FX Update: USD cuts higher through important resistance

Trading focus:

USD strength has now broken important technical levels.

The US dollar rally has taken on a new significance as  key resistance levels for the greenback have fallen nearly everywhere now save for in USDJPY (where the beta to the USD situation is far lower anyway since the JPY is rallying broadly at the same time). The drivers for USD strength here are partially a function of background pressures that have been building for some time and then a couple of new potential triggers. The medium term factors that have been pressuring the USD bears’ narrative include the coronavirus trajectory improving in the US while it gets significantly elsewhere – particularly in Europe and the UK – but also concerns that the expansive liquidity from the Fed and the US government that supercharged markets back in the spring is drying up. This is especially the case on the fiscal side with the risk of no new stimulus until the next presidential administration. At least yesterday, Congress was able to piece together a big enough deal to keep the government open, if only until December 11. As well, the Fed’s Balance sheet has only very slowly started to grow again, even if that is set to change as it is running out swaps and other measures to unwind, which will allow its regular purchases to resume expansion.

The proximate trigger for USD strength besides the factors noted above may also be the Fed’s weak communication of its new Average Inflation Targeting (AIT) regime – as the relevance of this policy is only tested in an environment of rising inflation, which the Fed has no power to create with its current tools – but only through fiscal forcing. This is even evident in the Fed’s own please for more fiscal, underlined in Fed chair Powell’s comments to a House Panel yesterday. The Chicago Fed president Evans commented yesterday that he thought the climb to 2% inflation would prove slow and seemed to walk back some of the conclusions of the AIT policy, saying that the Fed could raise rates before the 2% inflation level is achieved. Huh? Otherwise, he echoed other Fed officials in saying that “recessionary dynamics are going to kick in in a much bigger way” without significant fiscal support.

Finally, while more liquid markets like equities have bounced back reasonably well over the last couple of session, we are noting some moves in credit markets that suggest some underlying level of unease that is particularly significant because these markets have been so quiet for month. One widely followed Barclays high yield spread indicator popped well above 500 basis points to US treasuries suddenly on Monday and rose slightly more yesterday to 517 bps  – the high since late July were barely above 500 bps. Emerging market credit spreads have also risen sharply if somewhat modestly to the highest levels since mid July and key individual countries like Turkey are showing strain. (The general direction change this week in EM to the downside has been particularly sharp.)

Chart: EURUSD
The price action this morning has gotten sticky just below 1.1700 despite the release of very weak flash Services PMI for September out of the Euro Zone this morning, with all of France, Germany and the broader Euro Zone readings south of 50 as new Covid-19 inspired behaviour change and official steps are slowing services activity. Somewhat offsetting that development was a strong Manufacturing PMI reading (56.6) from Germany and for the Euro Zone (53.7), even if France (50.9) lagged in that category. This area just below the 1.1700 level is the last Fibo of note ahead of the largely empty space down to the critical trend support near 1.1500 – flatline and doubly-significant Fibo retracement levels crowded just below. As I have written this report, the EURUSD has rebounded back above 1.1700 and some may argue that was merely saw a running on weak longs overnight.