The US dollar: risk and reward (page 2 of 2)

The MXN may at some stage share the same fate, particularly from H2 as the U.S. slows and investors prepare for the 2006 presidential elections. For "riskier" assets as a whole, the endgame may take some time to play out as the fundamental dynamics remain supportive for now. However, the increasingly violent corrections we are seeing in currency and asset markets may be a warning of what is to come.
Potential Triggers for Risk Aversion
Trying to forecast when the market will eventually move from risk seeking to risk aversion is like trying to pick the top in the NASDAQ in 1999-2000. A more constructive approach is to try and suggest likely triggers for an eventual reduction in risk appetite and the likely ramifications for global FX markets:

• The continuing risk in risk-free rates: The Fed funds target rate has so far been raised 150bps to 2.50%. Our base case is it will be raised to 3.25% by the June FOMC meeting and risks rising further. The Fed is trying to return to a "neutral" policy stance, but it may not know exactly where that is. The only way it can tell for sure is if there is sufficient market distress, which suggests there is a risk the Fed may tighten too much. In any case, risk-free interest rates may rise to a level which may cause general risk reduction

• Growth deceleration in the U.S. and China: The U.S. and China have been the two main drivers of global growth. At some stage, most likely in H2, those two economies will start to cool, hurting commodities and commodity-related currencies

FX Strategy - Reduce Beta
Any framework to prepare for a reduction in investor risk appetite should focus on vulnerabilities to 1/ higher U.S. rates 2/ a stronger USD 3/ a commodity price correction and 4/ a U.S./China slowdown. In anticipation of lower risk appetite, investors should look to reduce overall beta within their FX portfolios, favouring those currencies with low USD debt, strong C/A surpluses, a good
balance of domestic- and externally-led growth and low dependency on specific commodities or countries. The most obvious vulnerability is C/A balance deterioration but debt levels may also become important.

• Leveraged funds: Look for opportunities to sell stretched G10 currencies against the USD, particularly from H2, using options to achieve best reward/risk ratio. Favour Asian currencies and the BRL over EUR, GBP, AUD, NZD, the ZAR and MXN

• Real money funds: Continue to favour overweights in Asian currencies relative to benchmark and also in the BRL. Reduce overweight in the EUR - effectively making one short EUR-Asia - and start to scale into underweights in the likes of AUD, NZD and GBP. Balance overall exposure
with a weighting in lower yielding currencies such as SGD and JPY with high current account surpluses

• Corporates: USD-based corporates should be looking to increase their hedging ratios against the G10 currencies, the TRL, MXN and ZAR. EUR-based corporates should look to be reducing hedging ratios against Asia and Latin America, but increasing them in Eastern Europe. Finally, Asian-based corporates should be looking to increase significantly their hedging ratios against the EUR, GBP and AUD

Callum Henderson, Head of FX Strategy