FX Update: Risk sentiment thaw reaches important resistance

Bonds stabilize after brief rout

Yesterday we dedicated considerable attention to whether the rally in especially long duration sovereign bonds is getting overdone now that the entire German yield curve out to 30 years had dipped below the zero bound. While yesterday did see a considerable correction, long bonds found support later in the day on a surprisingly strong US auction of 30-year T-bonds, where there was more demand – if still modest by historic standards – than at the prior auction of the same maturity. This despite the recent collapse in yields that has taken the 30-year yield close to record low yield of 2.09% from 2016.

The late bond rally took the US 30-year rate below the 3-month rate at one point earlier this week, inverting the entire curve, while the 2-10 portion of the curve has scraped new lows at 10 basis points. Expectations for the Fed remain on a cutting path – with a 100% odds for a September rate cut, with 33% looking for a larger 50-basis point move. The expectation for December for the Fed funds rates has dipped just below 1.50% - so two and a half cuts priced in. US President Trump indicated his ongoing displeasure with the Fed yesterday in a series of tweets.

I would suggest that an equity market sell-off beyond recent lows combined with a significant USD surge could see the Fed forced to panic with an unscheduled rate cut before the September 18 FOMC meeting. Either that, or the Trump administration will move with stronger medicine on the USD under such circumstances.

EU fiscal outlook questions heating up.

Two stories yesterday buffeted the euro in their own way, first on the positive side on a brief newsflash from Reuters (citing an unidentified senior government official) that Germany would consider expanding its fiscal outlays if this expansion was linked to climate-linked green spending. But the German finance ministry was out saying that there has been no decision to alter its balanced budget policy – we need to see EU fiscal for the Euro to sustain a strong recovery. Later in the day, the euro dipped and Italy-Germany yield spreads rose sharply as the leader of Italy’s government party Lega, Matteo Salvini, said that the government coalition is dead and that new elections are necessary.  Stay tuned there, but Salvini obviously looking to strengthen the Lega’s hand and engage in a full-bore confrontation of the EU leadership over the need for fiscal expansion, likely with new centre-right coalition partners. The most recent opinion polling as the Lega showing a stunning 38% popular support for Lega, up from around 17% at the election, while the Five Star Movement has collapsed to around 17%, down  almost half of what it got at the 2018 election.

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