By now, it should have become painfully obvious that USD demand is now predominantly a function of the weaknesses elsewhere, rather than expressing a positive view on the US economy. Naturally, it is hard to argue against a more favourable position stateside, but the US is not without its risks, which will be exacerbated every time the Fed decides to hike. The normalisation process was long overdue, and I argued that the Fed was perhaps a little too hesitant in tightening as Fed chair Yellen, at the time, wanted to wait for clear signals. Well they came through, and while the market focused on the twin deficits, the USD index was pounded into the ground and few could see a reason for the turnaround. And now here we are.
The market cannot get enough USDs, and at a time when the balance sheet is slowing contracting, the backdrop of year-end shortage maintains a relative bid in the greenback despite the prospects of a dovish hike tomorrow night. It would not surprise me if the Fed decided to stick on this one, and as per Jerome Powell’s rhetoric, watch the data. There is, however, one distinct drawback in taking this course of action, that being the perception of yielding to political pressure. President Trump makes no secret of his disappointment in the current Fed path, though come 7.00pm tomorrow evening, we will know through the dot plot whether there has been any moderation in how policymakers now believe the normalisation process should continue – if at all.
Anyone choosing to stick to the script need only look at the housing market, where yesterday’s NAHB House Price Index took another dip from 60 to 56, having fallen from 68 in the previous month to this. Domestically, neutral rates may be closer than the Fed thinks, and their recent commentary is certainly moving this way. Any suggestion of a pause tomorrow night will confirm Fed concerns, so in this respect, perhaps some of the outliers for an unchanged stance are a stretch at this point. The level of market dependency for direction from central banks has been raised significantly in recent years. so policy communication has to be dealt with kid gloves these days. In this regard, we do expect the Fed to direct market participants towards the data and coerce the mindset towards what is actually happening in the economy. It is long overdue.
That said, it is hard to steer the market away from the USD at the present time. The EUR is riddled with political instability in the region, exacerbated by the Brexit fallout, and the domestic data has taken a hammering from export-led weakness. The Pound, as undervalued as it is, faces a crisis of a magnitude not seen since the ERM debacle in the early 1990s and global trade worries continue to weigh on the majors closely tied to Asia. Australia, along with Canada also faces serious housing concerns as well as private debt thereon, and with Oil prices dropping like a stone, we cannot count on the traditional followthrough in the Canadian economy which has been a staple default scenario as a tailwind of US growth.
We still see room for a modest correction in the USD should the dot plot fall in line with market expectations. Whether this can effectively mark a more significant turnaround at this stage is in the balance. It will take some significant improvement in some of the USD’s major counterparts for this to develop, and this is clearly not going to happen overnight. The JPY and CHF look the obvious choice in the current climate, though both the BoJ and more so the SNB will have something to say on this, so the playing field is a bumpy one, to say the least. EUR/USD is making all the running this morning alongside a reluctant push lower in USD/JPY. 116.00 and 111.35-30 are levels we are watching for in either case.
(EUR/USD Technical Analysis)
Midweek, the FOMC meets to deliver their latest monetary policy announcement, where the odds continue to favour a 25bp hike – the fourth move this year. This would take Fed Funds to 2.5%, a level which touches on the lower end of the neutral range which has and continues to be under question. Consequently, the release of the latest rate projections through the dot plot will be of greater interest to the market, having tempered expectations for 2019. The odds for just one move currently stands at a little over 50%, reined in from the forecasts that the Fed will hike at least twice through next year.
Fed chair Powell has clearly stated in recent addresses that policy is data dependent, and while we would expect markets to adopt this perception at all times, recent years have seen a heavier reliance on forward guidance, so we may also see some changes in the statement which may be designed to steer the market towards data inputs rather than measuring sentiment around the general theme of ‘further gradual rate hikes’.
(DXY Daily Chart)
Starting off the week, we have seen the USD coming under a little pressure, and this may be little more than some modest catch up with the rates markets. The latter have been pre-emptive in accommodating for the recent change in rhetoric from policymakers, so there are risks to a surprise on the hawkish side if the dot plot sees little change to reflect market sentiment. In this instance, equities are likely to come under further fire, with the major Wall St indices already teetering on the edge at the levels we are at present.
The USD is still de facto a default currency, gaining on the weakness of others, so the impact of the outcome is pretty binary on how the Fed communicates any endorsement (or not) to how the rates markets are pricing the future rate path from 2019 onwards.
(DXY Weekly Chart)
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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.
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.
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
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.