Will Powell hold the QT line?

The market managed to close Friday on a positive note, and the Asian session today was without drama in the major currencies, though we continue to note the divergence in the US equity market, which closed within a percentage point of its all-time high, and the Chinese mainland market which continues to sound a sour note. 

The yuan, meanwhile, has pulled back to the strong side in sympathy with the US dollar’s recent weakness.

For the week ahead, we will be watching five themes:

Trade wars: The market tried to put a positive spin on China’s move to send an official to Washington for “low-level talks”. Our position is that we are unlikely to see any breakthrough in the near term as President Trump will only sign on to something that looks like a victory and could be spun as such, while China will not want to appear weak or lose face. The previously announced tariffs on $16 billion of goods will go into effect on Thursday.

Turkey and EM volatility: The line in the sand on a further contagion from Turkey is now rather well established at the 7.00 area in USDTRY. If Turkey’s recent moves to limit speculation can’t hold this level, we could see TRY weakness driving further EM contagion. My suspicion is that emerging market investors/traders are holding their collective breath for signals from the Powell Fed (see below). TRY has so far been stable to start the week despite downgrades on Turkish debt by S&P and Turkey’s refusal to release US pastor Brunson.

Italy’s bond market and the signals on the upcoming budget: The clock is ticking on Italy’s budget process as the market awaits signals from the government on how large a fiscal deficit it intends to run. A Bloomberg article states that the market is providing its own discipline in setting Italian rates and the clock on the European Central Bank's QE is also winding down over the next few months. Ten-year BTP yield spreads to Germany closed last week near 280 basis points, nearly matching the highest levels this year and therefore since the EU sovereign debt crisis.

Chinese yuan: The CNY weakness has taken a breather as we have a third session in a row with the USDCNY rate easing away from the pivotal 7.00 level. The CNY is a non-issue if USDCNY trades lower – it’s whether 7.00 comes into play that is critical for whether recent risk appetite wobbles turn into something a bit uglier. Here we also stress the importance of signals from Fed chair Powell this Friday that will drive USD direction.

Powell’s Jackson Hole speech: This is the week’s primary focus. Fed chair Powell has shown every sign of wanting to stay the course and continue to tighten US monetary policy, but a chorus of voices is beginning to speculate that the Fed can’t ignore the risks of an EM meltdown. Any hint that his stance is softening (second-guessing the current QT schedule?) could trigger significant volatility in FX, likely providing a massive sentiment boost for global markets and a steep USD sell-off. If Powell continues to shrug off global liquidity risks from the Fed’s tightening regime, meanwhile, we could slip back into risk-off mode, with EM currencies under a new bout of pressure and risk contagion back on the menu. I suspect that Powell generally fails to deliver anything hinting at a second guessing of the current course. The difficult bit is understanding whether this is also the consensus view. Given a gargantuan speculative short in US treasuries and sizable USD speculative long, the “surprise side” in positioning is certainly anything remotely dovish or possibly even non-hawkish.

Chart: AUDUSD

The AUDUSD chart is the major USD pair that is perhaps closest to challenging the strong USD trend as the Aussie has taken heart from the bounce in risk appetite and USDCNY pulling away from the brink of 7.00. But it’s hard to believe that any reversal back higher through the 0.7300-50 zone will stick unless Powell sends a message this Friday that weakens the USD broadly.