FX Update: The path to Fed yield curve control
Head of FX Strategy
Summary: The pressure from rising yields came to at least a near-term climax yesterday with a new spectacular spike in US Treasury yields that spooked global markets and drove a general leveraging across asset classes. In FX, this meant that the strongest trends of late reversed brutally, with JPY and USD soaring and traditional risk-correlated FX and sterling suddenly hitting the skids. Now the exercise is in gauging the scale of further fallout, or when the Feed swoops to the rescue.
FX Trading focus: The path to Fed yield curve control – short and straight or a long and winding road?
Yesterday we opined that the everything-up-and-bonds-down trade could not sustain for long, and it turns out we were right, although much more quickly than we could have guessed as yesterday’s action in the treasury market was one for the ages: a weak 7-year auction with very low foreign demand and a record low bid-to-cover ratio brought disorderly price action that spikes bond yields all across the curve sharply higher, with even shorter maturities and STIRs (EuroDollar contracts) seeing tremendous trading ranges relative to recent history. This was one bridge too far even for credit and commodities that had recently ignored the ratcheting higher in bond yields, and a broader deleveraging ensued. A “broader deleveraging” generally means whatever the most popular speculative bets are in play will reverse, and reverse they did, as commodity-linked FX was smashed back lower and the USD, JPY and even CHF to a degree, soared.
One of the contributing factors to the heady gyrations is the Fed not sufficiently addressing the issue of the US Treasury needing to draw down its account at the Fed from the current $1.6+ trillion to $120 billion, which creates all manner of havoc at the shortest end of the curve as banks and others in the financial system run out of places to park this money in “risk free” assets like t-bills, etc.. Already, the overnight repo rate went well into negative territory yesterday, a rare event. The situation was sufficiently distressful for former New York Fed Governor Bill Dudley to pen an op-ed for Bloomberg on the very subject. As well, something I thought was a bit of loud statement at the time from the Powell Fed that the market did not pick up on was his observation this week at testimony before Congress that all of the rise in treasury yields of late was merely a reflection of rising optimism for the economic outlook. What about the scary levels of treasury issuance? The weak bond auction demand speaks to the latter.
With yesterday’s move, we have now lurched into a powerful correction that has more or less fully erased the latest wave of trending action in key USD pairs like AUDUSD and NZDUSD and threatens to do the same for JPY pairs if it extends much further. If the Fed shows up quickly in the next few days, like it did in early 2019 after the fall-out over its mistake in hiking rates and signaling no change to the balance sheet reduction in the December 2018 FOMC meeting, the additional damage may not need be significant if the Fed first: moves both makes the technical moves need to avoid further system risk linked to the US treasury’s monumental shift of liquidity, but also second: provide some obvious hint that it will only allow yields to go so high before stepping in with yield curve control.
But there-in lies the irony and the chicken and egg question – the Fed may first need some more damage before it has the coverage to do something as drastic as yield curve control. So if the first move is merely the technical one on money markets to deal with liquidity issues and no hint at yield-curve-control, we could get dragged through the mud of a bigger traditional risk off move here for a while. Let’s make no mistake: yield curve control is a must, or the Fed will have no chance of seeing its inflation and employment targets met. In the beginning, we may only see this in baby steps, like a promise to cap two- or three year yields (the latter like Australia’s RBA). That would likely be enough for a while, even if the Fed would like have to shift to five years and longer if rising yields persist and this continues to plague risk appetite. The Fed’s “third mandate” of doing Draghi-esque whatever it takes to shore up markets kicks in at the very latest when the S&P 500 is down 20%, although 10% might be enough this time, given that the Fed desperately would like to have a look at how the economy is performing once the majority of Americans are vaccinated and the lockdowns have ended before feeling comfortable about any of its own forecasts or mandates.
This reversal in EURUSD is an ugly one for the bulls, coming as it did just after the pair had spiked through a major resistance level just below 1.2200. A weak close today would point to a test of the 1.2000 and possibly the even more important existential level for the uptrend at 1.1900. Already with this latest burst higher in yields spreading to Europe earlier this week, we saw ECB President Lagarde out declaring that that the central bank is vigilant on the need to watch yields, and this morning the ECB’s Schnabel (German, it should be noted) followed up with additional comments of concern on rising yields today. Is the ECB doing yield-curve-control even before the Fed – rhetorically, yes.
The AUDJPY risk proxy suddenly woke up and smelled the cross-market volatility, helped back lower by commodities feeling some of the contagion from bond and equity markets. Regardless of the longer term prospects for higher commodity prices and a secular focus on commodity-linked assets and currencies, the speculative positioning has gotten quite extended in commodities of late, and the market can’t avoid steep consolidations here and there. If this downdraft in commodities and risk sentiment extends (and if credit markets globally follow suit as well– particularly important for JPY, where carry trading in EM bonds is an important coincident indicator), then JPY pairs could be in for a significant consolidation, with commodity-linked currencies showing the highest beta to that development. Regardless, the first order of business to avoid a mini-crash is for downside momentum to slow quickly, if not, several weeks or even months of gains could be wiped out here quickly.