Head of FX Strategy
The combination of Powell not bringing anything new to the table, China apparently determined to shore up its currency and bolster its equity markets, and now a trade deal between the US and a lame-duck Mexican government (Obrador doesn’t take over until December 1) have global investors in a buying mood.
What’s not for the world’s optimists to like? Quite a number of things, really, but for the moment the ugly background music of Brexit, China’s economic landing, European existential woes, and emerging market hotspots is being drowned out by the latest developments, and well be the last to advocate standing in front of a charging freight train.
One of the key factors holding back the Federal Reserve from a more rapid pace of rate hikes, besides Powell’s discussion of the shifting policy guidance “stars” making a mockery of traditional Fed assumptions, is the flattening US yield curve; long US yields have gone almost entirely dead over the last several months. The US 10-year first reached its current level just above 2.8% in February of this year and has never managed to stray significantly above 3.0% or below that 2.8% level for any length of time since then. Meanwhile, it is the creeping higher in the Fed’s policy rate and pricing in of future Fed hikes that has taken the two-year about 50 basis points higher since February. That rate peaked in late July.
Those celebrating the “benign” Fed need to consider the very bad reasons that the US long end of the curve remains pinned at current levels despite a torrent of new issuance and record issuance in the pipeline.
For now, we’re entirely unsure whether the current bout of enthusiasm has already exhausted itself or will be enough to drive the USD another 2% lower or even more in broad terms before more significant resistance sets in. There are perhaps two routes to a weaker US dollar: the current one is Goldilocks, in which an easy or at least sidelined Fed keeps a fire under risk appetite and rest of the world eventually plays catch-up in policy tightening terms. Safe to say, we are sceptical of the Goldilocks narrative and suspect it can be sustained only for a matter of a few weeks at best and at worst may falter in a matter of days. For the longer term, a sustained USD-negative trend only seems likely once the US is clearly headed for trouble and the Fed has reversed course entirely on policy – and that requires ugly economic data and a sense that a recession is imminent. That’s not the narrative at present.
For now, the broad market narrative takes centre stage more than any incoming economic data and investors are likely making a bad mistake if they suggest that there are any parallels between the US-Mexico trade deal and the potential for something similar to develop from US-China negotiations. As well, Turkey is still a potential source of systemic risk if the spotlight is drawn back toward the struggling lira at any time.
EURUSD running into a big resistance zone here between 1.1700 and 1.1800 and this may be the first area for the bears to set up shop for a time and keep the pair contained. We see little reason to enthuse on the euro’s prospects as an endless fight over budgets has opened up before us and can only lead to a further quagmire once the next recession hits Europe. But if the Goldilocks story manages to hang around for a few more weeks, we could test all the way up to 1.2000, driven by USD weakness. Certainly, the recent technical reversal makes a strong argument that the lows for the cycle may be in for some time.
The G-10 rundown
USD – the flipside of animal spirits for now, as discussed above.
EUR – the euro already seems to be exceeding its full potential, but traders need to be patient for signs of technical weakness. 1.1700+ is the beginning of the wide pivot zone stretching as highs as 1.1800.
JPY – the yen is in the dollar’s camp and is more or less the same proxy for risk as the US dollar at the moment.
GBP – sterling is in dire straits and we’re not sure when the currency will be able to come up for air without a bolt-from-the-blue in Brexit negotiations. The post-Brexit range extends above 0.9300 for EURGBP.
CHF – EURCHF is perhaps the ideal pair for expressing the view that the euro is getting overdone in the short term.
AUD – an extremely underwhelming performance from the Aussie given almost all cylinders firing in its favour in the background. Technical uncertainty for another figure or more higher in AUDUSD, however, if resistance not found here well below 0.7400. We are long-term AUD bears.
CAD – the loonie enthusing a bit on the US-Mexico trade deal, but it will be important for Canada to sign up for the deal as well to justify the break below 1.3000 in USDCAD here. The next area of note is 1.2850 near the 200-day moving average.
NZD – the kiwi enjoying the risk-supportive backdrop, but not cutting a distinct profile.
SEK – the election fears are seeing EURSEK spill toward the highs for the cycle near 10.70. We’re sceptical of major immediate implications for what is still likely to be an historic election on September 9, but would prefer to express SEK upside potential through options.
NOK – could be SEK dragging the NOK lower – looks too weak given the backdrop, but would prefer a technical reversal signal to prove the point that NOK has gotten too cheap.