Two weeks into the year and most investors are nursing sizable drawdowns.  The recovery in the US equities on January 14 looked like the a potential turning point. However, the coattails proved non-existent, and the bull trap was sprung with new downside momentum established before the weekend.

The obvious takeaway is that the current driver is not to be found in New York. And to be sure, we are not just talking about equities, but during this market meltdown, correlations between various asset classes and instruments have increased (or become more inverse).

Nor is what is happening in the foreign exchange market driven by the US dollar. We suggest that presently it is best to consider the dollar as the fulcrum though it has appreciated against most major and emerging market currencies through the turbulence since the start of the year.

There are a few currencies that have appreciated against the dollar over the past two weeks. They are the euro, and currencies like the Danish krone and Swiss franc that are closely linked, and the Japanese yen. What the euro and yen have is that they have been used extensively as funding currencies.  Foreign portfolio investors are also believed to have been running high hedge ratios. Existing interest rate differential mean hedging not only does not cost money, but an investor is actually paid to hedge.

The emerging market currencies that have risen against the dollar over the past two weeks shares a common feature. They are all from Central Europe: Hungary, Bulgaria, Czech, and Romania. This is largely a function of the euro’s rise. They have mostly risen less than the euro against the dollar, which means that the euro has appreciated against them. The exception is the Hungarian forint, which is up 0.55% against the dollar compared with the euro’s 0.50% advance. The difference is insignificant.

The Polish zloty is notable in its absence.  The political climate has changed in Poland following the election last year.  The agenda of the Law and Justice Party is scaring investors and spurred a cut in its ratings by S&P ahead of the weekend.  Poland is also at loggerheads with the EU.  Having lost 4.5% in the past two weeks, the zloty is one of the weakest of the emerging market currencies. The euro is trading at four-year highs against the zloty.

As international investors (and rating agencies) re-examine the policy and economic environment, the zloty is likely to weaken further.  After closing at PLN4.48, the immediate target is PLN4.50, but the swing in investor sentiment warns of steeper euro gains with PLN4.60 being a reasonable objective. Further out, unless the government shifts gears, a return to the 2004 and 2009 extremes, in the PLN4.93-PLN4.95 cannot be ruled out.

II

The Federal Reserve did hike rates a month ago, but much of what has happened cannot be directly attributed to a 25 bp hike in the Fed funds target range.  The policy-sensitive two-year Treasury yield has fallen 30 bp from the pre-New Year’s high to the pre-weekend low.  At its closing yield of 85 bp, it is more than 15 bp lower than where it closed on December 16, the day the Fed lifted rates.  We also note that the effective Fed funds rate has consistently traded a little below the midpoint of the 25-50 bp target range.