It was an extremely volatile week for the whole of the asset classes in our Top Down Portfolio, with major international equity markets erasing early year’s gains, commodity prices falling and carry trades losing momentum. The only exception was the NOK/SEK exchange rate, which was little changed ahead of the 3 February Norges Bank monetary policy meeting that may see the CB hiking rate to 2%. Our base scenario is that the Bank will not tighten until the March 24 monetary policy meeting.
Three main events triggered an increase in risk premiums on major international financial markets: 1) early signals that China may tighten monetary policy following robust GDP growth in Q4 (10.7% y/y); 2) the Obama administration’s plan to limit the size and trading activities of financial institutions prohibiting banks from running proprietary trading operations solely for their own profit and sponsoring hedge funds and private equity funds; 3) lower than expected corporate results in the US.
As regard our investment portfolio, a higher risk premium prompted a fall in the Australian Dollar against the Japanese Yen. The decline in commodity prices and the unwinding of carry trades were the main triggers of the Australian Dollar’s drop. Compared to 5 December, when we built our first Top Down Portfolio, the AUD/JPY exchange is little changed, having given back previous gains (we do not consider the positive return coming from interest differential).
Although uncertainty surrounds the short term outlook, we believe that the AUD/JPY exchange rate will likely appreciate medium term. Indeed, the Australian Central Bank, after lifting interest rates three times in 2009, is widely expected to continue its tightening policy in 2010 as labor market strength may increase inflationary pressures, with a further rate hike during the 3 February monetary policy meeting that is a clear possibility. Moreover, while the markets were disappointed by signals of a more restrictive monetary policy in China, which dragged down commodity prices (a variable well-correlated with Australian Dollar exchange rate) estimating that it will trigger lower economic growth, we believe that this decision is the consequence of both strong economic growth and the Chinese Authorities’ willingness to curb excessive credit growth, preventing bigger problems in the months ahead. By contrast, in Japan the Central Bank should continue to implement an expansionary monetary policy for a long time in the face of a persistently sluggish demand and prolonged deflation.
Only an increase of the Vix Index (used as a proxy of risk premium on international markets) above 30 will lead us to abandon our bullish stance on the AUD/JPY. Indeed, since 1998 a strategy based on buying the AUD/JPY when the Vix index was below 30 and selling the exchange rate when the VIX was above 30 has gained a total return of 38%.