Currencies were quiet in aggregate in Q3—certainly the majors—but there were a number of entertaining single stories such as the weak AUD, and the strong NZD and NOK. It’s perhaps too easy to suggest that volatility is set to rise, but if that is what we do see, it would mark the first rise in volatility since the pre-US election quarter last year. Given uncertainties in the US fiscal outlook, the Fed withdrawing accommodation, EU political uncertainties, spiking commodity prices and a tectonic shift in China’s policy focus, the energy level should be set to pick up sharply in the quarter ahead.
USD: The last quarter showed that the greenback is a tough currency to weaken.
Up front, please note that this outlook, while released after the September 22 FOMC meeting, was written before that meeting took place. Given the scale of the reaction to the June FOMC meeting which jolted the USD significantly, some of the anticipated moves in the US dollar could prove significantly frontloaded (even in the rear-view mirror relative to the release date!) or backloaded, depending on whether the Fed surprises us with a more hawkish September meeting (actually my anticipation) or prefers to wait for the November meeting to play catchup on bringing forward its intent to tighten relative to where market expectations were heading into Q4.
In Q4 the US dollar may fail to continue the “tick-tock” pattern we otherwise saw in the USD this year—strong in Q1, weak in Q2, strongish in Q3, etc. The spectacularly complacent liquidity and risk sentiment conditions in the Q3 failed to see the US dollar weaker, in part aided by a mostly very dovish Fed after the one-off June FOMC semi-shock. If almost ideal conditions for USD weakness were insufficient to bring down the greenback during the last quarter, a modest brushback of an upside breakout aside, how are we supposed to drum up an outlook for a significantly weaker US dollar when the backdrop in Q4 could prove far less supportive?
In Q3, peak dovishness for the Fed relative to the rest of the world in Q3 came with the late August Jackson Hole speech from Fed Chair Powell, who stoutly defended the Fed’s belief that inflation will prove transitory, and that further progress would be needed on the employment side of the Fed mandate before the Fed would even consider lift-off. As an aside, almost zero coverage was given to the presentation of an intriguing paper at that same Jackson Hole conference, which argued that inequality was the chief driver of a very low r-star (the neutral level for interest rate policy), not demographics. Of course, getting the Fed to admit that its policies aggravate inequality has thus far proven an insurmountable task, but it could just be a sign.
Shifting to Q4, we expect the market to read the Fed differently as Powell and company are set to continue the direction of change toward withdrawal of accommodation that was established, however gently, at the June FOMC meeting. Payrolls should see significant gains on the confluence of a screaming demand for labour and job openings at record highs, with the expiry of pandemic job benefits that stopped for millions in early September. Our sincere hope is that the Delta variant outbreak that clearly impacted sentiment in Q3 will also wane but if anything, our confidence in understanding how long the virus effects will linger has declined with every wave and surprise the virus has thrown our way.
Other factors could also support a firmer US dollar in Q4 relative to the backdrop we have seen over the previous two quarters. The US treasury has wound down its prodigious general account from over $1.5 trillion to near $200 billion from Q1 and Q3. At the same time the Fed brought well north of a trillion of extra liquidity in Q2 and Q3 that overwhelmed even the Fed’s own QE programme, requiring the Fed to mop up the excess with a ballooning reverse repo facility that represents a “stored QE” of some 8 to 9 months at the time of writing. Further out, the USD will find headwinds as the fiscal impulse of the pandemic response will have fully faded as we roll into the New Year and won’t be fully replaced next year, even if the $3.5 trillion social spending programme that requires across the board approval from the 1-vote majority enjoyed by Democrats somehow sees the light of day. Next year will show that the Fed can’t ever really taper purchases and the US economic outlook will be losing altitude beginning as early as late this year. In the meantime, one-off factors like rising yields on expanded treasury issuance after a debt ceiling resolution, combined with reduced liquidity from Fed tapering and more volatile asset markets, could make the path more than a little difficult for USD bears. However, the quarter could see the greenback posting a major cyclical low setting up for a weak 2022 and beyond.
EUR: Backloaded strength in Q4?
In the Q3 outlook for the euro, I asked the rhetorical question about whether we could “fast forward to Q4 please?” It felt like the next potentially critical pivot point for Europe and the euro would be the outcome of the German election and what coalition eventually emerges. FX traders who were not sellers of volatility certainly agreed that Q3 was one to fast forward through as price action in EURUSD was highly rangebound and the 3-month EURUSD implied volatility dropped into the extreme depths below 5%. This is an area only ever visited briefly in 2007 and 2014, apart from a more extended bout of low volatility anticipation in late 2019 and early 2020 before the pandemic outbreak exploded the price action out of a compressed range. Early Q4 could see volatility picking up around the September 26 German election and what will inevitably prove a centre-left coalition of SPD/Greens and…who? Supposedly, we’re meant to expect a “traffic light” coalition that includes the surging liberal FDP party. It’s an intriguing possibility that comes with many pre-declared strings attached from the FDP if they are asked to join a government coalition, including a more supply-side policy focus of tax cuts to stimulate the economy. Still, if the parties manage to put together a coalition, it could end up bringing a significant boost to the German and EU outlook via an increase to both supply-side and fiscal-side stimulus. This could offer the euro increasing traction by mid-to-late Q4. Stay tuned, as Q4 could bring a significant launch point from local lows for a significant EURUSD rally.
Chart: EURUSD vs. EURUSD six-month volatility
We see the potential for a solid pickup in volatility in EURUSD in Q3, potentially to the downside first before a sustainable rally sets in by late Q4. With implied volatilities near historic lows, value may be found in long-dated options strategies for establishing a view during Q4 – possibly from the 1.1500 area or lower if a shift in US yields drive a solid USD revival. Further out, we see the euro significantly higher. (Source: Bloomberg)