A familiar triumvirate moving in tandem

Once again we are seeing the trio of US rates, currency and stock markets moving higher, reinstating the theme which based on evidence last November, has limited potential given the sensitivity to higher interests on equity valuations.  In the first instance, the recovery in stocks is as yet a moderation in the heavy sell-off seen in the latter months of 2018, and allowing for speculative short covering in the broader indices coupled with a reallocation of funds at the start of the year through discretionary and sectoral bias, we may have a little way to go on the upside before nervousness begins to set in again.
While optimism over a US-China trade deal is also a major factor in the positive change in risk sentiment, we must not forget that the Fed is still reining in the balance sheet and financial conditions are very steadily tightening in the background.  In light of this, the latest pick up in Treasury yields will at some point impact on stocks, and/or start to ease off and set up another potential recovery in mid-curve Treasuries.  At current levels, we would expect to see some degree of caution from portfolio managers, but the US economy continues to stand out above its major peers, despite nominal growth levels in China still outperforming in the global economy.  There are greater concerns on the structure of China’s growth going forward, namely that infrastructure spending has comprised a large part of GDP and output over the last decade and that we are potentially nearing exhaustion in terms of effective viability and profitability of any fresh projects in the future.  China is trying to transfigure its economy towards internal consumption and naturally, this takes time.  Based on this broad-based overview on China, the US remains the go-to-economy at the present time and as a result, we are seeing a continued bid in the USD.
There is another obvious factor in that despite attempted repricing of Fed rate hikes this year, divestment away from the USD requires a viable alternative.  Given the malaise in Europe on a number of fronts, headlined by the economic downturn in Germany, we are unlikely to see a readiness to shift away from the greenback until we get a clear reason to do so.
A resolution in Brexit will naturally prompt a readjustment in the Pound, though this is easier said than done.  At present, the political quagmire parliament finds itself in leaves many to believe that the withdrawal process is very likely to be delayed, if not reversed should proponents of a second referendum get their way in the Commons.  That said, there is a growing realisation that a second vote is perhaps not as popular as it may seem, with many of the Conservative party keen to preserve democratic integrity and this is shared by a number on the opposition benches according to recent rhetoric.  The Brexit mood-gauge (for want of a better phrase) now looks to more inclined towards a deal in order to leave the EU in an orderly fashion, though the power remains in the hands of the EU for as long as the UK refuses to countenance a no deal Brexit – fact!
In Europe, the ECB meeting later this week could prove instrumental in the direction of USD through what is leading component in the DXY – the EUR.  Having failed to capitalise on the breach of range limits at 1.1500, we are once again resigned to a narrow range inside 1.1300-1.1500, where a breakdown of the lower level may well see the USD extend its quest for higher levels – the headline rate still providing to the lead for the rest of the major USD pairings in the current climate.  The Jan PMIs will be a major factor when released later this week – ahead of the ECB meeting in fact, so we expect this to be one of the key market catalysts this week in an otherwise lethargic market for macro-based instruments – reflected overwhelmingly in FX.

An interesting start to the year ahead – looking for the USD to stabilise and eventually soften but external factors will have a big say.

The key theme last year was that of USD strength in the currency markets, coming off the back of divergent rate paths against which the EUR and JPY were the primary targets, while GBP was also in the mix on broader fears over the withdrawal from the EU.  Looking ahead to 2019, we can expect a softer line from the Fed, and having moderated the call from 3-4 hikes next year, the base case scenario is now for only 2 as both the real economy is decelerating, and stock markets are seen to be a little more sensitive to financial conditions than were previously believed – at the Fed at least.  Lower earnings growth potential should take keep a lid on any recovery in stocks though, at the moment, forced liquidations will continue to dictate the risk mood which further supports the JPY and CHF, with the USD next in line.
Based on the Fed projections for this year, however, the outright view on the USD will be mixed in the first half of the year, with proponents pointing to the lack of alternatives given Eurozone weakness, Brexit uncertainty and a negative view on global growth which has taken its toll on commodities with the exception of precious metals.  It is our view that the market is underpricing the possibility that the Fed may well sit on their hands until the middle of the year before embarking on any fresh tightening, and we believe there is also the outlying chance that there will be no (Fed) move at all in 2019.  Much is dependant on the US data going forward, and we believe there is room for the USD to moderate a little more, though the usual suspects are struggling to garner support.  EUR/USD has again faltered at 1.1500 this week, and we would have expected more of the same had we seen a push back to 1.1600, so we have defined a key area for USD bears to overcome if the greenback is to materially change direction.
For the Eurozone to come out of the doldrums, we will need to see some relaxation in the trade tensions between the US and China, and if they do strike a deal, we expect to see some of this relief reflected in the EUR rate as exporters here will have raised optimism that the US will reciprocate with Europe also.
Brexit is very much a binary outcome in terms of how we come out of the other side of the meaningful vote later on this month.  Every indication suggests the current proposal championed by PM May will be rejected, but there is a majority in the House of Commons in avoiding a calamitous withdrawal with no deal in place, though how we come about this is unclear as it has ever been.  The obvious expectation is that Article 50 will be extended, though GBP will be sensitive to comments from the PM who insists the referendum result will be respected and the UK is leaving on the 29th of March.  Red lines have been shifted in the past and we can see Theresa May giving up further ground.  It is just a case of where and to whom, which is the question at this stage.
Commodities have front run the US stock market sell-off due to the stronger USD impacting on emerging markets, so it is no surprise then to see the related majors suffering at the hands of the greenback.  At this stage, the economic slowdown in China is going to keep the AUD tethered to the lows and possibly lower.  News of fresh stimulus in China is having little soothing effect, as the mining backed currency threatens a sustained move lower, though we suspect the volume is coming through AUD/JPY as the key stock market proxy.
While oil prices continue to attack the downside, there looks to be little reprieve in sight for the CAD.  We have seen losses across the board, with EUR/CAD rallying through 1.5500 to highlight the impact of risk sentiment as much as anything else.  Perhaps shades of early 2016 spring to mind when USD/CAD tore through 1.4000 as WTI slumped into the $20’s, and while this threat is present, it is unlikely we will see a move back to longer fair value levels around 1.2500.
Even so, the USD is not the Holy Grail of safe havens anymore.  While it has taken time for the JPY to catch up, the resilience and later resurgence of Gold prices should have given the market an early sign that USD dominance was and is slipping, though in current times, repatriation flow can wash out speculative positioning with ease – much as we have seen in the collapse of USD/JPY, which was pounding on the door of 114.00 only a few months back.  It would not surprise us to see levels closer to 100.00 at some stage this year, though the catalyst for this is multifold.  As above, the Fed may turn even more dovish than is currently perceived (probable), or we could see significantly larger losses in US equities – which have outperformed considerably in recent year, or we could even see the BoJ finally throw the towel in on their aggressive asset purchasing program.  We expect a change in language at the very least at some point, and we don’t discount broader inflation expectations in countenancing this.
One way traffic in the USD looks set to give way to a little more differentiation at the very least.