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We live in interesting times and the markets are asking a lot of questions about whether or not we have seen genuine regime change from the G3 central banks, driven by a solid improvement in global economics, positive inflationary trends and ever-growing concerns around financial stability.
As we headed in 2018 something snapped. On one hand, we knew that the Federal Reserve (Fed) was behind the curve, and with such accommodative financial conditions and asset price inflation in the system, the Fed would have had to raise the fed funds rate a couple of times just to keep pace with the moves in broad financial conditions.
In the January FOMC meeting, we not only saw the fifth interest rate hike in this cycle (that started in December 2015), but importantly we saw the Fed turn more optimistic about hitting its inflation targets. When married with the moves higher in inflation expectations, as measured through the US and European bond markets (I’ve looked at 5y5y breakeven rates), where US inflation expectations pushed to the highest levels since October 2010, the buzzword around the trading desks just how underpriced the rates markets were relative to what inflation expectations were telling us.
Of course, these inflation expectations had been influenced by moves in Brent and WTI crude, where WTI crude had rallied some 60% from June and into $66.66.
When we saw the US January wage data (as part of the non-farm payrolls release) printing 2.9% - the strongest pace since June 2009, the markets came alive and volatility smacked us square in the face. Not just because the moves in markets were just so pronounced on an absolute basis, but because we had gone through a period in 2017 where markets lacked any kind of a pulse at all. So we just weren’t used to massive intra-day ranges initial driven by technical factors, such as systematic funds selling exposures as implied volatility spiked.
In actuality, implied market volatility (vols) hit equities significantly harder than the FX or fixed income markets, where we can see the US volatility index (or the “VIX” index) spiking to 50.3, before settling down into 25 and well ahead of the five-year average of 14.4. Consider that implied volatility in the FX market (as measured by the JP Morgan FX volatility index) did move higher, but only back to the five-year average of 9.1. While bond market implied vols (I’ve used the BoA/ML MOVE index here) also really only pushed back towards the five-year average of 11.09 and neither could be considered extreme.
So the macro backdrop of economic improvement and inflation expectations didn’t necessarily cause a prolonged period of risk aversion in FX markets, although we did see some demand for the JPY and CHF and out of higher beta currencies such as AUD and NZD.
For answers here, we need to look at the interest rate and bond markets and assess the relative yield differentials. We know the US has been improving and we have seen this with traders pricing increased policy tightening from the Fed, as well as modelling the world with less excess liquidity in the years ahead. From September, short-end Treasury yields underwent a sizeable sell-off, where we can see the US two-year Treasury moving from 1.24% into 2.18%, while the five-year Treasury moved from 1.59% to 2.61%. However, FX markets have been more sensitive to longer-term inflation expectations and when we finally saw the 10-year yields moving higher we knew it was on – traders had far more confidence in their estimates of future inflation, with the ‘term premium’ coming out of the markets and subsequently the yield curve steepened.
When taken in isolation, a steeper yield curve is extremely positive for the USD. However, when we also saw a steeper yield curve in Europe and the UK bond markets and notably on a relative basis, it shouldn’t necessarily surprise to see EUR/USD pushing up and above $1.2500. So while everyone is focused on rate hikes in the US, this is a market that is also seeing improvement in the European and Japanese economies, while the Bank of England have guided the market to expect a series of hikes. In Australia we can see a solid improvement in the fiscal deficit, while since October there has been a fairly strong correlation between the AUD and CNY (the regression shows an R2 of 0.63). Through Q4’17 and into Q1’18 FX traders have shied away from the USD, with the US economy at a mature stage in its economic cycle, rotating into currencies where the economies are improving and the central banks still need to move away from unconventional monetary policy settings.
We have liked the JPY for a while, not just because the speculative community has been running a monster net short position on the JPY (as measured by the weekly CFTC report), and still is, but because we feel the BoJ will gradually start to alter its Yield Curve Control program in Q3’18 and the market is not giving this enough significance. At the time of writing, USD/JPY is testing the ¥107.49/32 area (the July 2016 high and 8 September low) and a convincing break here should take the pair into my longer-term target of ¥105.00 and we now focus on whether Kuroda gets a second term as governor of the BoJ when his term expires in late March. The JPY crosses also found good interest from traders, where we have seen some strong downtrends in CAD/JPY and AUD/JPY too.
As mentioned, EUR/USD traded into $1.2500, coinciding with a rejection of the 2008 downtrend, although I feel there are strong risks this give way in the weeks ahead, which should take the pair into $1.2654 – the 61.8% retracement of the 2014 to 2015 sell-off. Fundamentally, I am watching the relative curve steepening as my driver, where a regression gives us an 84.2% correlation (or R2) over a two year period. Get the bond market right and you have a pretty good understanding of the moves in EUR/USD.
Traders saw a strong move higher in AUD/USD through December, failing just above the 81 handle and subsequently rolling over, in what is now a clear double-top and a set-up on many traders’ radars in the months ahead. Through February, AUD/USD did pullback a touch, driven my subdued Aussie Q4 inflation, RBA rhetoric and a general ill-feel around heightened market volatility. Bond market dynamics have also influenced and, where we can see the yield advantage to hold Aussie 10-year Treasury’s over US Treasury’s falling to zero – the tightest spread since June 2000.
That said, despite the move lower, the pair held the 200-day moving average at $0.7763 and perhaps this can be the platform for a move above the 79c, where I will be interested to see how price reacts around $0.7903 – the 38.2% retracement of the sell-off.
My preferred position is longs in EUR/AUD though, which has worked well in times of risk aversion. I have no position at the time of writing, but the set-up on the daily chart certainly has my interest, with the price having tested, but rejected the 1 December highs of A$1.5771. We have seen the buyers come back into the pair on moves in the low 1.56, but it feels like a renewed push is upon us and a convincing close through A$1.5771 would open up strong longer-term upside. Upon a close, I will be looking to increase exposures here.