Head of FX Strategy
Summary: The event of the week for FX traders is tomorrow’s FOMC meeting, for which the market is clearly positioned for a “dovish hike” as the market has both lowered and brought the peak Fed funds rate forward since the June FOMC meeting. Even if the Fed guides for a range of outcomes, USD liquidity will continue to shrivel due to the preset plan to accelerate balance sheet reductions through the end of next month. Elsewhere, the Eurozone and the euro are beset with tremendous pressure from the natural gas Sword of Damocles hanging over it.
FX Trading focus: Market pricing a dovish hike from the Fed.
The market appears priced for “dovish hike” from the Fed tomorrow, with a 75-basis point hike fully priced for the meeting, but the path thereafter having received a sharp adjustment lower after the June FOMC meeting, with the downdraft in US treasury yields late last week taking us back to the lower range of Fed expectations for the cycle since that June meeting. It is too early for the Fed to pivot on policy guidance, even if wants to retain some flexibility after today’s hike takes the Fed to the cusp of the highly theoretical “neutral rate” of 2.50%. The market figures that about 100 basis points of further tightening are likely through the December meeting – with more than half of that coming at the September FOMC. Perhaps more important for market outcomes, the Fed’s QT is theoretically set to accelerate on schedule and won’t reach its maximum level until the end of next month, but the four weeks from June 22 to July 20 only saw a $35 billion reduction in the Fed’s balance sheet, slightly only a third of the pace of $95 billion/month set for September. Signs point to continue USD strength until the Fed relents, and it looks too early for that to transpire here on the same month that the official CPI data series reached a new 40-year high.
But the Fed is only one of the market’s many irons in the fire, with the power/natural gas situation in Europe the most pressing issue for any economic region as discussed in the EURUSD chart caption below. Taking the USD out of the equation, if the Fed fails to inspire much of a reaction in longer yields, the EURJPY looks far too high here on a yield spread basis even if Japan is to a very considerable degree also pressured by the natural gas price situation (Japan actually consumes more total natural gas than Germany, even if current), as LNG cargoes are priced with only about a 30% discount to the latest, very high 1-month forward prices in Europe. And, of course, EURCHF already got the memo – trading to new lows for the cycle today.
Chart: EURUSD
The sword of Damocles is hanging over the Eurozone economy in the form of Putin’s threat to further reduce gas flows through the Nord Stream 1 pipeline after these were halved yesterday from levels that were already driving fears of an energy calamity this winter. It was surprising yesterday that the euro didn’t more immediately react to the latest natural gas flow reductions. Yesterday’s July German IFO release saw the Expectations component dropping 5 points to the second worse reading since 2008, only exceeded by a single month during the 2020 pandemic outbreak, and a Eurozone recession looks inevitable without a drop in power and natural gas prices for Europe. Even if the FOMC merely delivers as expected, EURUSD may be ready to probe back toward parity, with a significant test below that level in sight if the Fed entirely fails to indicate a less hawkish shift and Putin tightens the natural gas noose (yes, I am mixing metaphors…). Certainly, the upside resistance at 1.0250-70 is well etched here, with parity merely a psychological downside level.
Sterling is getting a modicum of respect in some crosses on the more hawkish Bank of England message in the most recent comments, but the UK is beset with the same cost-of-living challenges as the rest of Europe and higher heating prices are set to kick in. Watching the Truss-Sunak leadership battle for the Conservative party – with Truss offering a different and more populist message on her fiscal stance – low tax and low regulation. But GBPUSD looks ready for a trip lower on the same pressures affecting Europe and could trade below the panic lows during the pandemic outbreak below 1.1500 before we find a cycle low.
The status of the EURSEK trend is one to watch in coming days. The recent surge in risk sentiment and the solidly hawkish recent Riksbank have helped the pair to fall from 10.80 to test the 200-day moving average near 10.40. If the FOMC surprises hawkish tomorrow or if sentiment shifts more distinctly negative, the pair is likely to consolidation higher within the range. Still, longer term, watching for the potential that the SEK trades with some premium to the euro on the latter’s possibly mounting existential risks as the Italian election approaches and Putin’s abuse of the Eurozone natural gas vulnerabilities is likely set to continue.
Elsewhere, AUD looks a bit too ambitious given commodity prices and the weakening global outlook – looks like 0.7000 may not get tested for now if the greenback gets a boost post-FOMC.
Table: FX Board of G10 and CNH trend evolution and strength.
The euro is weak but could get weaker still and sterling should follow generally in its wake. Elsewhere, watching for the potential for the USD to surge again after it has lost its upward trajectory on a medium-term trending basis. And are the AUD, and perhaps CAD too strong here?
Table: FX Board Trend Scoreboard for individual pairs.
EURNOK and EURSEK are interesting at their respective 200-day moving averages – will the EU existential risk premium for the Scandies of 2011 and 2012 return? Elsewhere, watching the USD pairs in the wake of the FOMC meeting – note that the GBPUSD downtrend status just barely survived the recent squeeze.
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Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
