FX Update: The Fed has created its own worst nightmare
Head of FX Strategy
Summary: Risky currencies have all gone vertical against the US dollar as we head into year-end as the Fed has gotten well ahead of USD liquidity concerns with its massive balance sheet operations. But how will the New Year treat us as the Fed will start 2020 with clear evidence that it is inflating a bubble in risky assets?
The drivers for the US dollar haven’t been particularly clear in recent months, but the last couple of weeks’ action suggests that the market is finally celebrating the generous Fed liquidity provision into year end and that the Fed has now clearly avoided the issues so thoroughly fretted by market participants since evidence of USD funding issues back in September. The US dollar is weaker across the board and the obvious flip-side of the best performers over the last couple of weeks, the traditionally risk-correlated G10 smalls and many EM currencies like MXN and ZAR, as well as China-sensitive exporters like IDR and KRW.
This year, far more than the average year, the turn of the calendar page from the old year to the new one could prove especially pivotal – on the "now what?" question as we get past the year-end USD liquidity focus and whether the market’s aggressive assumption that the Fed will remain on side in juicing risk appetite at every turn is justified. Way back in the mists of time I seem to recall that Fed chair Jay Powell was most concerned that the source of difficult policy challenges from the Fed would not be inflation but financial stability issues. Well, the Powell Fed’s massive liquidity provision has now created the very monster it most feared – an obvious incipient bubble in risky assets that could prove a nightmare for the Fed to navigate in 2020.
As for whether the unwind in the bubble unfolds in the first weeks of 2020 or not until after the US presidential election will likely depend on three chief drivers: the Fed messaging after the New Year, the course of the US election, and the state of the US economy. All three represent strong risks to the current narrative (particularly if Bernie Sanders continues to gain momentum in the Democratic primaries). Some have fairly compared the current situation with Greenspan’s pump priming heading into 2000, which coincided with the final parabolic rise and mini-crash of the tech bubble by early March, followed by a very volatile year, even as the broader market didn’t peak out officially until September. If history rhymes, we may not be set for immediate setbacks in 2020 – but the combination of an obvious incipient bubble and the US political cycle almost have to mean that we will see a far more volatile 2020 than what we witnessed in 2019.
One thing sounding a wrong note in this environment across the major macro indicators is the long end of the yield curve in the US, where the sell-off has lacked the conviction one would normally see if reflation and a growth boost are supposed to be around the corner.
Chart: AUDUSD weekly
The Australian dollar is celebrating Fed liquidity provision into year-end, hopes for a Chinese growth revival on further stimulus and easing (as well as the USDCNY back below 7.00), not to mention hopes that the US-China trade deal will further boost the outlook. The pair has now thoroughly broken out of the former descending channel that dominated action since 2018 and has cleared the local pivots around 0.6900 after a treacherous false break earlier this month. 0.7000 looks like a psychological key as 2020 gets under way and the next objective looks like perhaps 0.7225-0.7250 if the good cheer spills over into the New Year for a time. Let’s see how the price action shapes up in the first couple of weeks of January.