Head of FX Strategy
Summary: Most USD charts have posted a significant bearish reversal pointing to the risk of further USD weakness, driven by poor quality US stimulus and a reflationary narrative in which the Fed and the US government are seen as pursuing an irresponsible level of accommodation. But lurking in the background, long US rates should be making everyone uncomfortable. Today we have a US CPI release and 10-year treasury auction.
FX Trading focus: Yes, USD looks weak again – but what about yields?
The last couple of sessions have proved one of the more intense episodes of “everything up and the USD down” trade. And the logic of the USD bearish case is fairly easy to outline. The strongest contributor to the USD bearish case is in part the scale of the Fed’s QE, but more importantly the even greater scale of the US governments “spray and pray” fiscal stimulus, much of it via the stimulus check. This provide no productivity boost to the economy and aggravates external US deficits, as much of the stimulus money is spent on consumer goods that in a lockdown lean heavily toward manufactured goods produced in China. The next step in the US fiscal stimulus response is the Biden stimulus plan – touted at $1.9 trillion but likely to prove some hundreds of billions smaller. That plan seems on pause at the moment with the distraction of the Trump impeachment trial, but look for action soon.
Critical: appreciating USD and US Treasury dynamics
And as noted in prior updates, the key factor weighing against the USD weakening is the rise in US yields, which has been generally more marked than elsewhere and where we have identified that the Fed will only buy a modest percentage of the treasury issuance this year at the current pace of purchases. Closing the gap would need higher domestic US savings and/or higher international purchases of US sovereign paper. From here, if the market somehow tells us that the US dollar can fall strong despite rising US yields, it could mean something dangerous and destabilizing, depending on the speed of the move. That’s because an environment of spiking US treasury yields and a weaker US dollar suggests that the global investors may be losing faith in the US dollar, and that it is beginning to trade like an EM currency. Perhaps most importantly, it could risk taking away the Fed’s yield-curve-control policy before it ever saw the light of day, as capping bond yields might only further aggravate USD weakness on the anticipation of explosive growth in the Fed balance sheet. This is not a prediction, merely a warning if this kind of dynamic were to develop as it would eventually force the US to move aggressively to defend the US dollar. No one wants to see what that looks like for their investment portfolio.
The euro – EU on a different path than UK and US.
The FT Big Read yesterday was an excellent piece outlining the challenges for the likely incoming Italian Prime Minister Mario Draghi. It discusses the difficulties Italian political leadership will face in coming up with "recovery and resilience" plans that are sufficiently well thought through for the EU to allow access to funds set aside for Italy's recovery under the European Recovery Fund and other emergency relief measures. Italy will need to launch deep reforms and cut red tape to get its economy out of a rut (although it sure would help with a very different currency it could print up in a hurry). The article also points out that both Italy and Spain were very poor relative to other EU peers at accessing funds under the prior 7-year EU budget that ran through the end of last year, with Italy only accessing a bit over 40% of fund available through Q3 of 2020.
The EU recovery will prove very different from that of the UK and the US, with the eternal difficulty of going large on stimulus in the EU stemming from net contributors to the EU budget – those generally with far smaller national debt loads – ever reluctant to loosen the purse strings – especially when it is stimulus of the “cash splash” variety that the UK and the US have especially engaged in, for better or worse. This approach will mean that the EU recovery will proceed as a function of external demand more than from internal efforts – remaining a demand drain of an economic bloc I the global context. Thanks a lot, EU. For FX, this should mean the euro remains relatively firm against the US dollar if global recovery proceeds apace if somewhat weaker against commodity-linked currencies and economies like those in EM with higher growth potential. A weaker euro outcome would need for inflation to pick up meaningfully in the EU without longer bond yields rising to compensate – a distinct risk when the ECB is buying more than net issuance for at least this calendar year. That or a new existential EU crisis – but that’s far over the horizon even if likely eventually.
Chart: EURUSD reversed course
The latest rally wave in EURUSD has helped to neutralize the recent episode through 1.2000. Next we will look for a takeout of the sub-1.2200 highs back in late January to o keep the needle pointed higher for a cycle high test and even a move to 1.2500+. After this latest strong rally off the 100-day moving average, any new weakness that takes the pair back below 1.2000 would suggest a rather profound setback for the USD bears.
The G-10 and CNH rundown
USD – the case for USD weakness is compelling, with the caveats noted above. Powell out speaking late today as well, although the Fed wants a look at a fully un-locked down economy in all likelihood, before considering any guidance change.
CNH – the renminbi poised at the top of the cycle against the US dollar as markets set to be closed or the next week in China. Interesting to note recently that the official renminbi basket has been allowed to strengthen beyond the top of the range established since mid-2018.
EUR- if recent patterns hold – the euro strong within G3 context, but not compelling as a pro-cyclical currency otherwise.
JPY – the key USDJPY pair has staged an impressive reversal, but isolated JPY strength is more likely with weak commodities, rising credit spreads, wilting risk sentiment – pretty much the opposite of what we have right now.
GBP – sterling spent a couple of days consolidating after the big move on the BoE last Thursday, which sidelined any thoughts of negative rates for now – we are constructive on the currency’s ability to trend higher versus the EUR and the weak USD seeing GBPUSD bounding higher as well – 1.4375 is the next major range resistance there.
CHF – the areas of interest in EURCHF are below 1.0750 and above 1.0900.
AUD – the Aussie enjoying a resurgence in key commodities prices of late – particularly iron ore in recent days and is the high beta trade, perhaps, within the G10 to the reflation/risk-on trade.
CAD – oil supportive and so is the strength of the US economy, but UDSCAD has been awfully boring and range bound for two months – need to take out the cycle lows for the US dollar to see fresh momentum here.
NZD – the kiwi on its back foot as the market has bigger eyes for AUD and the big renewed jump in metals prices. AUDNZD a bit Ziggy zaggy and needs a new close north of 1.0800 to take the focus back higher, but as long as market retains a hopeful outlook, would expect AUD to outperform at the margin.
SEK – the Riksbank today promises zero rates for years to come – no surprise there. The Riksbank’s obsession is inflation and ensuring it is high enough – so higher inflation ratings in EU and elsewhere will generally prove SEK supportive, as will continue strong risk sentiment. A bit disappointing to seek EURSEK pulling back higher after test below 10.05 today – but have to believe that the huge psychological 10.00 level comes under fire soon if conditions remains as SEK supportive as they have in recent months.
NOK – Norway prints an interesting 2.4% spike for the year-on-year reading, and 2.7% for the core reading. The biggest jumps were in “furnishings, household equipment and routine maintenance” and in the broader “consumer goods” category, although “services where labor dominates” were also up – is that down to inefficiencies and costs due to pandemic measures?. The fundamental implications are quite negative for NOK if inflation continues higher on the negative real rate implications, but not sure the market has its eye on the ball as long as oil prices are gunning higher.
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