FX Update: A summer of volatile discontent?

FX Trading focus: Extra pressure on the Euro, USD as safe haven, summer volatility risks

The Euro is under renewed pressure as the market second guesses the ECB’s ability to tighten in line with other central banks and the incoherence/awkward “anti-fragmentation” effort that prevents the kind of forceful balance sheet reduction operations that the Fed has committed to. EURCHF is the clearest expression of this lately, but EURUSD is under pressure – more in the chart discussion below. Elsewhere, the USD enjoys strength as a function of safe haven seeking in mushy asset markets, even as US longer dated treasuries are bid again and driving the 10-year Treasury yield toward the key 3.00% area.

Here we are at the end of Q2 and just ahead of the heart of summer and for my sake, ahead of three weeks of holiday starting on Monday. Any hopes for quiet markets during July and August are likely misplaced as any number of things can spark fresh volatility. I was asked by someone this week to draw up a list of what investors should watch for over the summer months, and I cobbled together a list that will inevitably prove partial, but one hopefully worth presenting here:

Geopolitics: the most urgent immediate question is the course of the war in Ukraine, and whether either side shows signs of emerging with the other hand, and if not, if that means the negotiation table is a possibility. Also key is whether Russia raises the stakes by cutting off even more of its gas deliveries into Europe, which will require rationing for industry.

China. Assuming all things are quiet as public relations require a smooth path toward the November party congress and Xi Jinping’s official securing of a third term. But if the USD continues an aggravated rally, the CNH deserves close watching

Covid. It is spreading again and already starting to have an impact on travel, not to mention China. Could we see an echo of the 2020-21 impacts through the coming winter with new supply disruptions and subsidies for idled companies and people that drive fresh inflationary risks?

Bank of Japan to be tested to the limit? Likely the issue with the most volatility potential for FX traders. There are enormous volatility risks for the Japanese yen if global yields pull back higher, and possibly even if they merely stay elevated (think relative balance sheet developments) as the Bank of Japan may try to hold the line on its yield curve control policy but then be forced to capitulate if the pressure on the Japanese yen gets even more extreme (for example sending USDJPY well north of 140.00 after it already hit highest levels since 1998 above 135 recently)

Recession now or recession later? the market keeps pulling forward when it expects the Fed funds rate to peak as it feels a recession is incoming fairly soon. Market currently pricing the Fed’s peak policy rate to arrive between December 2022 and March 2023 – but if inflation fades less than expected over the summer and the economic data looks less bad than feared, the market may need to readjust – ironically meaning that “good” economic news may be bad news in the near term for equity markets because of the implications for Fed- and other central bank policy tightening.

Oil prices: the worst outcome for global markets is if oil prices continue to rise on the ongoing supply woes led by embargoes on Russian imports and as demand destruction is slow to offset. Ever higher oil prices would keep inflation levels high and tie central banks’ hands to ease off the pedal. A steep fall in the oil price only looks possible if demand is collapsing – i.e., because the economy is spiraling into recession.

Q2 Earnings: too optimistic – stay tuned to our Peter Garnry on this issue as we look ahead.

Credit markets: One key spread I track of US corporate credit spreads has risen above levels that, pre-pandemic, were last visited in late 2018, shortly after which the Fed relented in its balance sheet tightening and rate tightening. This is a one-mandate, inflation fighting Fed, credit pain and bankruptcies will be ignored until inflation is falling or the unemployment rate rises above some unknown level that re-engages the dual mandate.

FOMC July 27: Fed has to juggle all of the above factors in setting policy and guidance from here and as it approaches what it believes is the “neutral” policy rate of 2.50% (a rate hike of 75 basis points would take the Fed funds target range to 2.25-2.50%). Right now, the Fed is a “single mandate” central bank, only fighting inflation, so inflation/earnings releases will be most important in determining whether Fed hikes 50 basis points or 75 basis points again at the late July meeting and how it guides for further policy tightening after hiking the most since 1994 at the June FOMC meeting.

Chart: EURUSD
The euro is looking weak on multiple fronts as EURCHF trades south of parity and to new 7-year lows this morning, the EURGBP rally faltered yesterday and as EURUSD has slipped well below the tactical 1.0500 sticky zone. The brutal pressure from rising natural gas prices on Europe continues, and the ECB’s difficult tight-rope walking act of “anti-fragmentation” simultaneous with the incoming policy tightening makes for an ugly mix for the single currency. Keeping an eye on the 1.0350 cycle lows now for whether the path toward parity is opened up here – interesting to see the US dollar achieving at this level as treasury yields drop, suggesting is retains its safe haven appeal for now. The next test for the pair is over today’s US May PCE inflation data (elevated or very low month-on-month core reading would be the most interesting development.)