The Latest Threat To The Risk Currency Rally

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Iran, China, and Some FX Implications

The following is a partial summary of thoughts and conclusions from our weekly fxempire.com  analysts’ end of week meeting, in which we share ideas about the outlook for global equities, currencies, and commodity markets for the coming week and beyond.

Risk assets and currencies continue to rally, as markets continue to shrug off concerns about a coming Fed Taper, the EU, and arguably overvalued markets. Here’s a new cluster of developments to consider.

While last week had little market moving news, it had some major geopolitical developments with equally significant potential to move markets as we move into 2014.

Iran’s Nuclear Win

 

On Tuesday representatives of the P5+1 nations signed an agreement with Iran. The term refers to the P5 or five permanent members of the UN Security Council, namely United States, Russia, China, United Kingdom, and France, plus Germany. P5+1 is often referred to as the E3+3 (or E3/EU+3) by European countries.

Per Western news sources, in exchange for Iran’s cutting and diluting stockpiles of highly enriched uranium, and allowing serious international monitoring of enrichment facilities, the U.S. and E.U. agreed to lift certain sanctions that Washington claims have cost Iran $80 billion. London-traded Brent crude oil contracts fell, even though the sanctions that are being eased are related to the repatriation of overseas funds and not to restoring oil sales.  However oil prices fell because as part of this deal, U.S. lawmakers have pledged not to impose new sanctions on oil over the next 6 months as long as Iran follows through on their pledge.

Oil dropped modestly on the news, and could see further pressure in the near term. Longer term however, the deal more likely means a return of tensions and higher prices, as it granted Iran concessions in exchange for what was arguably, less than nothing because the deal:

  • Explicitly allows enrichment even though the prior U.N. Security Council resolutions called for Iran to halt all Uranium enrichment. Worse, Iran denies Western reports that uranium enrichment levels must be mutually defined and agreed upon by both sides in further negotiations. According to Iran’s official IRNA news agency, Iran’s foreign minister Javad Zarif said “Iran will decide the level of enrichment according to its needs for different purposes…Only details of the enrichment activities are negotiable.” See here for details.
  • Even though it requires Iran to turn its 20% enriched Uranium into oxide, this is a meaningless concession because the process is reversible. In sum, the due date for an Iranian atomic bomb hasn’t even been deferred, much less stopped. 
  • Isn’t even agreed upon to be the same deal by both sides. Within the same day of the signing (Tuesday) Iran was already publicly disputing details of the detail that Washington had published on Sunday.

 

In essence this was just another example of how crises are handled these days – “extend and pretend.” Washington et al pretend they’ve addressed the problem while in fact another crisis is pushed off to the future.

There are many implications of this loss of US credibility as a deterrent against Iran, and of convincing the Israelis, Saudis, and other Sunni nations that they’ll have to deal with the Iranian threat on their own. They include:

Escalating the Syrian conflict

  • Raising the odds of a new Israel-Hezbollah conflict: Both sides have been intensively preparing for the next war. There are multiple reasons why an emboldened Iran could lead either side to start the next round.
  • Raising the odds of new Sunni nuclear powers, and of an Israeli strike on Iran, conceivably with tacit Sunni help.

Those seeking further details can find an excellent piece here. A key point the author makes:

While it may sound improbable for hard-line Sunni states to work with Israel, it really isn’t. For a Sunni fundamentalist, it’s easy to make a theological case for working with “people of the book” against the Shi’a, who many consider to be apostates (which is much worse than being an infidel).

One of the brakes for an Israeli attack on Iranian nuclear facilities has been the risk of it spiraling into a broader “Islam vs. the West” conflict. That is one of the reasons Israel has sought U.S. approval for an attack thus far. With many of the Sunni Arab states supporting action against Iran, if only tacitly, that brake may now be gone. Does Israel really need U.S. approval for an action that other countries in the region support?

Forex Trader Implications

 

For currency traders or investors that consider currency trends in their investing and portfolio allocation decisions:

  • In the short term this is bearish for energy related currencies and other risks asset, as the markets price in both Iran oil and increased Saudi production to keep economic pressure on Iran.
  • In the longer term this is bullish for the currencies of energy producers beyond the Mideast, particularly the USD (also benefits from safe-haven flows), CAD, and NOK.

It’s very possible that Washington’s lack of resolve against Iran brought another geopolitical tremor.

 

China Escalates Dispute Over Islands

 

Could Washington’s weakness in opposing Iran and abandoning its allies in the Mideast be behind China’s latest moves against Japan and other neighbors?

Since 2008, China has been slowly escalating its disputed claim over possession of a few barren islands (really over the fishing and mineral rights their possession implies) that have been under Japan since the late 19th century.

Although Washington has no position on the sovereignty of the islands, it recognizes Tokyo’s administrative control and says the U.S.-Japan security pact applies to them.

Nonetheless, China raised the heat on the simmering dispute when just over a week ago (as the details of the Iran deal came out), China announced that foreign aircraft passing through its new air defense identification zone (ADIZ) – including passenger planes – would have to identify themselves to Chinese authorities. The zone includes the skies over these islands.

The newly declared ADIZ overlaps with that of South Korea and Japan, as well as with Japan’s territorial claims. Meanwhile:

  • The Philippines is unhappy with Washington for what it sees as a US failure to give it sufficient support in its dispute with Beijing over a group of islands in the South China Sea.
  • Vietnam has a separate quarrel with China over its maritime borders.
  • India also has a simmering territorial dispute with China that has escalated recently.

 

Thus as FT.com’s Philip Stephens wrote late last week, “Consciously or otherwise, Beijing has now turned control of the air space around the Senkaku into a litmus test of the US security commitment to east Asia. For Washington to accept the Chinese restrictions would be to send a signal to every other nation in the region that the US cannot be relied on to defend the status quo against Chinese expansionism…My guess is that Mr. Obama, accused of presiding over a collapse of US power in the Middle East, cannot afford to back down over the Senkaku (islands).”

Japan and the US have responded by sending warplanes into the area without informing China. China has countered by sending its own air patrols.

While no one wants an armed conflict, the dangers of one from some kind of miscalculation are rising.

 

Implications for Forex Traders 

Given the complications of reducing tensions, the uncertainty will likely get worse before it gets better. With risk assets and currencies already high and vulnerable, rising tensions could provide here could become the catalyst for a shift into safe-haven assets and currencies.

Any brokers offering USDCNY should see some added trading volume there.

The USD and USD bonds should get a boost if this story drags on, given that:

  • Recent data out of the EU continues to support the view that the ECB is likely to become more dovish relative to the Fed.
  • The JPY is the only currency that ranks higher on the safe haven spectrum. However its vulnerability to rising tensions with China makes the USD a better bet.

Traders remain overall short the EURUSD per both latest COT reports, and the forexfactory.com EURUSD live positions chart below.

 

The Latest Threat To The Risk Currency Rally

The Latest Threat To The Risk Currency Rally

Source: www.forexfactory.com (homepage, under Positions/Live Accounts heading)

 

02 DEC 010031

As we’ve pointed out before, although the sample of retail traders is small (438 as of this writing), the fact that it provides a real time reading makes it a useful tool in combination with the U.S. CFTC COT reports, which present far larger (and more statistically meaningful) but much less timely sample, particularly when the two are in rough agreement.

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DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING OR INVESTING DECISIONS LIES SOLELY WITH THE READER.

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About:Cliff Wachtel

Author of the award winning book, The Sensible Guide To Forex: Safer, Smarter Ways to Survive and Prosper from the Start (Wiley, 2012), Cliff Wachtel, CPA, has been serving as investment advisor, analyst, writer, trainer, trader and investor for over 30 years in a variety of markets and asset classes throughout the world. He’s a widely read contributor on a variety of financial media, including seekingalpa.com, businessinsider.com, forexfactory.com, forexstreet.com, econintersect.com, and other media too, with or without with his explicit permission.

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