Head of FX Strategy
Summary: Risky assets remain on fire as the US gets back to work today, with US long yields, easily the most important risk benchmark for global financial markets, having broken to new cycle highs ahead of a three-day weekend in the US and with China out on holiday until later this week. USDJPY has poked higher in sympathy with US yields, likely a coincident indicator for whether a lid stays on the pair.
FX Trading focus: risk appetite, the USD and US yields
This market feels rather pivotal with the current mix of cross-currents we have covered in recent days on the Saxo Market Call podcast. In today’s episode, I looked at the three prior major market tops and discussed the very different circumstances during those tops and what the market looks like this time around. The only situation that vaguely rhymes is the end Q3 market top, in which financial conditions looked fine across major metrics, but rising yields and the Fed balance sheet shrink. Again – “vaguely rhymes” is the key point, as this time, we have a US dollar that is weaker, a Fed that has no intention to shift direction, although US yields have been rising for months, and have accelerated at the long end of the yield curve since the beginning of the year.
I have recently outlined the scary implications in the event the US dollar continues to fall – especially if it does so aggressively – as US yields rise. So far it is too early to discuss either an aggressive rise in the yields (pace of rise is most important regardless of the level, but otherwise, the next major assessment takes place if the US 10-year yield is pushing on 1.50% vs. current 1.24%), and the pace of USD weakening has been nothing to write home about recently. But with yields potentially on the loose here, the attention I am directing to moves in yields far exceeds that of any other indicator. Note the USDJPY chart below, which is clearly also driven by the latest rise in US bond yields, and where Japanese yields have moved far less at the long end of the curve, widening yield spreads between the two.
As far as incoming drivers for the next move in US yields, the factors beyond incoming data will be the final size of the US stimulus package, where we already have a ball-park figure of at least $1.5 trillion, and any signals from the Fed. On the latter, the FOMC minutes tomorrow evening likely to come and go without much fuss, as the Fed leadership has tamped down on any discussion of tapering for now, an idea that was always laughable, given the scale of net treasury issuance in the coming twelve months that far exceeds the Fed’s QE and the ability for US- or foreign savers to absorb, unless they want to crash the economy with a brutal new acceleration in the savings rate. The conundrum of who will buy the US treasury issuance beyond Q2 (treasury has a ton of cash that can take it into Q3) is the single most pressing question to answer in coming months beyond how hot the US and other economies run as they emerge, increasingly vaccinated, from lockdowns. Eventually it will have to be the Fed. But at what level of inflation, employment, risk assets and bond yields does this take place? An excellent discussion of this very topic, by the way, in the MacroVoices podcast episode with MI2 Partners’ Julian Brigden.
Chart: USDJPY – a potential red flag for USD bears or in its own world?
USDJPY may not be as interesting as we are making it out to be – but the technical situation is rather compelling as the pair has traded up against the 200-day moving average again, clearly driven by rising US yields since the beginning of the year. We will continue to watch this pair for signs of a break higher – presumably because US yields are also heading higher – as well as whether the situation is a curiosity limited to USDJPY or drives an increase in volatility across FX and other USD pairs. For what it is worth, 3-month implied volatility for USDJPY is still very low at near 6.0%, even if this latest volatility has driven the slightest of rises.
Odds and ends
Itchy finger on the interest rate policy lever in Turkey? With the world snapping up anything and everything with a yield on it, the Turkish lira and its 17% policy rate has been the star performer of EM, leading the rest of major EMs by a factor of nearly two over second place ZAR over the last three months, up over 15% in carry adjusted terms against the US dollar, with the last month bring a return of over 9% . With the USDTRY rate trading below the critical 7.00 level – one that was heavily defended on the up last year and even before, might the central bank be ready to cut rates on Thursday or at least flag the intention to do so. Gains for an EM of this pace are not sustainable for much longer.
Sterling rally continues – eyeing GBPUSD 1.4000. Sterling is enjoying the current backdrop, with EURGBP setting new lows and GBPUSD now not far from 1.4000, although 1.4200 and higher can quickly come into the picture if the USD weakens further. As I have noted previously, the fundamentals for the UK and the US are similar – both running twin deficits of terrifying magnitude and risking hotter inflation and more negative real rates on the aggressiveness of their stimulus. But the starting points are very different, with GBP emerging from the Brexit devaluation and the USD emerging from a long period of strength. The sterling trend looks nice and may continue for now, but I will be watching comparative real yields like a hawk in coming months for signs that inflation and increasingly negative real rates are eroding the appeal of sterling.
China moves against US on rare earth metals – the FT ran a story (paywall) this morning, citing unnamed sources, on Chinese plans to investigate whether limiting rare earth mineral exports that are key in sophisticated US weaponry in particular. This is yet another sign of ongoing US-China “cold war” risks and points to a painful and drawn out process of disengagement between the two economies. US President Biden’s Buy American and Build Back Better strategies are longer term signals in that direction as well and a very inflationary signal. Eventually, US stimulus should prove more inbound and less aggravating of external deficits, though this next stimulus round will not (stimulus checks leaning more to driving purchases of imported goods).
The rest of G10 and CNH - In the rest of G10 FX, all of the G10 smalls are poking, to varying degrees, at cycle highs versus the US dollar, with USDNOK the first to poke to a new cycle low here. As noted, a reflationary backdrop is less euro supportive and the yield focus as well as higher commodity prices are likewise keeping JPY under pressure. An important signal for the USD status is on hold as China and the on-shore USDCNY rate is on hold until Thursday of this week, but USDCNH hit a new cycle low yesterday before rebound slightly overnight.
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