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FX Update: Illiquidity and its discontents.

Forex 5 minutes to read
John Hardy

Head of FX Strategy

Summary:  With the very odd exception of EM currencies, one overlay that seems particularly important for FX traders to consider at the moment is that of liquidity, as the less liquid currencies among the G10, at least, are running for cover even as rate tightening expectations rise by leaps and bounds for even some of the former laggards like the Swedish Riksbank. The next test for whether a smaller central bank can make a last impression is up with the RBA meeting tonight, which should hike rates, but will it and by how much and will the market care?


FX Trading focus: The liquidity overlay, RBA and FOMC

Friday saw US equity markets closing the week in a deep funk, poised at the lows for the cycle ahead of this Wednesday’s FOMC meeting. At the same time, US treasury yields jump higher all along the yield curve despite the slightest of misses on the year-on-year March PCE inflation data, both for the headline and for the core (both 0.1% lower than expected at 6.6%/5.2%, respectively). Looking at how the market traded late Friday and to open this week, liquidity features prominently in how markets are trading, with the G10 smalls generally down while the G3 (and CHF and very oddly GBP) were generally flat or indifferent versus one another.

In for particularly rough sledding have been the Antipodeans, certainly not due to any lack of central bank policy tightening credibility priced into the forward curve as yields continue to march higher nearly everywhere It’s somewhat jarring to see the 2-year AU vs US yield differential close to the highs for the year while. Rather, the new angle for the Aussie is likely the weakness in industrial metals on Chinese demand concerns and the recent sharp devaluation of the renminbi that has all of us wondering how far China wants to shift its currency to the weak side after it tracked the strong dollar higher so persistently in recent months. That devaluation is, in turn, likely throwing the JPY a bone of support despite the yawning yield differentials that have made the JPY so unattractive while the BoJ won’t allow JGB’s to adjust higher out to the cap on 10-years at 0.25%.

Similarly, we noted that a hawkish Riksbank on Thursday has entirely failed to impress this market, as the SEK knee-jerk rally on the back of that meeting has been erased and then some, continuing to underline that the krona is supremely sensitive to global risk sentiment.

Chart: USDJPY
A very important week for global yields as the market is expecting for the Fed to deliver its first 50 basis rate hike in 22 years and to guide for a string of 50-basis point hikes for the first time since 1994. Given how vastly the market has repriced the forward curve, I can’t help but wonder if we have reached at least a near-term peak for the cycle in treasury yields, with longer yields possibly even falling even if the Fed were to surprise with a move all the way to 1.00% on Wednesday (a 62.5 basis point hike that would rid us of the 25-bp range of the current Fed funds lower and upper bounds) which would be a sign that it is willing to surprise beyond market expectations and to hike more now to get ahead of the credibility curve. In any case, US yields are the key to the reaction function across markets. Would a hawkish Fed take short rates nowhere, longer rates slightly lower and risky assets also lower due to the impression that the Fed is willing to trigger a recession to get ahead of inflation? Or do we simply see the Fed meeting the market where it is at and then risk sentiment broadly improving for a while on a “buy-the-fact” reaction? Conviction is rather low on my part, but if we see a “risk-off” reaction post-FOMC that sees longer yields flat to lower we could get the US dollar going in different directions on such a pattern: with USDJPY lower and AUDUSD lower as well by the end of the week. Technically, the first time of a USDJPY rally failure would be a close solidly back below perhaps 128.50. The momentum indicators on shorter time frames (for example 10-day stochastics shown below) are bearishly divergent.

Source: Saxo Group

The RBA meeting tonight is an odd one for expectations, coming as it does ahead of the May 21 election and the May 18 Q1 wage data that is expected to give the RBA the green light to touch off a series of large rate hikes that the market has now priced in, with the RBA policy rate of 0.10% priced to rise above 2.5% by year end. Whether the RBA goes 15 basis points tonight (baseline expectation) or 40 basis points to take the rate to a round 0.50% seems immaterial with the current backdrop: whether Beijing lockdowns happen and the copper price finds support may be far more important at the moment. As well, AUD bulls should be eyeing the political situation carefully, as labor is set to win the May 21 election. Left-leaning governments are rarely celebrated by markets, but a green agenda that could temper Australia’s extractive commodity industries and the general tendency for redistributive policies will go a long way to offset the considerable AUD positives chiefly centered on the country’s jack-of-all-trades commodity portfolio, whether energy, industrial or food. Consider as well the plainly dumb idea of subsidizing first-time home buyers rather than looking for ways to increase housing supply or to increase macroprudential approaches to discourage speculation in housing – this is bad economic policy.

Table: FX Board of G10 and CNH trend evolution and strength.
The USD reading remains strong in the trend strength readings – watching the JPY closely and CNH on recent shifts in those two currencies, particularly on the back of the FOMC meeting if US treasury yields consolidate.

Source: Bloomberg and Saxo Group

Table: FX Board Trend Scoreboard for individual pairs.
Gold is stumbling badly and looks in danger of full capitulation technically. The EURCHF attempt to flip positive is not yet technically relevant – needs more like 1.0400 on the chart. EURSEK is a big surprise after last week’s hawkish Riksbank, with risk sentiment deciding whether the pair risks a squeeze higher still. AUDJPY is worth a flag as well as it tries to lip negative – a traditional risk sentiment proxy.

Source: Bloomberg and Saxo Group

Upcoming Economic Calendar Highlights (all times GMT)

  • 1400 – US Apr. ISM Manufacturing
  • 2300 – South Korea Apr. CPI
  • 0430 – Australia RBA Cash Target

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