Head of FX Strategy
Summary: As 2022 looms into view, it is worth looking at and trying to understand why the US yield curve remains so flat and what this could mean for the US dollar next year as the Fed policy trajectory for the coming cycle has picked up sharply for the year ahead, but not beyond that. Also, it is worth considering whether USDJPY is set for a fourth consecutive pump and dump as we are set to roll into a new quarter.
FX Trading focus: US yield curve conundrum. USDJPY set for another rollover into new quarter?
In this morning’s Saxo Market Call podcast, we discussed, among many topics, perhaps the most important conundrum as we head into 2022: why the US yield curve remains as flat as it does, held down chiefly by the long end going nowhere even as the 2-year US treasury benchmark yield notched a new cycle high today near 75 basis points, and what that may tell us about the prospects for the US dollar. I have touched on the subject in previous columns, but it is certainly worth additional effort to understand why this is happening and to sketch out possible scenarios for what this will mean for the global markets and for the US dollar if the market is proven right and if it is proven wrong.
Why do long US treasury yields remain so low, and hence keep the “terminal” Fed policy yield for the coming cycle so low (well south of 2.00%)? I ran across the best recent discussion on this very subject just yesterday, a discussion between “Convexity Maven” Harvey Bassman and Jeff Snider of Alhambra Capital, with further commentary from Mike Green. The conversation is billed as one centering on inflation vs. deflation, but I found the discussion around the shape of the yield curve and Jeff Snider’s points on where money is created (chiefly in the global “Eurodollar” or offshore USD system) as the place we need to focus to be the most interesting. His message is that the forward policy curve and the US yield curve are telling us that the Fed can only go so far before triggering the next seize-up in the system that then requires a new easing while reminding us that yields are so low on US and especially Japanese and EU debt because the premium for liquidity is so high. This seems a more likely reason for yields remaining low beyond the 1-2 year time frame than that the market is making any strong statement in its belief in whether inflation will remain high.
So how does this hiking cycle play out and what about the US dollar? That very much depends on whether inflation subsides substantially in the nearer term. If it does fade sharply (even if still above 2%) and the Fed is repriced to only hike a couple of times at most because an oncoming recession take shape, brought forward by the significant fiscal drag that began with the end of many benefits already in September, this would like prove USD negative, particularly against the Euro and the yen as yields drop further and the market warms up for a new round of Fed easing as asset prices come under pressure from a profits recession anticipated for equities.
In a more benign scenario, if inflation only eases slightly and the economic growth outlook remains positive if decelerating in the first half of next year, the Fed will remain on schedule to hike starting in March and may even have to pick up the pace of hikes slightly beyond what is now anticipated. But other central banks may move more quickly than the US, meaning a broadly weak US dollar as the Fed talks big but effectively remains behind the curve, weakening the US dollar versus riskier currencies within the G10 and especially versus EM currencies if real US rates remain extremely low. Even the Euro might rise smartly in this scenario, provided the ECB is forced into a capitulation on having to end it negative rates policy.
Chart: USDJPY - quarterly roll effect, round four?
USDJPY nearly rose to 115.00 this morning before easing back as the recent rally has only seen modest support from longer US treasury yields, normally a critical coincident indicator for JPY weakness. Other indicators, like strong energy prices and strong risky assets of late (especially EM) are more fitting with JPY weakness. It is certainly worth noting the clear signs this year that quarter-to-quarter rollovers have seen strong surges higher in USDJPY into quarter-end, followed by at least a solid mean reversion once the quarterly roll has passed. Are we set for another one of these into next week? Certainly worth keeping an eye on.
Other bits and pieces.
Interesting to note the fairly aggressive rally in AUDNZD into year-end that seems short on drivers, at least in relative rate terms, although some of the attractiveness for the Aussie is likely in the anticipation of more upside potential on a post-pandemic rebound relative to New Zealand, which saw fewer limitations, as well as the anticipation of more stimulus to arrive from China. Elsewhere, NOK is performing strongly on Norwegian rates almost recovering the highs prior to the omicron variant announcement. SEK looks a bit unfairly priced relative to the strong equity market, though it saw a bounce today and may have been a bit under the NOK’s thumb recently in the crosses. EURCHF is under pressure again – still thinking that the SNB will only put up a major fight closer to parity.
Table: FX Board of G10 and CNH trend evolution and strength
Not much to report here save for the JPY weakness and the NOK strength as we watch and see how the early days of 2022 take shape.
Table: FX Board Trend Scoreboard for individual pairs.
Note that EURUSD is trying to flip up to a “positive trend” since yesterday, but the entirety of December’s trading action has been within the range of the last week of November, though the chart certainly look spring loaded to do move out of the tight range in the first weeks of 2022. Elsewhere, the oldest trend on the table, the 77-day EURCNH downtrend, looks about set to reverse, encouraged by recent signs that China is against a stronger currency.
Upcoming Economic Calendar Highlights (all times GMT)
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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.
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.
