DB FX Daily: Market Sees Little Risk from SED, USD Weakness vs. Majors/OITP

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FX Daily: Market Sees Little Risk from SED, USD Weakness vs. Majors/OITP

Market Currently Sees Little Risk from US-China SED
The China-US Strategic Economic Dialogue (SED) begins today with the market currently showing little concern over a short-term appreciation of either CNY or JPY as a result of the talks. 1W USD/CNY forward points are currently trading close to the average level observed over much of 2007. 1M USD/CNY forward points have moved since the band widening on Friday but remain short of the levels seen prior to the last SED talks in Beijing during December of last year. The options market also reveals few signs of concern in USD/JPY where 1M risk reversals have continued to come in to levels not seen since the end of February as USD/JPY has steadily moved higher. Given the lack of movement in market prices, perhaps the expectation is for the high level political and economic discussions to focus on bigger picture issues - chiefly the bilateral trade issues. The chart at left below tracks the share of China in the US trade deficit over the past 12 months as well as the share of the US trade deficit with Asia over the same window. While China's rapid GDP growth has seen US exports to China grow at almost a 30% pace y/y in 2005 and 2006, this growth rate has recently slowed while US import growth from China has remained steady between 10-20% y/y. Still with China taking a larger share of the world economy each year and the US running consistent trade deficits over the years, the increasing share of China in US imbalances is not too surprising.

USD Weakness Shifts from Major Currencies to EM: The chart at right below tracks two of the Fed's trade weighted USD indices - one for major currencies and the other for important trading partners (OITP) which is mostly large emerging market countries. Here we can see the very recent USD weakness coming more via the EM currencies in the OITP index and less from the major currency index where only CAD has been appreciating against the USD of late. The chart also shows that the OITP index has been less volatile over recent years. Though high yielding EM currencies went through a period of significant volatility in May last year, the EM currencies which hold larger trade weights with the US in both Asia and Latin America have shown a relatively steady path of appreciation. The volatility of the OTIP index using weekly returns has averaged 2.4% since 2004 and been remarkably stable while the major currency index had an average historic volatility of 6.7% since 2004 though it has recently converged quickly towards the OITP level.