FX Update: A nervous dance from here

Forex 5 minutes to read
John Hardy

Head of FX Strategy

Summary:  With no further follow-on moves after the multi-sigma volatility acceleration in US treasuries last week, the market is trying to pick up the pieces and get back to where it was before that move, but there are hurdles to any quick return to normalcy. And a nervous dance is likely now between risk sentiment and real- and nominal bond yields in coming days and weeks as the market tries to feel out whether the central bank put is still there and its strike price.


FX Trading focus: a nervous dance after treasury trauma
The “treasury trauma” phrase is stolen from the headline of today’s Saxo Market Call podcast, in which we discussed where markets are looking for the next catalyst after the spike in US treasury yields administered a shock to markets, if one that has rapidly faded as there was no follow-on signs of market dysfunction. Markets are nervously trying to creep back to where they were before last week’s volatility, but I doubt if a full return is possible until the future of fiscal and central bank policy is more firmly established, particularly from the Fed.

Sure, perhaps yields can rise again and not necessarily derail sentiment, as long as the rise is very orderly? Is that even possible from these levels? Hard to discern, but as long as moves in the market are orderly, the Fed may avoid sending any signals for now, even if the Fed’s Brainard did take the trouble to note recent moves in the treasury market: “I am paying close attention to market developments…Some of those moves last week, and the speed of the moves, caught my eye”.

Looking at the big picture and the centrality of US treasuries to the entire situation, a Bloomberg article discusses the “$21 trillion Treasuries Mystery” that is “bedeviling markets”. At the center of the problem is US banks’ willingness and ability to hold every large amounts of treasuries, an issue that will only become more pressing late this year and beyond, when the overwhelming US treasury issuance that far exceeds the Fed’s current purchase pace. Let’s not forget that the proximate trigger of the treasury market volatility last week was weak demand at a 7-year Treasury auction. Also at issue is whether the Fed will extend the suspension of capital requirement rules, a measure it took last year to avoid financial system chaos. This rule suspension is set to expire at the end of this month if not extended, and Democratic Senators Warren and Brown have penned a letter asking the Fed and other agencies not to extend the rules. This issue must be solved or we will inevitably bump into more chaotic events before a technical solution or new Fed measures are inevitably enacted to enable the fiscal side to operate unimpeded by anything save for inflation (i.e., MMT and fiscal dominance). Already next week, the next test arrives in the form of 10-year US T-note and 30-year T-bond auctions.

So, given the above issue, and the fact that we have hit the 1.50% plus area in the US 10-year Treasury yield benchmark, that markets will engage in a nervous dance to figure out whether this issue will return before a solution is found, or if yields can progress higher again in orderly fashion without sending risk assets into a tailspin. The latter is likely only possible if inflation expectations rise persistently (and faster than long bond yields, i.e., real rates go lower.) It could prove a very nervous dance and we may have reached a post-pandemic outbreak inflection point that brings a lot more two-way volatility in asset markets. USD bears may have to sit on their hands until it becomes clear that the Fed is sitting more forcefully on the US treasury market and/or US real yields are hitting the skids more quickly than elsewhere in the world.

Another small news item:  today, Bloomberg sources at the ECB say that there is no need for “drastic action” at the moment to tamp down yields, despite a couple of recent prominent comments suggesting discomfort with recent yield rises. The Euro jumped a bit briefly on the news and EU sovereigns sold off quite sharply – a move worth about two basis points of drama in the German 10-year yield, which is still below -30 basis points after peaking out around -20 bps on Friday before the ECB’s Schnabel’s noting concern.

Sterling traders: watch for Chancellor Sunak’s spring Budget Statement today – a lot has been leaked ahead of time and the theme seems to be – max gas for now on handouts/furloughs/income support  and only hint at austerity to come much  further down the road (corporate tax hikes etc.).

Chart: AUDUSD and US Treasuries
This chart shows that the AUDUSD rally was entirely untroubled by steadily rising US and global yields (showing here in the declining price for the US 10-year Treasury Note future in blue) for quite some time prior to last week. But then came the sudden volatility last Thursday in the US treasury market, particularly as it involved a multi-sigma expansion in volatility for 2-year T-notes as well as the belly of the yield curve out to 7-year T-notes on signs of market dysfunction. This unsettled everything, triggering an across the board deleveraging that heavily impacted the likes of AUDUSD as the Aussie was one of the strongest currencies globally on the reflation theme as a commodity currency. Since the shock, AUDUSD and US t-note futures have become more positively correlated. We can only go back to the old lack of correlation if US yields can rise slowly without triggering further train wrecks. AUDUSD needs to re-achieve 0.7900 on a daily close to signal any neutralization of this sell-off or dump back below 0.7700 to send a directional signal lower again.

Source: Bloomberg

Upcoming Economic Calendar Highlight (all times GMT)

  • 1230 – UK Chancellor Sunak Spring Budget announcement
  • 1300 – ECB’s Panetta to speak
  • 1315 – US Feb. ADP Employment Change
  • 1500 – US Feb. ISM Services
  • 1500 – ECB’s Guindos to speak
  • 1530 – US Weekly DoE Crude Oil and Product Inventories
  • 1600 – UK BoE’s Tenreyro to Speak on Negative Interest Rates
  • 1700 – US Fed’s Bostic (Voter) to speak
  • 1800 – US Fed’s Evans (Voter) to speak
  • 1900 – US Fed Beige Book
  • 1930 – ECB's Schnabel to speak
  • 2015 – New Zealand RBNZ Governor Orr to speak
  • 0030 – Australia Jan. Trade Balance
  • 0325 – Australia RBA’s Kearns to speak
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