Macro FX trading Q1 2020 commentary

Market overview

In Q1 2020, COVID-19 spread across the globe. The economic impact of lockdown has been immediate and severe with hotels, airlines and leisure among the hardest hit.  Perhaps the most dramatic economic number is the huge increase in weekly US jobless claims.  The impact constitutes a dual supply shock and demand shock, as supply chains are disrupted and people stay at home. Supply chain shocks constitute a shock to payment systems and the flow of cash, notably the USD, which is the global reserve currency used in cross-border trade transactions, resulting in a “global dash for USD”. 

Volatility across all asset classes shot up and correlations went towards 1 across the spectrum of risky assets such as equities and corporate bonds, and at times, across traditionally safe haven assets such as Treasuries and gold.  The global dash for USD cash saw extreme stress in money markets, with the commercial paper market seizing up, cross currency basis swaps blowing out along with the FRA-OIS spread (the difference between the interbank lending rate and the overnight index rate). To add to the mix, following the collapse of OPEC talks, oil crashed in excess of 70%, leaving Saudi Arabia and Russia pumping volume for market share, thus challenging the viability of higher cost producers like US shale. 

The global policy response was fast and sizeable, central banks globally cutting rates aggressively towards zero and restarting quantitative easing. The Fed increased the scope of its asset purchases to include investment grade credit. In Europe, the ECB enlarged its bond buying program and, importantly for countries such as Italy and Spain, constraints were eased. On the fiscal side, the US announced a USD 2 trillion package to shore up business and individuals in the coming months. And across Europe and emerging markets, governments announced similar sizeable fiscal easing and loan guarantee schemes. 

Widespread recession is inevitable, but the measures taken by governments can smooth the scope and help the rebound once the virus passes its peak. The S&P 500 found a floor on 23 March and rallied into Q1 quarter end. In FX, the EUR and JPY rallied into the end of February as risk assets began to roll over, but a scramble for USD ensued from March 9, when markets finally recognised the global nature of the viral threat with a new epicenter in Europe and the resulting risk to supply chains.  

Currencies then reacted along traditional risk lines with the USD, JPY and CHF gaining against other riskier G10 currencies including AUD, CAD, NOK, NZD, SEK and GBP.  The most volatile currencies were NOK, with its links to crashed energy markets, and GBP with its current account deficit and own underlying supply chain uncertainties.  Emerging market currencies such as ZAR, BRL, MXN, RUB and CNH, already on a back foot, have seen lower dramatic moves.  These moves in themselves, against a rampant USD, constitute a serious threat to global stability.

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Outlook

We are in a period of very high uncertainty as geopolitical and societal changes join the monetary fray. The extent of the economic crisis will be determined by the timing of the peak of the virus throughout the world and the corresponding depth and length of the lockdown measures in place over both the short and long term, as well as the extent and mix of temporary or permanent damage to industries.  However, once phased emergences take hold, a sharp rebound in consumption and global industrial production can be expected. 

In the longer-term, supply chains will be reconfigured and industries organised along new lines after such a shock to health and security, with a shift away from globalisation to more local production.  

Fiscal packages and central bank actions will determine financial conditions. The Fed looks set to expand its balance sheet from around USD 5 trillion to now 8-9 trillion and possibly more, as the Treasury seeks buyers for new issuance of around USD 3 trillion.  

The key for FX markets, and indeed all markets, will be how the USD performs and its impact on economies across the globe.  In Europe, we must watch core versus peripheral bond spreads and how the debate surrounding fiscal assistance for the hard-hit southern European countries unfolds.  Commodities and their currency block will be determined by the demand and industrial production cycle, again back to the timing and success of lifting lockdown restrictions.