Currency markets backed into a corner

c668d1a3-9f0d-453e-a4b2-d5ef832470c5.jpgIn past weeks, we have seen the USD surge fizzling out, and depending on one’s measure of what a strength and weakness, we can see that the greenback is losing some of its shine, however temporary this may prove to be.  Even so, our fundamental view that with the DXY at these levels, the key feature of the USD is that it offers the only attractive option away from the risks attached to all other currencies.  With the Fed path through 2019 now thrown into doubt, we can see that despite uncertainty over the EUR due to multi-political factors and GBP with Brexit, there is some room for relief, though, at this stage, we are not getting our hopes up for any major recovery in either case.
For EUR/USD, there seems to be a never-ending interest to sell ahead of the 1.1450-1.1500 zone, and unless this can be overcome, we are still vulnerable to printing fresh lows, though the prospect of a material fallout is looking slimmer by the day.  As weak as the Eurozone data is at the moment, if the US and China can resolve some of their differences to alleviate fears over global trade, then the major European exporting nations can hopefully regain some confidence and add to poor growth prospects.  Only this morning, we heard Germany’s IFO institute downgrading 2018 GDP from 1.9% to 1.5% while 2019 is seen worse still at 1.1% – also previously 1.9%.
While Brexit continues to hang in the balance, GBP will also remain under pressure – also adding weight to the EUR – and the heavy discount to longer-term fair value will continue.  On Tuesday morning, we saw the announcement of the leadership challenge pushing Cable back under 1.2500 again though notable was the support seen here.  For now, this could have been anticipation that Theresa May would ‘win’ the contest – which she did – though the recovery back to more familiar levels is facing plenty of resistance into 1.2700.  Unless the EU offers some material assurances on the backstop, the deal on the table will not get the votes, so no deal or no Brexit are the options for MPs to consider on all sides of the House. The ERG will look to avoid any threat of the latter, though whether this will be used as bait to get them to back the current proposal is another unknown factor, but potentially a prop for GBP.  Anything is possible at this stage, so downside momentum has eased off at the very least.  We also saw EUR/GBP fended off 0.9100, though sentiment is harder to gauge from this cross rate given the single currency’s own detractions.
Moving onto the JPY, the market seems happy enough to go along with the BoJ’s assurances over maintaining ultra-loose domestic monetary policy.  Despite the sell-off in stocks, the divestment story continues to play out, and USD/JPY stays in the lead as we continue to see dip buyers propping up the exchange rate.  At the point, when these outflows show any signs of fading, we may see some fresh downside materialising here, but for now, any expectations of repatriation seem to be slim given investors switching to US Treasuries if scaling down on stocks and related ETFs.  It is worth considering the inflation backdrop, however.  If we see global disinflation taking hold – oil prices just cannot recover at the moment – then the relationship to consumer prices in Japan could be a potential flashpoint for JPY strength, especially with oil importing nations (much like German) benefiting from profitability levels (assuming core rates hold up).   For now, we continue to press for 114.00 despite notable resistance seen well ahead of this.  A move above 115.00-50 paints a completely different picture despite our conviction over a JPY turnaround in coming weeks, though more likely months.
Finally, USD/CAD has managed to push on to new highs through the 1.3400 mark.  As a level, 1.3500 is purely psychological at this stage, but enough to contain the last upturn in the cycle.  Oil prices have made an impact, and the lack of recovery in WTI is proving CAD negative for now.  Against this, domestic prices (Western Canada Select) have risen sharply, but to limited, if any effect on the exchange rate.  Pipeline issues continue to offer a modest input to headline GDP, though on the domestic front, strong job gains as reported in the employment report last week suggests consumption can offset some of the negative factors weighing on the economy such as household debt levels as well as a house price correction in the major provinces.  Technically, 1.3625-75 is a strong area of resistance should risk shocks push us up here and this could include another sell-off in Oil.

An interesting 24 hours in the House of Commons – Pound bears take note. 

By the title, you could be excused for thinking that I am about to trot out a host of reasons why the Sterling should be considered a buy, though, at this stage, it would be premature (amongst other things) to fight the negative sentiment which is predominantly based on high uncertainty. That, by and large, has not changed, and into the meaningful vote on the current EU deal next week, it is hard to envisage any material confidence in the UK’s position and indeed Sterling.
However, last night’s series of motions against the PM ended with parliament voting in favour of greater powers for the Commons as a whole, to engage in the Brexit process if (or when) the deal is voted down on Tuesday.  Having reiterated that this would risk a no deal or no Brexit, the focus has naturally been on the latter, where only a second referendum, either through a turnaround by the current government or after a general election could facilitate this – assuming the electorate did not vote to leave again(!).
Odds for (effectively) canceling Brexit have naturally risen as a result, and those with an eye on the markets during last night’s session parliament would have noticed the bump higher in the Pound once the last motion (mentioned above) was won by a narrow majority, as were the previous two.  At this stage, exchange rate stability is the best we can hope for with the modest recovery a function of the increased odds of no Brexit at all – however that comes about.
Not that GBP was materially affected over Tuesday’s, as some of the cross rates showed. GBP vs the commodity currencies and most notably CAD were an example that the push lower was engineered to a larger degree, with US markets taking full advantage of thin markets to push for levels as we have seen in many instances in the past.  It would not surprise me to hear that the BoE will be continuously on red alert in order to avoid another flash crash to the order that we saw in September 2016.
Looking at the GBP/CAD chart, we can see that no fresh lows were forthcoming, and indeed, vs the EUR, we also saw a limited move which ran out of steam despite taking out some resistance above the 0.8900 level.  Cable, therefore, looked to be the solitary target, having repeatedly tested the 1.2700.  Well, we gave way and touching on 1.2660 again, we saw momentum swiftly fade which leads us to believe that there is significant demand at these levels if not lower.  As Raj will show you on the weekly chart, 1.2500-1.2600 looks pretty significant.
GBP/CAD Technical Analysis
From a longer-term perspective, the argument for a higher GBP rate at this stage is all based on longer-term valuations, which on OECD/PPP measures lies closer to the 1.4000 mark.  This narrative was given credence earlier in the year, though largely off the back of a weaker USD, which as we know is now king based on US economic supremacy as well its safe haven status based on liquidity first and foremost.
GBP/USD technical analysis
Over the coming week, we expect to see plenty of twists and turns within parliament, though it is worth noting that there was an overriding consensus within the Commons to avoid a no deal outcome.  Whether this can translate into something tangible rather than purely ideological remains to be seen, though does take a chunk out of the ‘hard Brexit’ mantra which has been damaging on the Pound.  For this reason, I will take issue with some of the projections of a Sterling rate falling to new cycle lows, 1.1500, 1.1200, 1.1000 and parity all cited by some corners of the market and suggest that it will take a monumental and determined effort by the UK parliament to lead us into a cliff edge Brexit which would lead to a capitulation in Sterling to this degree.  The political will is clearly there to avoid this.  If politics is driving GBP, then perhaps we could see probabilistic factors ‘repricing’ exchange rate levels a little higher.

USD/JPY Technical analysis

USD/JPY has recently broken lower following the recent sell-off in equities markets. There are some key signals to wait for before the downside move can be confirmed. Obviously, we have had the shooting star candle a couple of days ago but the trendline break will be significant. Elsewhere, the price has made its first lower high and a break of 112.30 would make a lower low.

The weekly RSI trendline has broken to the downside. If we see a confirmation of the move lower, look out for the 111.78 support level. The chart below then shows lower down the 50% Fib confluencing with some key previous support and resistance levels.

Zoomed in hourly chart of the trendline: as you can see if the trendline was on your radar it offered significant support.

US-China trade tensions do not change the fact that cheap money is drying up

While the stock markets are poised for some strong gains in the aftermath of the G20 meeting, it is – as ever – best to stand back and look at the overall economic landscape on which to base the medium-term outlook.  It was, as some would have anticipated, a natural reaction to what some perceive as one less risk factor to contend with, even if it is only a temporary ceasefire where the US has seemingly agreed to hold off raising tariffs on Chinese goods as long as China agrees to buy more goods from the US. While this is all well and good for the time being, we cannot help but think that stocks are all too quick to price in the best case scenario, which then suggests that any upside is dependent on global growth and the financial conditions we are operating in
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On the latter point, the Fed is still shrinking their balance sheet, and while the prospect of a shallower rate path is also cause for some near-term relief, the undercurrent of quantitative tightening is and will not go away.  Maintaining the level of valuation in stocks in a tightening environment is what is now at stake and portfolio managers will be seriously considering value in long end Treasuries at over 3.00%.  For the brave, fixed income yields look attractive in countries such as India, though I can see little sign that the markets are ready to differentiate.  EMs are, therefore, still largely viewed as a positive ‘risk-bloc’ rather than considering the individual components.
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How this translates into macro FX is uncertain as yet, and made more confusing by the widely acknowledge of breakdowns in a host of traditional correlations.  The JPY has been particularly resilient in times of stock market stress, with the USD rate pushing higher on the narrative that the greenback is both safe haven and yield play.  No surprise then that the persistent move higher has been relatively unscathed, though there are clear signs that we have exhausted the upside into 114.00.  At this stage, repatriation risk looks underpriced, and even if we see Japenese investors switching to fixed income, the argument for the yield play also falls down.   Consider that the BoJ will continually reassess their uber accommodative stance, and note the perfect recipe (storm) for a material adjustment in JPY levels.
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Moving onto GBP, tomorrow week sees the House of Commons convening for the vote on the latest EU deal.  By latest, the EU will have us believe that this is the final deal they are prepared to offer the UK, so the slim prospect of this getting voted through on the 11th sees the market trying to price in a no deal outcome.  In this instance, we still expect to see both sides renegotiating on a lesser scale (so to speak) on an arrangement which will avoid the chaos following a ‘cliff edge Brexit’.  The free flow of goods and maintenance of supply chains benefit both the UK and EU, so it is hard to imagine this will be sacrificed in the name of political ideology – as naive as that may sound!
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Technically, it is hard to put any faith in levels on either EUR/GBP or Cable, but we note that since the recovery from the flash crash 2 years ago, 1.2500-1.2600 has established itself as a key area of significance.  If breached, however, we must assume the lows closer to 1.2000 will be tested, though as yet, we note a rebellious tone once we get to 1.2700.  EUR/GBP is mirroring this in the low 0.8900’s as we can see with the numerous failed attempts to push above here,  resulting in (as yet) shallow dips.
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This may be down to the EUR’s own weaknesses at the moment.  Aside from the EU’s ongoing battle to try and rein in some of Italy’s spending plans, Eurozone growth continues to cause nervousness over the medium term.  Oil prices have also dropped significantly to suggest headline inflation is heading lower, yet if the core rate moves in the opposite direction, we could see this having an outsized positive impact further down the line.  It is hard to argue the point at this stage, though at the present time, it seems that there is little more we can ‘throw’ at the EUR, so there is also evidence that on longer-term valuations, we may be close to, if not already have set a near-term base just ahead of 1.1200.  Should we push above 1.1500, better still 1.1625, then we can be a little more confident in suggesting a period of wider consolidation which may or may not result in an eventual move towards 1.1800 again.
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Naturally, this will also depend on how US growth develops into 2019.  It is fair to expect
a deceleration in the pace of expansion, and as we have seen with comments from Fed chairman Powell, data dependency is paramount from here and we expect the USD to be a little more sensitive to any softness in the numbers.   Based on the heavy positioning in the greenback, it is also fair to assume some profit taking over the next few weeks, though we cannot discount the reluctance to do so ahead of the FOMC meeting later on this month.
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FX Week Ahead: Fed chair Powell could rock markets this week

The story that the Fed could rein in their rate profile next year has been gaining traction in recent weeks, and it has been hard to ignore when there have been tentative signs in the US data that a higher rate environment is impacting on the economy. The recent drop seen in the NAHB housing index gave the markets a sharp jolt, though, before this, the ISM PMIs also suggested tighter financial conditions are starting to rein in business activity. It would have been somewhat short-sighted to believe that with higher rates and an ever-strengthening USD, there would be no impact on the growth dynamics.

Now we have a situation where the Fed could start to reassure markets that data dependency prevails and that a rigid path of normalisation should not be counted upon. This has tempered the outlook in short-term interest rate futures market and may well prove to be supportive on the mid-part-longer end of the yield curve, though into Dec, we may see the strongest reaction in the USD itself. Fed chair Powell is due to speak on Wednesday evening when he gets the chance to prep markets for any potential softening in forward guidance. He will be preceded by vice chair Clarida on Tuesday.

This week, however, we are looking to another month end of USD demand, as rebalancing requirements are pointing this way given another bout of heavy losses on Wall St equities. The return of stock markets today has seen a rebound in all the major indices, though, for material traction, we still feel the Fed will have to offer some solid indication of restraint. Indeed, today’s rally may be a case of pre-empting this scenario, as well as technical levels and an oversold status in the short term adding to the near-term relief.

In line with this price action, USD/JPY as wasted no time in pursuing the upside as we make a beeline for the mid 113.00’s if not 114.00, though the Fed meeting next month is a double-edged sword for the JPY spot rate if yields start to come off again – recall 10yr testing 3.00% and dragging USD/JPY back through the mid 112.00’s before basing out around 112.30 or so.

Elsewhere, EUR/USD will have a task and a half to push back and sustain the 1.1400-1.1500 area. Eurozone data gives little incentive to price in higher levels in the EUR just yet, with some possible flexibility from Italy in its budget considerations providing the modest relief early on Monday morning.

The EU Summit’s agreement of the withdrawal text and the declaration were also cause for some EUR upside, just as it was for GBP, though the latter lacks conviction either way as investors choose to sit this one out on the sidelines until we get more insight into the balance of sentiment in parliament over the deal. Cable support at 1.2790-1.2800 is the closest prop for now, while 1.2925-30 was evidently a push too far after last week’s initial response to the deal PM May brought back from Brussels.

Risk sentiment may have stabilised in Monday’s session, though this has failed to translate into any upside in the AUD or the CAD, with oil prices also edging back up again. As a result, we can only assume market players are looking lean on the anticipated month end flow expected into Friday, which could see a push for new USD highs over coming days.

Is this the end of easy money?

It won’t have escaped anyone’s notice that the US equity markets have been in an astonishing bull run which has outpaced expectations for many, and some. Based on the availability of cheap money, the heavy composition of buy-backs has accentuated the move on Wall Street to levels where valuations are not only high but largely seen as overstretched when taking into account the pace of growth in the real economy.

However, in recent week’s and months, we have seen jitters in the major US indices, more notably in tech stocks, when US long end rates have neared key levels. The 10yr Note has tipped the 3.25% mark while the 30yr got tantalisingly close to 3.50% and the sell-off (in stocks) was not pretty.

This has prompted some to suggest the Fed may rein in their aggressive tightening path, which is in direct response to an economy close to, if not at full employment, while inflation is also picking up, based on the data received by official sources. Some are sceptical that inflation is as strong as is reported, but going off core PCE, there is pick at least – something the Fed were patiently waiting on through 2017 under chair Yellen’s leadership. Now we have it, Powell and Co are applying the brakes, with a terminal rate of 3.50% suggested by the dot plot.

However, the ECB and BoJ remain in an accommodative mode and come the end of December, the former will have ended their asset-buying program, though the focus is on Japan, where central bank and institutional buying of US assets continues. Whether this will do so after another jolt to the downside (on Wall Street) remains to be seen, but there is still cheap money out there and it continues to support equities.

While the BoJ suppresses JGB yields on the 10yr to 20bps, it is hard to see how this QQE can filter back into the economy and reflate prices, though there are structural issues which point to anaemic consumption, while savings – which exacerbate divestment for yield – continue to bolster assets with higher returns.

Next year will be the more interesting for global equities, which have shaken off a range of risks including trade wars, systemic risks from Brexit as well as an EU slowdown (hampered by populism). However, there is also the combined effect of a potential slowdown in the US, with the effect of the tax cuts working through the current cycle, a well as a higher rate environment. Japan will also have a higher debt to GDP ratio which is already in excess of 250%, and it is hard to see how they will be justified in maintaining this path if inflation has not materially worked through. There surely has to be an endpoint at which one has to say this is not working. What then for stocks

Something for the contrarians – what can turn the EUR?

It has been the perfect storm for the EUR in the last 4-5 months. Having reached highs a little over 1.2500 vs the USD at the start of the year, we finally saw a little relief here as market participants started to rein in their fears over the budget and trade deficits in the US – which for the record, are still rising and widening as nominal yields continue to head north. Back to the EUR and Eurozone specifically, the move back to 1.2000 would have come as a welcome relief to the ECB, having sat nervously, watching their currency leap from high to high as a function of momentum and mass euphoria over the turnaround in growth. And how that has ended! Not that we were not given signals of caution – (I say us, I mean the market). During the ECB press conferences in late 2017, projections on growth and inflation were based on a EUR/USD level of 1.1800, though at the time we had already pushed through 1.2000, with the market chomping at the bit to extend the bullish view on the EUR – and in tandem deficit fears on the USD – to its limits. This naturally had consequences and the results have materialised, but only after a prolonged period of jostling at the highs despite going against yield differentials. The fact that we are now trading on the self-same yield differentials to a higher degree – 10-30yr Treasuries some 50-100bps higher and ECB normalisation pushed further out on the horizon – shows just how sentiment can change.

At this point, everyone will be pointing to the level of economic weakness, which has been exacerbated by the protectionist policies of the current US administration, and its influence on the soft data in Germany and the rest of the exporting nations in Europe has been clear to see.

Then we come to the fears over Italy’s debt ratio and its potential blowout stoked by the budget plans of its populist government, and we have a game, set and match scenario which has all but consigned the single currency to the sidelines – and I am being polite here. Gone are the notions that we can consider the EUR a safe haven as we have in previous episodes, as the momentum in sentiment is that we are potentially moving to all out fears of an existential crisis. Are we? Based on much on all the dirty laundry being aired by the EU (and Italy), it is not hard to see why investors are shying away from Europe at the present time, though at this stage it is hard to discern just how much is down to a possible implosion of Italy and/or the lack of flexibility by the EU hierarchy. Current accounts have been a key determinant of exchange rate bias, but politics wins hands down at the moment, so we can discard that one for now despite this being in favour of the EUR and JPY. Convenience plays its part here, yet when measured alongside that of fair value based on purchasing power parity, there is a positive backdrop (no matter how remote at this stage) against which the EUR can lean on – eventually.

Consequently, constructive trade talks with the US will or should have a positive impact on EUR/USD going forward. From a technical perspective, everything is pointing to a test towards 1.1000 from here, though timing will be key as ever. Liquidity – or the lack of – has played its part in removing support points on the way down, with 1.1500 and 1.1300 both needing a series of tests to eventually break through. There has been anecdotal evidence of central bank demand at these levels – PBoC and SNB likely – though banks have seen little interest from domestic exporters ready to lock in much-improved rates, so this will likely be reinforced by any developments in the initial point made in this paragraph.

In conclusion, there is little to feel optimistic about the EUR at the moment, other than the fact that in the crosses, we have seen a relatively tame response to the data and political uncertainty in comparative terms. With the USD on the front foot and effectively winning out in all scenarios – whether it’s risk on or off – but just as we noted with the impulsive EUR rally into the start of the year, we expect the same dynamics to play out in the US, which will also see the effects of the tax cuts passing through, if they haven’t already.