50 680

Q3 2017 6.95 6.95 70.0 1,160 1.40 35.00 33.00 13,200 62.00 3.00 15.00 4.40 27.00 310.00 3.30 17.50 660

Q4 2017 7.00 7.00 69.0 1,150 1.38 34.50 32.50 13,000 58.00 2.90 14.50 4.30 26.50 300.00 3.20 17.00 640

Source: ABN AMRO Group Economics

ABN AMRO Emerging market currency Changes in red/bold

USD/CNY (onshore) USD/CNH (offshore) USD/INR USD/KRW USD/SGD USD/THB USD/TWD USD/IDR USD/RUB USD/TRY USD/ZAR EUR/PLN EUR/CZK EUR/HUF USD/BRL USD/MXN USD/CLP

28-Jul 6.66 6.66 67.0 1,125 1.35 34.87 32.40 13,116 66.09 3.02 14.22 4.38 27.04 313.09 3.26 18.77 667

Q3 2016 6.70 6.73 68.0 1,165 1.36 35.00 32.80 13,100 64.00 2.95 14.75 4.40 27.10 320.00 3.30 18.50 670

Source: ABN AMRO Group Economics

Q4 2016 6.80 6.83 69.0 1,165 1.40 35.00 33.00 13,400 64.00 3.00 15.00 4.45 27.15 320.00 3.35 18.50 670