FX Update: Reflation narrative struggling for air

Forex 4 minutes to read
John Hardy

Head of FX Strategy

Summary:  Late yesterday, US Treasury Secretary Mnuchin announced he was pulling the plug on a number of emergency Fed facilities. The market met the news with a collective shrug, but it could prove pivotal down the road. Meanwhile, the long end of the US yield curve is generally failing to support the reflationary narrative as FX generally fails to confirm anything, mostly bottles up in tight range.


Today’s FX Trading focus:

A couple of roadblocks in the reflation narrative

Yesterday, I took a look at Hungary and Poland nixing the 2021-27 EU budget and recovery packages due to the “rule of law” provisions that these countries see as violations of their sovereignty. Yesterday’s video-conference of EU leaders saw no progress on the matter, with German chancellor Merkel set to lead further negotiations with the two countries. (To be fair, other pressing issues on the Covid-19 resurgence, Brexit contingency plans and more were also on the agenda). But the longer this drags, out, the bigger the risks to the euro recovery and the more it could hold back the euro’s fortunes. Peripheral EU countries are already slipping into deflation again – Greece at -1.8% YoY, Italy: -0.6% Spain: -0.8% Portugal: -0.1%.  But as indicated, the market is registering zero fear on this, even PLN and HUF on this matter. And consider this story from Bloomberg discussing the Hungarian central bank purchasing bonds in a company it owns shares in.

Late yesterday, another story has grabbed our attention, even if the market hardly seemed to register it: US Treasury Secretary Mnuchin’s announcement that he is ending a number of the emergency facilities at the end of this year, importantly including the facility set up to rescue the corporate bond market when credit spreads panicked back in the spring. (The main street lending and local government lending facilities also set for a halt). The move may merely be a petty move by Trump and inspired by Republican sympathizers in Congress to limit the incoming Biden administration’s access to significant funds (specifically, $455 billion in unused funds will have to revert to the Treasury for Congress to spend as it sees fit). Regardless, the development in credit spreads will be worth watching in coming days and weeks on this. The Fed hardly deployed any of the funds at its disposal to buy up corporate debt – rather, the market took the mere creation of the Fed’s facility as a declaration of an implicit backstop of the market and snapped up debt – sending yields to record lows for lower rated debt. Corporations took advantage by issuing a torrent of new debt in recent months. How confident are credit markets without the backstop explicitly in place after the end of the year?

Finally, on the “frustrated reflation narrative” front, we have the awkward fact that the longest end of the US treasury yield curve continues to come down from the spike inspired by the vaccine success news last Monday. This just does not square with the narrative that we are set for a reflationary rebound. Yes, risky assets can flourish if the market assumes that central banks will bring endless QE provision, which they will, but a flattening yield curve without the central bank forcing it that way (yield curve control) is not the strongest tailwind for USD bears, who assume that the Fed will be the primary driver in driving negative real interest rates by possibly capping yields while allowing inflation to run hot (in turn more likely in an economy that runs external deficits).

What does all this mean for FX? A bit of a head-scratcher. As long as sentiment is maintained, we can see the USD weaker, if less so than in a reflationary scenario, and lower long yields means the JPY can rise more than it would otherwise, even as risk currencies do well, too. But it is weak environment for pronounced moves and trends compared to the more full-scale fiscal stimulus arriving on the scene, and the move against the Fed’s corporate bond purchases beyond the end of this year at the margin at least suggests a strong risk that financial conditions will have a hard time getting looser, and might get considerably tighter – raising the risk that sentiment will have to rely on quick progress on the Covid-19 vaccine front in the months ahead.

Chart: AUDUSD
AUDUSD will likely prove an excellent barometer for the success or failure of the reflation narrative in 2021 (and AUDJPY, although it has an r2 of 0.88 with AUDUSD (very highly correlated) for the last 300 trading days – so likely the same trade directionally) and on that note, we tactically await a move either above 0.7414 or below perhaps 0.7150 to begin to indicate direction, sitting as we are with the middle of the recent trading range precisely half-way between those trigger zones after going nowhere for two weeks. The upside impulsivity if risk sentiment stays strong while long rates remain low would likely be far weaker or nonexistent relative to the potential higher if a proper reflation trade develops, with commodities and hard assets running higher, while long yields do likewise (until they are possibly capped by the US Fed – turbocharging the reflationary narrative even further if rates remain capped while inflation indicators run higher still). The uh-oh- moment here for the reflation narrative and AUDUSD comes if we see aggressive safe haven seeking in long sovereign bonds and risk-off on fears that the path to more generous fiscal remains obstructed.

Source: Saxo Group
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