Head of FX Strategy
Summary: Risk sentiment is the name of the game since late last week, as mixed US data did not deter the market from piling into risky assets and currencies, especially as the noise level on a US-China trade deal has picked up and suggests that a phase one trade deal is imminent.
US data on Friday was a somewhat mixed affair. The payrolls data was very strong on the headline, with the +128k much firmer than the 85k expected (the low expectation down to Boeing woes and GM strike), but the internals were less pretty, given most jobs added were of part time and lower end service jobs. The ISM Manufacturing survey surprised on the negative side of expectations at 48.3, but improved from the prior month, and given the very weak Chicago PMI the day before and hopes that temporary factors are behind some of the weakness, the market was apparently more than ready to brush the data aside for now as hopes that a phase one US-China trade deal is imminent.
Even as China officials have supposedly aired reservations on the prospects for a longer term deal, with Chinese state media recently repeating that no longer term deal is possible until the US rolls back all tariffs, but the noise level on the phase one deal is picking up pace, with both sides suggesting the most recent high level talks were “constructive”, and Commerce Secretary Ross’ promises that licenses for Huawei to purchase components from US companies are on the way “very shortly”. This is an added positive surprise for markets at the margin as it is part of the national security angle of the US-China rivalry.
In today’s Market Call podcast, we question whether the fresh, aggressive rally suggests that risk appetite/equity markets are lurching into a full “melt-up” scenario, driven by the Fed’s powerful accommodation since changing directions early this year and perhaps echoing the stress and response pattern of the Greenspan Fed back in 1998, when the LTCM crisis in the wake of the Asian financial crisis and Russia’s default triggered Greenspan’s three rate cuts (sound familiar?) that helped feed the final blowout in the tech bubble. History never repeats, but the ingredients are there for a melt-up in the pattern of the Fed’s – and other central banks’ – accommodation and in the market behaviour. Have a listen to the podcast for the full discussion – especially on the duration of a possible melt-up – the most important question.
On Friday we noted that short EURUSD implied volatility for options is near an all-time low, currently around 4.5%. Normally, we think that strong risk sentiment is associated with falling volatility, but if we do lurch into a proper melt-up scenario, we may discover – or rediscover – that risk sentiment and implied volatilities don’t always have to correlate. Consider the parabolic acceleration in risk sentiment in early 2018 that was associated with a higher VIX and a pickup in FX volatility as well before both accelerated further in the ensuing “volpocalypse”. 1999 was a very volatile year for equities as well, if there are any parallels there, relative to the early-mid 1990’s bull market. And the same could prove the case for currencies as volatility is usually contagious. Long volatility trades look cheap here.
One of the more interesting things going at the moment is the strong SEK rally, as Swedish short rates are stuck at the very top of the recent range – perhaps on hopes for global growth if the US and China can come to terms on a phase one deal. Normally, SEK is highly attuned to the global growth outlook. Medium term, an additional angle may be that the market is warming up hopes for a fiscal move from the government as the anti-immigration Sweden Democrats are close to polling as the largest party in the country at the moment.
Chart: NZDJPY
A pair like NZDJPY (and NZDUSD, also poking higher) is looking at breaking up here as the equity melt-up and a failure of global long bonds to sustain the recent rally have JPY heavily offered and smaller currencies bid aggressively. A melt-up scenario, especially one driven by a US-China phase one trade deal signed delivered, could mean considerable further upside.
The G-10 rundown
USD – the US dollar is chiefly weak against riskier currencies as the Fed is seen providing sufficient liquidity from rate cuts and balance sheet operations to drive a further rally in risk assets. The question is whether the US economy will stabilize or worsen further and if the Fed will be required to deliver even more ahead of year end as the big banks seek to shrink their balance sheets to avoid punitive payments for their sheer size. A melt-up scenario generally associated with a weaker USD, if not necessarily against traditional safe haven currencies like JPY.
EUR – ECB president Lagarde out speaking much later today and has already made a point to talk up the uneven playing field in fiscal policy across the EU – meaning monetary policy has bottomed out. A euro positive backdrop if her message is well received.
JPY – the yen getting the worst of it here on the combination of aggressive runs higher in risky assets and currencies and as safe haven long sovereign bonds reverse last week’s rally. JPY crosses likely to reverse hard once the melt-up peaks out, if historic patterns repeat.
GBP – sterling sidelined for now as we await possibly chaotic election scenarios – more later – for now a holding pattern and wait for Thursday’s BoE meeting to see if Carney and company are changing
CHF – seems EURCHF should be trading considerably higher here, given the backdrop – and seeing is believing, starting with a move above 1.1050-60
AUD – weak Retail Sales out overnight from Australia and AUDNZD correcting a bit lower still after the recent rally stumbled, but given hopes for a thaw in trade issues and the Fed having shifted into neutral, hard to see why RBA sends any loud dovish signal at tonight’s meeting.
CAD – the loonie likely to show low beta to risk appetite relative to other commodity dollars after last week’s cautious tone from the Bank of Canada – although a US-China phase one trade deal announcement and further crude oil rally could offset this factor quickly.
NZD – the kiwi higher versus the AUD, perhaps on flow linked to NZDUSD breaking a major level and possibly NZDJPY as well, and as AUDNZD longs on the recent rally beat a retreat.
SEK – interesting SEK rally as we note above, but gets more interesting through the next pivot zone toward 10.60-50.
NOK – firmer oil and hopes for a trade deal helping drive a more notable EURNOK sell-off – a bit more wood to chop to call a bigger chart reversal, starting with a dip well through 10.00, which is still some ways off.
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As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
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