Risk recovery, Fed report weaken USD

It looks like markets are going to do what they can to re-engage the “Goldilocks” story for global risk assets, hoping that the recent volatility shock was a one-off accident driven by absurd leverage in the volatility space. 

Traders, meanwhile, could put back on the weak USD trade based on the narrative – and it really is only a narrative – that policy convergence will continue. The Federal Reserve itself re-inserted a key Goldilocks plot element as the general takeaway from Friday's long Monetary Policy Report was that the Fed is not about to accelerate its pace of rate hikes based on any concerns that labour shortages will spark inflation. 

US yields across the curve have turned lower since peaking last Wednesday. 

If Goldilocks does return for a time, the riskiest emerging markets may do well, and within G10, the smalls and commodity dollars may do well. The key risk barometer across markets, besides a general calming across markets and gently lower US yields, looks like the 2,750 area in the S&P 500, which developed as the key resistance in the wake of the volatility tsunami earlier this month. 

One factor that is very different this time around relative to the bulk of the market action in 2017 is the JPY, which is pulling stronger again to start the week. As we discussed last week, this looks mostly flow driven, perhaps as complacency has lifted on the Bank of Japan path or because the fall of key technical levels (the former range in USDJPY between 108-114) has sparked large-scale hedging.

We are seeing some whiplash for CAD traders, as USDCAD teased above local resistance and had a showdown with the 200-day moving average before a supportive boost from external factors (a stronger than expected January CPI report on Friday, the return of risk appetite, and fresh strength in energy prices) inspired a dip back into the former range. CAD and the other commodity dollars may perform very well if the Goldilocks reprise can continue, though it is truly remarkable how little the Antipodean rates have failed to respond to what is supposed to be a reflationary environment, even if a modest one. 

We’re highly contrarian to any further strength in these currencies over the longer term.

The focus this week will be squarely on newly minted Fed chair Powell and his testimony, demeanour, and response in the Q&A before Congress this week. Elsewhere, we’ll look for further signs of whether the Trump tax reform is leading to any new economic momentum as we have a look at the February US ISM Manufacturing PMI (the non-manufacturing ISM is not up until next Monday) and the reactivity to Thursday’s PCE inflation data will also prove a crucial test of market sentiment this week.

Chart: USDJPY

We see a nice trend continuation pattern in USDJPY, which pushed back lower after interacting with the lower portion of the 107.50-108.50 resistance. The trend may prove rather persistent and rather orderly if global markets maintain strong risk appetite here, but the JPY could move significantly stronger if we see a further large-scale unwinding of short positions; in such a case, USDJPY could go on to test the 100.00 area.