FX Trading focus: How convinced is this market in its cycle forecast?
After the greenback only knee-jerked briefly to the strong side in reaction to both the very strong ISM Services survey last Wednesday and then the even stronger US jobs report on Friday, it’s hard to see why even a somewhat firmer July CPI print tomorrow will drive a more sustained move. For whatever reason, the market seems uninterested in bidding up the dollar on firm US data, even when that brings a solid adjustment higher to the front end of the US yield curve. Perhaps the relative anchoring of the longer end of the US yield curve is the key as the market’s view of how the cycle plays out has continued to solidify despite. This has further inverted the yield curve as the market tweaks the “peak Fed” terminal rate for the end of this year while longer yields have moved far less, resulting in the most inverted 2-10 yield slope since 1982 at -46 bps at one point yesterday, just a few bps above the 40-year record of -51 bps posted in the year 2000 (and back then there was a lot more yield to work with – the 2-year was well north of 6.0% for much of 2000.)
If risk sentiment continues to roll back lower after the surge-and-reverse in equities yesterday and regardless of whether the US July CPI comes in slightly stronger or weaker or inline, the US dollar risks drooping further if US yields remain subdued or lower, but perhaps with more pointed weakness against the EUR and JPY if long US treasury yields push back toward the recent pivot lows. Yesterday, after all, saw the market erasing the bulk of the bump in 10-year treasury yields from Friday’s US jobs report with no real fresh inputs save for the thin excuse yesterday of July inflation expectations dropping sharply in a New York Fed survey (a drop of some 20% in peak June retail gasoline prices by the end of July likely the chief driver there). But who knows, perhaps the market is waiting for this inflation print tomorrow with more anticipation than I realize (my assumption is that the 20% fall back in gasoline prices and a steep fall in crude will have the market wanting to look through any surprisingly high number tomorrow. If the number is to shock, it would be in the details and likely in core month-on-month figures popping more than the +0.5% expected). Certainly, a scenario of higher yields and risk off are the most likely combination to bring USD support.
One wild-card here for treasuries is the auction schedule, with 3-year T-notes on the block today, a 10-year T-note auction up tomorrow and 30-year T-bond auction Thursday. In short, a risk-off cycle driven by end-of-cycle concerns and a tilt toward recession will likely play very differently in the FX market relative to the bear market move into mid-June driven by the vicious intensification of CB inflation-fighting signaling and pricing.
The EURUSD has traded for three weeks within the 1.01-1.03 range, on the one hand not an impressive performance, given the further mark-down in US yields from the June highs and strong risk sentiment, which often drives a weaker US dollar, but ECB expectations have actually been adjusted lower still, so the 2-year yield spread is near the bottom of the range, and the euro’s resilience despite an onslaught of negative news from the entire natural gas/power situation has been remarkable. Technically this sideways bout of range trading has sucked all of the momentum out of the bear trend, which suggests that the market may need to “recharge” before it can push back lower – a close clear of 1.0300 after the US CPI release tomorrow could drive a considerable squeeze well back into the old range of 1.0500-1.0750, even if it is far too early to call a cycle low. Still, the lack of momentum in either direction for three weeks makes calling a direction difficult – easier to test the market after an actual attempt to move out of the range or to trade long strangles (tough risk reward there even if implied volatility has come in quite a bit.)