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Risk-on, risk-off tops the agenda again

John Hardy

Head of FX Strategy

Summary:  After yesterday’s ugly session on Wall Street, global FX has switched back to risk-on, risk-off mode, with the strong USD and JPY firming across the board and pushing back on the EM currency resilience of late.

The equity market’s fresh weakness has traders on edge again, especially as the bounce from last week’s ugly sell-off hasn’t taken the market back into a more technically neutral territory. The 200-day moving average in the S&P 500 looms large again after another touch yesterday and the pivot low from last week’s sell-off needs to hold on today’s close to keep the bears at bay here. We’ll rinse and repeat last week’s warning about closing on an ugly low on a Friday potentially making for very rocky market conditions early next week.

Let’s recall the February sell-off in equities for comparison, as it was a very different animal than this latest weakness in risk appetite. Back then, the correction came only after a parabolic acceleration to the upside. The selling was even more brutal, but quickly found a low that was revisited only several weeks later after a powerful initial bounce and a volatile consolidation period. This time around, the first multi-day bounce attempt has been weaker and suddenly we find ourselves testing lower once again. 

In FX, the reaction to all of the above still feels muted, and we credit a large degree of that to the two things. First, the equity market weakness may be linked to a decline in the negative correlation in equity and bond markets as we note that the latter are providing no real haven status on this selling down of risky assets. Second, all eyes remain on the USDCNY rate and whether China will choose to defend the floor in the renminbi, possibly keeping volatility suppressed until we see the price action veer strongly in either direction.

Still, yesterday’s fresh equity market volatility did show the patterns we normally expect when risk appetite sours, with the JPY and USD catching a bid and emerging market currencies finally wilting as a group. 

The euro is under fresh pressure from Italy’s budget setting process as the EU has roundly rejected the proposed budget and says the deficit must come in below 2.4%. Italian BTPs were heavily offered again, with the 10-year yield closing at a high for the cycle north of 350 basis points yesterday. The EU approach seems to be one of forcing. For perspective, a weighted average of the yields for BTPs that need to be rolled over in 2019 is around 2.7% (this does not count the new issuance necessary to fund the deficit), and sovereign funding at these levels and even higher is possible, but as yields rise, the focus will intensify on Italian banks.

The situation is untenable – which side will blink? I would have thought at some point Italy’s populists would compromise just enough to ram some half-measures through this year and then pick up the fight again next year, post-EU parliament elections that the Lega’s Salvini will cement a rising populist wave. Either way, max pressure on the euro for now as long as Italian yields continue to rise and maximum two-way headline risk.

Chart: EURUSD - weekly

EURUSD is finding more separation from the 1.1500 area and momentum is building for a retest of the 1.1300 area, which is unlikely to hold if we continue to see a stand-off over the Italian budget situation and an ugly intensification of that crisis could see the pair testing into the 1.1200-1.1000 area. Note the important 61.8% Fibo retracement level at 1.1187.
EURUSD. Source: Saxo Bank

The G-10 rundown

USD – the US dollar is firming on a safe-haven bid and we watch today’s close with trepidation. A close at new lows would be ominous for potentially chaotic markets early next week.

JPY – is keeping up with the greenback when risk-off behaviour intensifies. 

EUR – the euro is weaker versus the USD, JPY and CHF on the fresh existential pain from Italy’s budget as the risk of downside picks up here. Headline risk is intensifying.

GBP – sterling is wilting again as despite the friendly noises from the EU on the prospects for an extended transition period for the entire UK through 2021, Tory rebels don’t like the idea of continuing to “pay without say” and may vote with the opposition to force a second referendum. Long-term options are the only way to keep a position through the ugly back and forth likely to mark the next two months of Brexit developments.

CHF – the EU existential risks are forcing EURCHF back lower, though that pair looks inferior to EURJPY for expressing euro risks.

AUD – AUD rally attempt is wilting, but feels dampened relative to risk-off behaviour, perhaps on crowded short positioning and China continuing to prop up the CNY above the floor.

CAD – USDCAD free of local resistance as oil weakness and risk off weigh – could look toward 1.3200 next if the break above 1.3050 holds. Watch out for Canada CPI and Retail Sales data later.

NZD – AUDNZD test higher rejected and could open for test lower below the 1.0850-00 pivot area.

SEK – SEK doesn’t like risk off and likes EU existential pain even less.

NOK – ditto SEK comments with the Brent crossing back below 80 a warning sign for NOK longs.

Upcoming Economic Calendar Highlights (all times GMT)

1230 – Canada Aug. Retail Sales
1230 – Canada Sep. CPI
1400 – US Sep. Existing Home Sales
1600 – US Fed’s Bostic (Voter) to speak on economic outlook

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