Great rotation set to rock FX markets
The prospect of a great rotation from bonds into equities promises a regime shift in the FX market that throws up opportunities for currency investors.
Many believe the case for a rotation from bonds into stocks is fairly straightforward.
After all, even if the world’s largest central banks are being cautious as they seek to normalize monetary policy and abandon unconventional measures, the direction is towards the exit as the global economy recovers.
Thus just as monetary tightening is bad for bonds, so cautious tightening while the global economy is recovering is good for equities.
Some believe that rotation might develop into a seismic shift that alters the dynamics of the financial landscape and has the potential to trigger a new regime in the currency markets.
“A rotation from bonds into equities seems inevitable to us, and it could be a great rotation taking into account the huge bond inflows since the global financial crisis,” says Athanasios Vamvakidis, FX strategist at Bank of America Merrill Lynch.
Clues about how currencies might react to a great rotation can be gathered from the price action that surrounded the mini-rotation from bonds into equities triggered by the debate over the prospect of the Federal Reserve tapering its asset purchases.
Figures from EPFR, which tracks global fund flows and asset allocation data, show strong global liquidity was pushing flows into bonds and equities before the Fed floated the idea on May 22 that quantitative easing tapering might take place before the end of the year.
As the chart below shows, however, bonds have experienced large outflows since then, while equities have seen strong inflows, following an initial risk-off market correction.
Indeed, even though more cautious recent language from Fed chairman Ben Bernanke has helped to stabilize bond markets, bond outflows since the end of May have offset more than half of the inflows seen since the start of the year. Meanwhile, equity inflows have continued.
|Flows into global bonds and equities - percentage of assets under management
Vamvakidis says FX moves sparked by the Fed-triggered mini-rotation can serve as a template for how currency markets might perform during a great rotation.
“We would expect a strong correlation of flows during the mini rotation that followed the Fed tapering debate and flows during the great rotation that may be ahead as major central banks normalize monetary policies,” he says.
The reason, according to Vamvakidis, is that, to a large extent, both flows reflect position adjustment.
“In this context, currencies in countries that have experienced the largest equity inflows and the smallest bond outflows since the Fed tapering debate started should do well when the great rotation takes place,” he says.
BAML, therefore, used EPFR flow data to rank currencies based on equity and bond flows since the Fed tapering debate began on May 22 in order to identify trends that might develop during a great rotation.
Bond and equity flows during Fed tapering debate - percentage of assets under management May 22 to August 7, 2013
As the chart above shows, the dollar, perhaps unsurprisingly, is likely to be the best-performing currency. US bond outflows are likely to be of a similar magnitude to those in the rest of the G10, although the dollar might benefit from stronger equity inflows.
Equity inflows into Japan might be even stronger than those into the US. However, Japanese officials might be comforted to hear that they are likely to be driven by a weaker yento begin with.
The chart suggests the best opportunities in G10 might be to buy the US dollar against the Norwegian krone and against its Australian, New Zealand and Canadian counterparts.
Meanwhile the euro and the pound look set to benefit against their non-dollar peers.
It is clearly emerging market currencies, however, that are likely to suffer the most. Indeed, since the Fed tapering debate started, all emerging market countries with the exception of Israel and Colombia have seen both bond and equity outflows.
“This suggests substantial emerging market risks during the great rotation,” says Vamvakidis.
The analysis suggests that emerging market currencies that might be particularly vulnerable include the Brazilian real, renminbi, rouble, Turkish lira, Indonesian rupiah, Indian rupee and Thai baht. In contrast, the Polish zloty, Korean won and Israeli shekel might all outperform within emerging markets.
Of course, it is not a definitive guide, the rouble for instance might benefit from rising commodity prices, while the Mexican peso might get a boost from improved US growth.
Above all, however, the analysis might be a comfort to US bulls, frustrated at the lack of progress made by the US currency in recent weeks.
Indeed, the prospect of a great global rotation from bonds to equities would seem to have the potential to finally push the dollar out of the 11-year bear trend in which – save for a couple of sharp haven-related rallies during the financial crisis – it has been stuck for the past 11 years.