Weak transmission to FX from risk swings

Yesterday revealed that the FX markets are reluctant to draw strong conclusions from the gyrations in the equity markets over concerns that the US-China trade negotiations are on the rocks. It is rather clear in the meantime that the JPY is the safe haven of choice when risk sentiment weakens badly and that the US dollar is rather neutral.

But it is also clear that we shouldn’t draw conclusions just yet about where all of this will lead and we have a lot of pent up energy ahead of Friday, when we assume we get an announcement on the status of both the tariffs threatened to go into effect and the temperature of relations.

Best case at this point: a delay of tariffs and suggestion that the sides can work towards a deal. Worst case: one of the sides walks away from the table and hostile language emerges from both sides. This is the short term, for the longer term, the relationship between the two powers risks turning into a rivalry or worse, so the upside beyond tactical  headline response should be taken with this longer-term trail of salt grains in mind.

Besides the immediate trade issue dogging investor sentiment, the chief driver has been the switch to a more dovish policymaking stance and whether the Fed is set to cut rates sooner rather than later and whether those cuts come ahead of signs of an actual growth slowdown (the Fed ahead  of the curve) or that the Fed has already hopelessly over-tightened policy and the rate cuts will be too little, too late.

One thing is clear to me: a bad outcome this Friday in trade negotiations could lead to weak sentiment that elicits a quick and large policy response – a 50-bps chop to the rate at the June Federal Open Market Committee meeting, for example. That’s a scenario, not a prediction – we’ll revisit after Friday.

Overnight, the Reserve Bank of New Zealand did deliver the rate cut we expected, but the outlook remained fairly upbeat and the policy forecast for the official cash rate through Q3 of next year suggests the bank only sees about 50/50 odds for another rate cut between now and then. So the kiwi has bounced strongly after the kneejerk lower.

Trading interest

Squaring NZD shorts – RBNZ not sufficiently dovish.
Looking at short term USDJPY calls for a risk-friendly immediate outcome to US-China trade talks – 2-week 110.75 calls cost about 30 pips with spot trading 110.15 this morning.
Looking at 1-month EURCHF calls, strike 1.1450 – cost around 40 pips this morning with spot trading 1.1415

Chart: USDJPY

The yen is one of the few things moving in the currency space this week – USDJPY has managed to clear the first key supports and is staring down the last bits of the range just below the psychologically important 110.00 level. The JPY crosses likely to react with the highest beta to US-China trade talk outcome this Friday – certainly two risks.