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The US dollar could make life miserable for the bears in Q4 before rolling over

John Hardy
Head of FX Strategy

Summary:  If the USD didn't weaken in Q3 when conditions were perfect, don't expect it to in Q4. But what about 2022?

Currencies were quiet in aggregate in Q3—certainly the majors—but there were a number of entertaining single stories such as the weak AUD, and the strong NZD and NOK. It’s perhaps too easy to suggest that volatility is set to rise, but if that is what we do see, it would mark the first rise in volatility since the pre-US election quarter last year. Given uncertainties in the US fiscal outlook, the Fed withdrawing accommodation, EU political uncertainties, spiking commodity prices and a tectonic shift in China’s policy focus, the energy level should be set to pick up sharply in the quarter ahead.

USD: The last quarter showed that the greenback is a tough currency to weaken. 

Up front, please note that this outlook, while released after the September 22 FOMC meeting, was written before that meeting took place. Given the scale of the reaction to the June FOMC meeting which jolted the USD significantly, some of the anticipated moves in the US dollar could prove significantly frontloaded (even in the rear-view mirror relative to the release date!) or backloaded, depending on whether the Fed surprises us with a more hawkish September meeting (actually my anticipation) or prefers to wait for the November meeting to play catchup on bringing forward its intent to tighten relative to where market expectations were heading into Q4.

In Q4 the US dollar may fail to continue the “tick-tock” pattern we otherwise saw in the USD this year—strong in Q1, weak in Q2, strongish in Q3, etc. The spectacularly complacent liquidity and risk sentiment conditions in the Q3 failed to see the US dollar weaker, in part aided by a mostly very dovish Fed after the one-off June FOMC semi-shock. If almost ideal conditions for USD weakness were insufficient to bring down the greenback during the last quarter, a modest brushback of an upside breakout aside, how are we supposed to drum up an outlook for a significantly weaker US dollar when the backdrop in Q4 could prove far less supportive? 

In Q3, peak dovishness for the Fed relative to the rest of the world in Q3 came with the late August Jackson Hole speech from Fed Chair Powell, who stoutly defended the Fed’s belief that inflation will prove transitory, and that further progress would be needed on the employment side of the Fed mandate before the Fed would even consider lift-off. As an aside, almost zero coverage was given to the presentation of an intriguing paper at that same Jackson Hole conference, which argued that inequality was the chief driver of a very low r-star (the neutral level for interest rate policy), not demographics. Of course, getting the Fed to admit that its policies aggravate inequality has thus far proven an insurmountable task, but it could just be a sign.

Shifting to Q4, we expect the market to read the Fed differently as Powell and company are set to continue the direction of change toward withdrawal of accommodation that was established, however gently, at the June FOMC meeting. Payrolls should see significant gains on the confluence of a screaming demand for labour and job openings at record highs, with the expiry of pandemic job benefits that stopped for millions in early September. Our sincere hope is that the Delta variant outbreak that clearly impacted sentiment in Q3 will also wane but if anything, our confidence in understanding how long the virus effects will linger has declined with every wave and surprise the virus has thrown our way.

Other factors could also support a firmer US dollar in Q4 relative to the backdrop we have seen over the previous two quarters. The US treasury has wound down its prodigious general account from over $1.5 trillion to near $200 billion from Q1 and Q3. At the same time the Fed brought well north of a trillion of extra liquidity in Q2 and Q3 that overwhelmed even the Fed’s own QE programme, requiring the Fed to mop up the excess with a ballooning reverse repo facility that represents a “stored QE” of some 8 to 9 months at the time of writing. Further out, the USD will find headwinds as the fiscal impulse of the pandemic response will have fully faded as we roll into the New Year and won’t be fully replaced next year, even if the $3.5 trillion social spending programme that requires across the board approval from the 1-vote majority enjoyed by Democrats somehow sees the light of day. Next year will show that the Fed can’t ever really taper purchases and the US economic outlook will be losing altitude beginning as early as late this year. In the meantime, one-off factors like rising yields on expanded treasury issuance after a debt ceiling resolution, combined with reduced liquidity from Fed tapering and more volatile asset markets, could make the path more than a little difficult for USD bears. However, the quarter could see the greenback posting a major cyclical low setting up for a weak 2022 and beyond.

EUR: Backloaded strength in Q4?

In the Q3 outlook for the euro, I asked the rhetorical question about whether we could “fast forward to Q4 please?” It felt like the next potentially critical pivot point for Europe and the euro would be the outcome of the German election and what coalition eventually emerges. FX traders who were not sellers of volatility certainly agreed that Q3 was one to fast forward through as price action in EURUSD was highly rangebound and the 3-month EURUSD implied volatility dropped into the extreme depths below 5%. This is an area only ever visited briefly in 2007 and 2014, apart from a more extended bout of low volatility anticipation in late 2019 and early 2020 before the pandemic outbreak exploded the price action out of a compressed range. Early Q4 could see volatility picking up around the September 26 German election and what will inevitably prove a centre-left coalition of SPD/Greens and…who? Supposedly, we’re meant to expect a “traffic light” coalition that includes the surging liberal FDP party. It’s an intriguing possibility that comes with many pre-declared strings attached from the FDP if they are asked to join a government coalition, including a more supply-side policy focus of tax cuts to stimulate the economy. Still, if the parties manage to put together a coalition, it could end up bringing a significant boost to the German and EU outlook via an increase to both supply-side and fiscal-side stimulus. This could offer the euro increasing traction by mid-to-late Q4. Stay tuned, as Q4 could bring a significant launch point from local lows for a significant EURUSD rally.

Chart: EURUSD vs. EURUSD six-month volatility

We see the potential for a solid pickup in volatility in EURUSD in Q3, potentially to the downside first before a sustainable rally sets in by late Q4. With implied volatilities near historic lows, value may be found in long-dated options strategies for establishing a view during Q4 – possibly from the 1.1500 area or lower if a shift in US yields drive a solid USD revival. Further out, we see the euro significantly higher. (Source: Bloomberg)

jjh-01

Source: Bloomberg

JPY and CHF: Looking lower as US yields poised for a breakout higher

Pretty straightforward here. Q4 will bring a snap Japan election with a mandate to “do something” on the fiscal side. Ruling LDP leader candidates are falling all over each other in promising maximum fiscal stimulus, with the BoJ ever ready to toss fresh QE logs on the monetary fire. Also, with our bullish commodities outlook, we could see the JPY under further pressure on Japan’s current account balance heading in the wrong direction. The Swiss franc should also lose out on higher yields and a sense of EU fiscal impulse on the way in 2022.

GBP: Increasing stability in the Brexit lie of the land helps, but only so much.

UK policymakers seem to have identified the task from here as one of bringing a credible fiscal belt tightening without crashing the economy, remembering that austerity under Osbourne, together with the 2015 immigration crisis, helped bring about the populist-led Leave vote back in 2016 in the first place. A BoE solidly wary on inflation risks has provided a modicum of support for sterling in the meantime, and the BoE is priced to achieve lift-off by mid-2022, ahead of where the market sees the Fed starting its hike range. A rapidly stabilising détente on trade issues with the EU should help in the background and keep much-needed investment inflows offsetting the mind-numbing trade deficit that will keep a fairly low ceiling on GBP’s potential upside.

AUD and NZD: Maximum divergence point to be reached in Q4?

One of the more remarkable themes in Q4 was the relative policy outlook divergence in the Antipodes, with the RBA determined to wait out its declared 2024 policy horizon for the first rate hike. That stance was “supported” by the failure of Australia’s zero-tolerance policy, leaving much of Down Under in lockdown and shifting to a rapid vaccination rollout policy that should be complete before the end of the year. In New Zealand meanwhile, the RBNZ was in a rush away from accommodation on the embarrassment of high inflation and record housing gains from ZIRP and QE at a time at a time of a ruling left-populist government that had made affordable housing a policy cornerstone. Q3 saw RBNZ Governor Orr and company fully abandoning QE and talking up rate hikes, with rate expectations from the RBNZ notching new highs late in Q3 even as the NZ commitment to its own zero Covid tolerance policy didn’t entirely prevent a fresh outbreak of cases in Q3. Two-year AU-NZ rate spreads are nearing their modern wide levels well south of -100 bps and we are likely to see some mean reversion in favour of the AUD in Q4 as the market anticipates Australia’s outlook quickly normalising relative to the rest of the world in Q1. We suspect conditions will make a mockery of the RBA’s policy guidance on no hikes until 2024, much as the RBNZ was forced quickly into a retreat.

Chart: AUDNZD and Australia-New Zealand 2-year yield spread

As noted in the text, the spread between short-term Australian and New Zealand yields has widened to near-historic extremes in Q3 as the RBNZ has exited QE and is hankering to hike rates, while the RBA seems convinced it will be able to sit on its hands with no rate hikes until 2024. We suspect this divergence in rates has reached or will soon reach an extreme as Australia will likely aggressively open up by late Q4 or early Q1 at the latest, helping AUDNZD find a low and begin to mean revert within the 1.000-1.1500 long-term range. (Source Bloomberg)

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Source: Bloomberg

CAD: Like it on commodities theme, looking for ways to get long in Q4

An election in late Q3 doesn’t appear to have much at stake in policy terms, as a minority government looks inevitable after Trudeau’s gambit to ride popularity in the polls to a snap election victory backfired badly. We like CAD on its commodity-linked potential, even if housing hangover concerns are a long-term worry. Given fears of a USD upside potential noted above, we look for valued in CAD in USDCAD levels near and above 1.3000 as the pair overshot to the downside in Q2.

NOK and SEK: Interesting twist for NOK more than SEK

NOK has gone from strength to strength in Q3 as oil prices remained high and natural gas prices surged to unprecedented levels, with the latter taking over the former in terms of import revenue for Norway. If Russia can get the NordStream2 pipeline online in a big way in Q4, this could crush natural gas prices back to historic ranges and take the NOK outlook down a couple of notches, even if we remain constructive on the NOK outlook. We like SEK as well and would look to fade the dips (SEK is one of the most risk-sensitive currencies) on the assumption that the EU fiscal and inflation outlook is set to surge next year. SEK often trades with high beta to EUR direction.

EM currencies: CNH too strong given capital market uncertainty

Helmets on for more volatility across the EM complex after conditions were extremely supportive over the last couple of quarters, with falling credit spreads and a general easing of market volatility. Specific commodity-linked stories may do well, although the last couple of quarters have shown us that politics and policy can disrupt. One extremely significant driver of uncertainty is the massive policy shift in China which, broadly speaking, looks set to further discourage inbound investment in China. The leadership has set about “picking winners” and discouraging whole categories of companies and their practices as drivers of inequality and values not fitting with CCP principles. The country has seen huge surpluses in recent quarters on post-pandemic outbreak stimulus that have helped support the renminbi to multi-year highs. However, those surpluses could be set to decline on rising commodity prices (natural gas and oil, we are looking at you in particular) and the surge in goods demand could ease relative to services as economies “normalise” back to pre-Covid consumption mixes. In late Q3, the CNH looks too strong.

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