I wrote a piece about VIX on 12 Aug – that happened to be the bottom (19.12) of 2nd half of 2022 - and things have changed quite a bit since then. VIX is now at a lot more elevated level at 32.45 while 36.45 being this year’s highest close and its term structure has backwardation compared to contango two months ago. Also US 10 year treasury yield has moved up by more than 100 bps from 2.88% to 4% and inflation expectation trio – copper, gold and 10 year break even rate – has declined as Fed continued to fight inflation by raising interest rates with fourth consecutive 75bps rate hike almost fully priced in – after better than expected US job numbers last Friday (NFP 263k with unemployment 3.5%) - heading into Sep CPI figures this Thursday (est 8.1% and 6.5% for core). Inflation expectations from Cathie Wood also continue to be biased to the downside as she wrote an open letter to the Fed last night flagging the risk of deflationary bust given declining commodity prices and retailers’ increasing inventories.
However, the ongoing focus is still expected to be the CPI headline number that seems to have peaked as it has been falling last two months and S&P 500 futures (ESZ2) showed high sensitivity for first 30 minutes of price action after these releases (8.5% vs est 8.7% up 1.1% and 8.3% vs est 8.1% down 3.2%) so the disappointing number brought a lot bigger volatilities unsurprisingly. Also it is no coincidence that headline CPI peaked when oil also found the top above $120 back in Jun then it has been trending lower till September therefore energy components are expected to continue the decline but food and services have been steadily rising so core inflation might remain high while headline inflation may show some moderate drop.
One thing that has not much changed the trend since inflation or major commodities (CMOD) have peaked in June is US dollar index (DXZ2) that has risen 12% trading at $113, highest level since May 2002 but given the much heavier weighting on EUR (58%) than JPY (14%), actual US dollar strength has been relentless on the back of soaring yields driven by aggressive tightening from Fed – 30 year treasury yield hit 3.94%, highest since 2014 but only key tenor that is yet to touch 4% handle. Ahead of US earning season that kicks off this Friday, Goldman Sachs highlighted US companies make nearly 1/3 of sales from overseas hence the current strong momentum of US dollar isn’t just a safe haven or carry trade with attractive yield but also put additional selling pressures on equity valuations.
All G10 currencies are in negative territory for YTD returns and AUD – not included in US dollar index - is the third best performing currency among them with -14% return compared to the worst performer yen that is -21%. One of the reasons behind the relative strength against USD could be the aggressiveness of RBA’s tightening – four consecutive 50bps hikes except the recent surprised one with 25bps – so the interest rate differential (1 year forward premium 57 pips or 91bps return) isn’t as attractive as other major currencies such as EUR or JPY that show high correlations/sensitivity especially at the time of the CPI release. For example, when last Aug CPI came 0.2% lower than estimates, AUD, EUR, JPY and XAU all immediately fell more than 1.5% against USD. AUDUSD also typically has high correlations of 0.6 to both S&P 500 (SPX) and copper (HGZ2) however YTD normalised return shows SPX and HG are down about 25% yet AUD is outperforming them being down about half of that.
Based on Aug unemployment rate that unexpectedly rose from 48-year low 3.4% to 3.5% followed by the surprising RBA move only raising cash rate by 25bps vs consensus 50bps last week making them relatively less hawkish central bank, the relative outperformance of AUDUSD may be justified somewhat with property prices have been cooling down with Sydney falling 6% annually even though the most recent Melbourne Institute inflation gauge remained sticky at 5% that is still far from RBA’s target range 2%-3%. 30 day interbank futures imply the terminal rate at around 4% in about a year’s time at slower pace compared to Fed’s expected rate hikes that is expected to end sooner with more urgency, so this policy divergence may further worsen near term downside risk for AUDUSD (or even AUDCAD) that has shown some resilience prior to last week’s lower than expected RBA rate hike.