FX Trading focus: How high is the bar for further USD strength?
The chief point of interest since yesterday is noting that the brief mini-meltdown in equities on Friday was reversed, as was the reaction in US 10-year treasuries (where yields are effectively unchanged relative to the day before the FOMC meeting after having traded first sharply higher and then sharply lower). Was this because the market has simply brushed off the hawkish talk from the St. Louis Fed’s Bullard Friday or because weak liquidity and the expiry of monthly and quarterly interest rate and equity derivatives on Friday in the wake of large post-FOMC moves were the cause of a confusing and choppy market reaction? Pass, but given the general flattening of the yield curve, the market has shifted hard in the direction of pricing a significant Fed tightening cycle – and maybe even a full one. After all, even the 2-5 year portion of the Fed expectations yield curve has flattened aggressively, and not just because, for example, early 2023 rate expectations are going up, but also because expectations further out (for example late 2025 rate expectations) are actually going down. That’s right, as the market has brought Fed rate hike expectations forward, it has lowered the expected (or arguably, hedged) terminal rate of the cycle.
This suggests that the market sees the inflation threat as largely transitory and that the Fed’s hiking in the medium term will lower the risk that inflation runs uncontrollably higher in the longer term and/or that the Fed will have a hard time taking rates to the previous cycle high above two percent before any such move becomes self-limiting, whether due to the greater amount of debt or otherwise. These yield curve moves will bear close watching as the next rounds of macro data become available, but for now, the lower terminal rate and recovery in risk appetite would seem less immediately USD bullish than otherwise, although USD liquidity is another question and factor and the 5-bps hike on excess reserves represents a tightening of the market that has reduced said liquidity has helped support this USD move higher. All of this is building to a head into quarter end (banks reducing balance sheet size) and August 1, the date the US Treasury has declared it will complete its drawdown of its general account to below $500 billion, with some $250-300 billion left to go from the most recent data point. In other words, we are in for a long wait not only on the transitory inflation question, but also the equally important USD liquidity question.
Elsewhere, the other recent development of note, the stronger JPY, has partially reversed back lower as US yields at the longer end of the curve picked up again. This has kept the USDJPY chart in the rising channel, with the 111.00 area the next resistance, while the bounce in most JPY crosses has been modest relative to the size of the prior sell-off. The JPY will likely only turn notably strong again on long safe haven yields pushing back lower, with any aggravated JPY rise needing that plus a deterioration in global credit spreads to send bond investors packing. Complacency in credit remains at extreme levels – no signs of fear there from any recent developments.
Not a lot of differentiation across USD pairs as the US dollar move from last week has consolidated little in broader terms, although in USDCAD the fresh jump to new cycle highs in crude oil has helped CAD push back a bit more than against the strong USD than elsewhere. Still, it’s important to note that the move off the cycle lows in USDCAD showed higher beta to USD strength than elsewhere, likely as a function of the impressive prior outperformance of CAD, a sign that USDCAD shorts have become over-crowded. So far, the selloff from yesterday’s highs is modest relative to the sharp squeeze higher in the US dollar on the back of the FOMC surprise last week. 1.2500 has shaped up as tactical psychological resistance here, with the next resistance into the 1.2650-1.2700 area as we watch for any follow on potential higher. Interesting all the while to note that market pricing of the Bank of Canada has stretched more aggressively higher in recent sessions than pricing for Fed rate hikes, offering CAD bulls some fundamental support here.