Weekly FX Outlook – 11/03/2019

No surprises for guessing where all and sundry expect the volatility to come through this week as the Brexit circus rolls out the main acts starting with the meaningful vote on Tuesday evening.  Sparing the rundown on what to and what not to expect, the plethora of coverage makes it pretty obvious that either parliament votes for the current deal or we effectively decide on ruling out a no deal and ensure a soft quasi Brexit.  Do the probability of outcomes warrant a material drop in the Pound at this stage?  We would suggest not, as it is clear both sides will suffer in a no deal scenario and anyone keeping tabs on parliament will see there is a majority to reject this – irrespective of how this impacts on the UK’s negotiating leverage.  Our base case scenario is that – albeit at the 11th hour – one or both sides will avoid the worst of possible outcomes.

From a purely technical perspective then, we look to the 1.2850-1.2950 zone as a significant area which should define whether we could see an early base forming, so soon after 1.3000 gave way last week.  We anticipated a little more support ahead of this psychological level, but late week/pre-weekend fear and jitters gave Sterling little chance of stability in this context.  We maintain price action and the time zones they trade in have a strong bearing on where and how far levels can be stretched.  It abundantly clear that traditional technical analysis is losing touch with the modern day trading patterns.

From a fundamental perspective, EUR/GBP perhaps confounded many with the way it pushed higher on Friday, so soon after the dovish actions by the ECB sent the EUR down through cycle lows to test the 1.1175-1.1200 area vs the USD.  EUR/USD is now widely expected to test towards 1.1000 over the coming weeks, though we will need to contend with further support in the low 1.1100’s to challenge this pivotal level.  Given its historical relevance, we would argue that only the prospect of an existential Eurozone crisis will drive the EUR below here.

From current levels, we will need to assess how the medium term outlook develops in the key member states, with Germany’s economy having caused justifiable concern as its manufacturing PMIs remain below the 50.0 mark.  Only this morning, we saw industrial production falling 0.8% in Jan, as well as its trade surplus narrowing once again.

In the current climate of fragile global demand, all export-reliant regions are undergoing testing times, and US-European trade tensions are still lingering in the background.  This may be alleviated for a temporary period if US talks with China can yield positive results, as we expect some presumptuous follow through into the EUR.  For now, trying to establish a base in EUR/USD is not only premature but also offers little prospect on the upside based on the economic climate at present.

Optimism over a US-Sino trade deal was reinforcing the carry trade up until the middle of last week, after which time the cumulative impact of central bank caution (heightened by the ECB) led to a brief fallout in risk assets.  This seems to have stabilised again with Wall Street equities grinding higher again pressing on the JPY once more.

USD/JPY managed to hold off a resistance area capped by 112.30-35 last week, which may well serve as a longer-term top, but as long as 110.25-30 holds firm on the downside, we expect flights to safety favouring the USD to some degree, which will continue to takes out a large tranche of volatility in this pair.

There is also a lack of response to a softer tone from the Fed, which as is now widely acknowledged as a positive backdrop for risk assets in DM.  It is our belief that the only real catalyst for a sharper move in USD/JPY is likely to come from any tapering expectations from the BoJ, who at present, stick to their ultra easing bias though global asset purchases.

The commodity-linked currencies seem to be drawing little inspiration from broader sentiment, with dovish turnarounds from the RBA and BoC proving to be the ultimate driver for AUD and CAD respectively.  The traditional correlations have been sporadic, to say the least, but we can see little respite for the AUD as long as fears over China’s slowdown persist and the how slowing demand will eventually impact on Oil prices and the Canadian economy.  The BoC made a point of citing caution on activity and output based on the outlook for Oil prices ahead.   CAD buyers are likely to be tempted in should we see a spike above 1.3500, but at this stage, broader themes have not ruled out a stronger move towards the 1.3600-1.3800 region as yet.

AUD/USD set out its parameters at the start of the year by hitting levels in the mid 0.6700’s, and at some stage, we expect a move back to test these levels if/when China’s slowdown gathers prominence again.  After the recent stimulus measures from China, we would have expected a stronger response from the 0.7000 area, but the reluctance perhaps tells its own story.  0.7120-0.7170 is a region we are keeping an eye on, but the lack of momentum suggests this area will contain trade unless we get a material turn in the US data.
USD prominence continues to highlight, or more so reflect the lack of viable alternatives at present, though net exposure is making for a challenging environment in G10 FX as USD strength also has its limits.  Markets are pricing in a flat year at the Fed, and this is consistent with our view.  Policymakers still believe there is scope for another hike this year and next, but only significant wage inflation will force their hand against a sensitive equity market.

AUD/USD Technical Analysis

What can we expect from AUD/USD?

AUD/USD Technical Analysis

Technicals:

  • Could be at the start of a new Elliott Wave pattern to the upside but a break of .7400 is needed to confirm
  • .7160 is an important support level if it breaks this could suggest trend continuation
  • RSI has broken lower watch out for a hold above 50

AUD/USD Market Profile

On the market profile chart, the area between .7157 and .7018 looks very congested. We have since auctioned higher and ranged between .7157 and .7393. If we saw a bearish NFP result we could revert to the mean value area of .7254 or possibly higher. If the market is net bearish this could be the area where a lower high is formed. In a bullish view, only a break of .7293 would confirm a wave break higher.

Fundamental backdrop

Across the currency spectrum, and not just against the USD, we have seen a weakness in the AUD in the past week or so, with domestic matters weighing on the currency, in particular, this week. The RBA meeting threw up few surprises in keep rates unchanged and maintained the balance of economic pros and cons within its statement. In essence, the RBA still sees the next rate move as up, though as has been the case for some time now, it is a matter of timing and widening differentials with US rates have largely dictated losses in the spot rate. In the past month or so, however, AUD – along with the NZD – has recouped some ground against the greenback, though this has been more a function of its oversold status and in the time it has been achieved.

Hitting highs close to 0.7400, AUD/USD resistance has been largely based on the global factors surrounding the threats to global trade. As US actions against China have threatened demand for Australian raw materials, so the longer term negative bias is set to contain the upside. There was been some periodic mismatch in the sensitivity to data – for example, the relief from the near term truce between the major economic powerhouses over the G20 weekend, though as above, domestic matters are now weighing on the AUD, with this week’s Q3 growth coming in lower than expected at 0.3%. Trade data was also lower than forecasts, though both cases argue for continued expansion – perhaps not as much as expected, though enough to battle through tough times in the current climate. We have also seen commodity prices picking up and finding some resilience despite a stronger USD, so this should suggest a level of underlying demand as the world ‘ticks over’.

Australia may be some way off raising rates from current levels, but at this stage, some of the alarmist calls for a rate cut seem out of place in our view.

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USD pullback post-Powell does not deflect from weaknesses elsewhere

There was great anticipation ahead of Fed chair Powells speech in NY last night, where there were concerns that he may have attempted a tone down in the rate path going into 2019. Some will argue that this came off the back of political pressure, though some of the recent data show that aggressive USD buying to reflect economic outperformance in the US looks overstretched. Looking across the spectrum of major currencies, we can see the likes of AUD and NZD have redressed some of the excessive positioning in recent weeks, though all USD rates moved in tandem and to a similar degree in the North American session last night.
Rather than jumping in and assuming these moves would continue, we thought we would wait to gauge the reaction from liquid markets through Europe this morning. Price action this week will be heavily distorted from month-end flows, where USD demand is and was anticipated in light of rebalancing requirements after heavy losses in US stocks this month. Once the dust settles, we may have to wait until next week to get a true gauge of how current positioning will be affected by the latest Fed communication, with the benchmark 10r Note only now testing the $3.00% mark. In light of this, we would have anticipated a little more downside in USD/JPY specifically, though correlation traders will likely have been mesmerised by the relief rally in stocks which saw the Dow ramp 600pts, on par (in percentage terms) with the leading S&P. The NASDAQ regained some 200pts, though we should have anticipated the positive impact on stocks however temporary it may.

Into the weekend, fears over the Trump-Xi meeting should see some risk pairing, though it is now clear to see that equities need all the help they can get from any form of accommodation, and last night, Powell’s address proved that in spades.
In the background, the Fed is still (albeit very gradually) shrinking its balance sheet, so this slow retraction of cheap money should start to erode any near-term bonhomie seen in stocks. Eventually, we expect this to start impacting on the traditional safe havens such as the CHF and JPY, though I maintain that the latter is largely a case of repatriation risk as markets finally realise the US stocks are no longer the Golden Goose which keeps on giving. Naturally, emerging markets will even more vulnerable as USD liquidity contracts, so USD demand is also likely to hold up to some degree, but it is a matter of picking your targets. As above, we may see those currencies which have gained ground start to suffer.
More immediately, the EUR and GBP are easy targets for those looking to maintain a level of positive USD bias irrespective of the interest rate backdrop. Strength in the greenback is as much above safety as well as perceived demand from those burdened by USD based debt, so we expect to see a level of resilience in the face of some potential walk back from the Fed.
EUR/USD looks set to trade water in the 1.1200-1.1500 range in the meantime and we are far from comfortable in calling for a base in the leading spot rate as yet, with growth in Germany suffering from low export demand with the auto industry in the spotlight at the moment. Should we see the US offer an olive branch to the EU, then we could see a little more optimism here, but for now, sellers are ready and waiting to pick off rallies with pre 1.1400 a clear example this morning.

BP will remain pressured into the parliamentary vote set for next month. Few if any believe the current deal can pass in its current form, and at the very least, we expect the DUP to maintain their pressure on the PM to seek an alternative route. The threat of retracting their current confidence and supply agreement will further embolden the hardliners within the Tory party. Labour and SNP continue to argue for a second referendum as they see current membership more favourable than any proposed deal, and GBP traders smell blood once again as pressure on the 1.2660-1.2700 zone remains vulnerable, to say the least.
It is worth noting that speculative positioning seems relatively light based on the data at hand, and may explain some of the hold up seen ahead of 1.2700 in recent sessions. EUR/GBP, however, looks to be a more appealing play for a potentially bearish outcome, with growing calls for parity in the event of a disorderly EU withdrawal. Neither side wants that, no one wants that, but strong political red lines show a lack of flexibility which continues to heighten fears of a breakdown in the UK-EU relationship.

EUR/USD Technical Analysis

Above is a weekly EUR/USD chart – I have outlined a potential bullish scenario but some conditions have to be met in order to confirm the theory:

  • Looked like we had a rejection on the weekly candle last week
  • We now struggle at the 50% Fib retracement that is acting as resistance
  • On the downside, we failed to reach the 1.27% extension and 61.8% retracement
  • A move weekly close higher could confirm the bullish sentiment
  • Right now we may be at an ABC correction after the 5 wave Elliott pattern from 1.0340 to 1.2555. If this is the case we could be in for a correction higher

The daily chart contradicts the view on the weekly:

  • The daily chart has turned higher but in recent days the USD has resumed control
  • A firm break of 1.1545 is the confirmation needed to back the weekly Elliot Wave theory
  • We are in a phase of lower lows and lower highs
  • This extension lower stopped nicely at 1.12 area which is also the 61.8% retracement level
  • There is also a resistance at the trendline running from the start of 2017 to the last wave low
  • A break past the 1.1550 would confirm the move higher but it may be resisted

All in all, there is some traffic in the way but the risk/reward looks attractive. I must stress the conditions have to be met before the outlook changes to bullish. Each time the sentiment looks like it’s about to change another wave of USD buying comes in so keep risk tight.

No surprise to see the Dollar softening as tighter financial conditions forced upon by the market – again!

Since the end of last week, we have seen the narrative that decelerating (rather than fading) economic momentum at this stage in the US has, and may well continue to lean on the USD in the near term. Something we have been keen to stress in the last month or so is the combined effect of a tightening Fed and a stronger USD, which then start to prove restrictive – or less accommodative as the Fed would put it. It’s not rocket science, but we have seen this time and again. As a function of the market overextending fundamental themes, we have therefore reached a point where the Fed now have to actively consider whether maintaining their current rate profile is ‘prudent’ – a term used by Harker last week.

Even so, the USD rally is not all about yield differentials, though naturally they come into play and provide an added draw for the greenback. With little appetite to carry risk elsewhere, it’s default status is as strong as it has ever been. Europe – or rather the EU – is doing little to soothe investor concerns with its disapproval of the Italian budget, while trade tensions have been hurting all major exporting regions. It is pretty clear what is hampering GBP at the moment, so we won’t go there! Asia’s current malaise is clouded by worries over a potential slowdown in China, exacerbated by worries over private debt, though with focus on the impact of US tariffs. There are signs that this is also feeding into the US manufacturing sector, as highlighted by the ISM surveys. For now, we will concede that protectionist measures are effectively a lose-lose situation, yet with the ultimate loser being the consumer, it stands to reason, that domestically generated growth (rather than export-focused) based economies will eventually suffer also. We need to listen to some of the doomsday scenarios on UK inflation should we settle on WTO rules!

Yesterday’s NAHB house price index also raised some eyebrows as we saw a drop from 68 to 60, so with the US being far from immune to personal debt dynamics, we expect to see a challenge – to some degree – of the USD as the out and out safe haven. Liquidity is a huge draw, but there is room for some differentiation here and the resilience in Gold price leads me to believe that we could start to see this gain traction soon.

Adding to this view is the all too modest pullback in USD/JPY. It’s equal resilience to the downside has also endorsed the USD in times of flight to safety, coerced by the BoJ’s insistence that it will keep printing JPY in order to get inflation moving. It’s not working – and why would it when we continue to see the divestment mill pushing funds into higher yielding overseas vehicles, and in its obedience, the market seems to be more inclined to tow the central bank line.

In conclusion, the signs are there that the USD seems unlikely to give up any material ground just yet – USD/JPY is telling us that. For the EUR to gain any serious traction back towards longer-term fair value will require the EU to try and calm matters with Italy. Red lines are all over the place, however, as we have seen in the Brexit saga, so political ideology (intransigence) continues to weigh on sentiment. Even so, just as we saw the market trying to squeeze blood out of a stone at 1.2500 earlier in the year, we may well be seeing the same ‘destructive’ pattern in ignoring current valuation levels in the USD. Volatility can be a positive ‘pressure valve’ (if you like), in smoothing out exchange rate averages over time.