Trading opportunities in policy divergence

Policy divergence is likely to be the key theme this year and we’re already seeing strong signs central banks will play the most significant role in how markets and asset classes perform.

ECB - Trading opportunities in policy divergence article
Source: Bloomberg

The year has kicked off with a Greek political crisis after the country failed to elect a president, leading to snap elections being called on 25 January. At a time when Europe is trying to focus on stemming the economic bleed and spur growth, this was something investors did not want to see unfolding.

The problem is Greek polls are currently pointing towards a victory for the anti-austerity left wing party Syriza. This puts the risk of a Greek exit on the table and could even force a renegotiation of the bailout terms.

To calm markets, German Chancellor Angela Merkel made comments suggesting Greece should stay part of the Eurozone and Germany is open to Greek debt talks. The reality, though, is any negotiations are likely to prove difficult, particularly if Greek political leaders fail to form a government.

As far as contagion is concerned, it seems European banks are much less exposed to Greek bonds than they were at the heart of the crisis in 2011/2012.

ECB to expand balance sheet

As a result, it’ll be all about monitoring bond yields very closely as that’ll be a key indication of sentiment.

From an ECB perspective, everyone is anticipating sovereign bond purchases and, given the ECB is looking to expand its balance sheet by around a trillion euros (current size €2.2 trillion), then this is a path they’ll have to venture down.

While the ECB has already been conducting covered bond purchases, this has hardly made a difference to the balance sheet and all roads lead to sovereign bonds. The question now is what happens with problematic countries such as Greece.

There have been suggestions the purchases will come with conditions for the countries where the bonds are purchased. Whether this will come to fruition or not is still debatable, but the euro is already starting to feel the effect .

The single currency has dropped to levels not seen since 2006 against the greenback in anticipation of the divergence between the two economies.

US lift-off a pivotal issue

On the US side, it’s all about the timing of the rates lift-off and recently released FOMC meeting minutes shed some light on how the Fed feels the economy is progressing.

While the Fed managed to calm markets by adding the word ‘patience’ to its language as far as rates lift-off is concerned, the minutes showed that not much has changed and we are still likely to see an increase.

The minutes reinforced the data-dependency of rates lift-off, with the Fed more confident about growth but concerned about low inflation. Interestingly, the Fed saw lower oil prices as a net positive for GDP and employment growth, dismissing some of the concerns investors have about lower prices.

The Fed also clarified the introduction of the ‘patience’ phase, saying it gives it more flexibility to adjust policy. Overall, it seems the consensus is still for rates lift-off in the middle of this year. The slight risk is for a later-than-middle of the year lift-off due to low inflation and perhaps pressure from a changing global outlook.

Regardless of when we get lift-off, it seems demand for the USD will pick up given the decreasing US current account deficit and weakening commodity revenues.

Key currency pairs to watch

Having said that, it is likely flows will continue to favour the greenback. This puts several key currency pairs on the radar and makes for an exciting year for traders as various policy themes evolve.

At the beginning of the year, focus will be mostly on EUR/USD, with the pair already trading at eight-year lows.

This is one pair where traders will be looking to take full advantage of the glaring divergence between the two economies. Selling into any recovery is likely to be a preferred strategy while some aggressive traders will be looking to take advantage of the momentum.

Meanwhile, USD/JPY is also likely to remain on the radar despite having had a quiet start to the year. With elections wrapped up in Japan and pressure mounting on officials to take action in a bid to achieve the country’s inflation goals, the yen could be headed for further weakness.

Every BoJ meeting is capable of producing fireworks, making USD/JPY one of the most important currency pairs to watch this year.

Later in the year, the world will assess how US economic data progresses and any signs the Fed is preparing to tighten are likely to have ramifications for emerging market currencies. This will be a big event as it will resonate throughout global markets.

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