FX Update: Trading the central bank normalization theme.

Forex 6 minutes to read
John Hardy

Head of FX Strategy

Summary:  The RBNZ is the latest central bank to remove policy accommodation among G10 currencies, with the Bank of Canada having led the charge in April and likely set to taper purchases again at its meeting later today. Today we look at some hopefully uncorrelated trades for the coming months as the normalization theme potentially deepens, and even in one case if it fails to do so.


FX Trading focus: Trading the central bank normalization theme in G10 currencies

Yesterday’s extremely hot June US CPI print saw a fairly modest impact across markets relative to the magnitude of the surprise. Sure, the USD did pick up in places and Fed expectations were jolted a few basis points, but there was no broad shift out of recent trading ranges, suggesting that the market continues to buy into the Fed view (or partial Fed view, at least, as dissenters are increasingly vocal) that inflation will prove transitory. Our view is that, while sequential month-on-month inflation measures are likely to moderate in coming months as some one-off factors fade, inflation is by no means transitory. Regardless, the market has respected that the Fed has shifted direction, so for USD bears to get the upper hand, the view will have to be confirmed that the Fed will lag in removing accommodation relative to the underlying fundamentals of real interest rates, current account deficits, etc...

Overnight, the RBNZ surprised the market with its hawkish move as discussed in the trade view on AUDNZD below and I decided to dedicate today’s update to considering a few medium- to longer term trades that may play out from here if we continue to see a deepening in the move toward central bank normalization from here. Hopefully, the trades are somewhat uncorrelated, though it is unavoidable that the first three may share directional sympathy if, for example, we lurch into some deep correction in risk sentiment.

Bank of Canada expectations today: a further taper and encouraging words – has USDCAD topped out here?

Some trade ideas for the next couple of weeks to couple of months:

NOK too weak?
The Norges Bank is likely to prove the first G10 central bank to hike rates, having specifically forecast that it is set to hike rates in September at its June 17 meeting and forecasting a rate toward 1.50% by the end of 2024. The NOK has been in for a rough ride to the downside despite that hawkish upgrade, however, and that despite the surge in oil prices (normally very NOK supportive) as the market’s surprise at the FOMC meeting just the night before the Norges Bank on June 16 surprised markets and caught many USDNOK shorts off guard – with short covering in USDNOK a possible driver of the considerable downside in NOK. This NOK squeeze may be near completion as the focus could return to central banks normalizing rates and Norway leading the way.

Trade: Long NOK vs. a basket of EUR, SEK and USD (stops if NOK is weaker versus all three and EURNOK, for example, trades north of 10.50 and USDNOK trades north of 8.90 while NOKSEK falls below 0.9700).

Chief risk for this trade: a further squeeze on NOK longs on a chunky correction in crude oil prices or in risk sentiment if Fed Chair Powell spooks markets in testimony before Congress this week and this sees the USD rising further.

EURGBP downside potential?
Today’s strong UK inflation print has pulled BoE rate expectations back toward the highs for the cycle, while UK Prime Minister is expected to remove all Covid restrictions next week, which could further supercharge UK activity numbers and have the BoE pull forward its rate expectations more in line with the market’s expectation for a move early next year, it’s recent mimicking of the US Federal Reserve’s stance on inflation likely proving “transitory” notwithstanding. EURGBP is trading heavily today, and earlier this week, we have to remember that the ECB is preannouncing that it is warming up some reassurance that QE won’t quickly come to an end next year with new guidance updates at is meeting next week – a meeting very unlikely to prove hawkish. Further out, the chief focus will be on the August 5 BoE meeting.

Trade: Short EURGBP at 0.8515 with a stop above 0.8620 for a test of 0.8300 (trading target: 0.8325)

Chief risk for this trade: the ECB review next week comes out less EUR negative than expected or weak risk sentiment generally weakens conviction in the strength of the forward outlook for sterling bulls.

Chart: EURGBP weekly
EURGBP is pushing on the bottom of the range today after the UK print this morning, which has helped UK rate expectations back higher, a break of the 0.8500 area support could lead to a test of the major post-Brexit referendum support into 0.8300.

Source: Saxo Group

AUD vs. NZD policy divergence too great – will reconverge?
The RBNZ surprised last night by moving suddenly to simply abandon all QE purchases as of next week and removing language pointing to the need to wait considerable time for achieving its inflation and employment objectives. This points strongly toward a rate hike later this year. This is relative to Australia’s RBA, which has been extremely cautious in its moves and continues to express the view that it can wait until 2024 before conditions will be ripe for a hike. Either New Zealand is wrong to be so hawkish or Australia is wrong to be so dovish over a 6-month time horizon from here. Australia is also in the midst of dealing with a Covid variant outbreak after successfully dealing with the virus previously – a factor that could suddenly fade quickly once it rounds the corner as has been achieved elsewhere. The AU-NZ divergences are so strong between the two economies that we actually have a hard time seeing how they can stretch much wider from here with 2-year rate spreads at six-year lows, as the market has priced in considerable tightening from the RBNZ, while we expect if the normalization process continues to play out, the RBA caution will have proved excessive, leading the market to play catchup down the road.

Trade: Buy half a position at 1.0600 and another half position in the vicinity of 1.0500 with stops below 1.0400 for an eventual recovery toward 1.0900+ as Australia’s commodity mix will prove more compelling for the requirements of green transformation (copper, even uranium, etc..). Will revisit if the price action reverts higher and keeps well away from 1.0500.

Chief risk for this trade: simply that we are too early - the policy divergence between NZ and Australia could continue to widen, driving the AUDNZD pair below 1.0400.

USD – Fed will continue to lag?
While the US CPI print for June was a massive headline grabber and the USD has managed to rally off major support in the wake of the June 16 FOMC meeting, that move may have played itself out if the market shifts to the view that while the Fed is moving cautiously toward tightening, it will never be able to do so in earnest and will lag other central banks. A key test of this will be the FOMC meeting of the week after next.

Trade: EURUSD 6-month call option, strike 1.2000, partially offset by 1.1500 put (total cost about 60 pips with spot ref: EURUSD trading at 1.1800 on July 14). An AUDUSD 3-month call option, strike 0.7700 (cost: 46 pips with spot ref: AUDUSD at 0.7457 on July 14). Stop on the EURUSD short put if spot drops below 1.1600 for more than two days.

Chief risk for this trade: the FOMC meeting the week after next shows a more robust discussion of the need for the Fed to taper asset purchases, which sends the USD higher and risk sentiment lower.

Upcoming Economic Calendar Highlights (all times GMT)

  • 1400 – Bank of Canada Rate Decision
  • 1600 – US Fed Chair Powell to testify before House panel
  • 1800 – US Fed Beige Book
  • 0100 – Australia Jul. Inflation Expectations
  • 0130 – Australia Jun. Employment Change
  • 0130 – Australia Jun. Unemployment Rate
  • 0200 – China Q2 GDP
  • 0200 – China Jun. Retail Sales & Industrial Production
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