"Trading Summary | While the air above is thinning, we hold to our long EUR/USD tactical view. GBP/USD has more upside and this may pressure EUR/GBP lower. European currencies remain favoured over Asia FX as investors chase risk adjusted carry returns in a vol crushed world. Stay with long GBP/JPY as the BoE falls further behind in the Race Not to Tighten First. USD/CAD to trade lower initially as spot catches up with rate spreads. However, the medium-term outlook is still one of likely appreciation on ultimately higher US yields and a USD supportive US energy story. Tactically, we like AUD and NZD longs, as data support both currencies. NOK out-performance against the SEK and JPY is also likely as the Norwegian currency trades more in line with its traditional drivers.
What We Learnt Last Week | Vols can fall further and carry trades can become more popular. This includes EUR/USD, where a move out along the yield curve means it's a carry-trade, just not in the traditional sense. Periphery spreads can narrow further as the market chases the last increasingly shallow pools of yield. Draghi's comment on excessive EUR valuations is new information but not a deal breaker. It's too early to go fishing for USD longs as the data and Fed speakers just aren't providing enough encouragement. The BoE is in a holding pattern unless data breaks one way or the other. The market's Wall of Worry is a little higher as China's financial excesses seemingly hit metal prices. The market is becoming more attuned to downside growth risks around sanctions on Russia which will ultimately hurt everyone. The Riksbank is unlikely to cut rates on April 9th. There may be life after ZIRP after all as RBNZ raises rates and tells the market more are coming. The Australian economy may be stabilizing and there are more short AUD/USD positions to be squeezed.
FOMC Statement Re-write | The market will be looking for +250k payroll reports over the next few months, so the FOMC will have a tough job on its hands to keep a firm grip on short-end rates. This starts with this Wednesday's FOMC statement. While we've already heard from Yellen in her recent testimony to the House, this will be her first FOMC meeting as Chair. As guidance transitions, so might her tone from uber dove to a flexible, consensus building Chair. Any significant rewrite comes with risks of miscommunication. We expect a shift from quantitative guidance to qualitative guidance, more like the BoE's framework. At this stage, the minutes are still the most fertile ground on which to propagate a view of how sentiment on the FOMC is shifting regarding the recovery. While we expect the FOMC to find it increasingly difficult to keep to a dovish path, this doesn't appear to be a story for this week.
Pain Trade is EUR/USD Higher | EUR/USD continues to trade like a pain trade. It also seems a quasi carry trade, driven higher by narrowing periphery spreads. With last week's regional CPI data coming in a little softer than expected, today's Euro area inflation may be revised a tenth lower of 0.7% yoy. Cue Draghi's surprisingly direct comments on the impact of the exchange rate on inflation. Of course, he has traditionally characterised the impact of the EUR on the economy through its impact on CPI and the risks around the forecast. However, he added that "given current levels of inflation, [the strengthening of the effective EUR exchange rate] is becoming increasingly relevant to our assessment of price stability." The timing of the comment is odd given that the level of the EUR isn't materially different from that prevailing at the March ECB meeting. At that meeting his comments were neutral. Hence we doubt his comments will have much lasting impact as there's few speculative positions to be squeezed and the ECB appears a long way off delivering a significant easing of policy. Our estimate of EUR/USD short-term fair-value is currently just above 1.38, so it's not clear that the EUR has run significantly ahead of fair value.
GBP, Yields and Imbalances | Last week's trade deficit provided an update on one of the UK economy's triple imbalances (of international trade, household balance sheets and government borrowing). While news of a widening in the deficit is very unlikely to have an immediate impact on short-term GBP valuations, it does provide information on medium-term valuations. This week it's the turn of excessive levels of government borrowing to take the limelight. With only modest upward revisions expected to the OBR's GDP forecasts, the public borrowing projections are likely to be trimmed rather than slashed, suggesting little by way of any change to the UK's fiscal or macroeconomic outlook. The UK's fiscal position remains poor in absolute terms but there appears to be sufficient progress in reducing the deficit to prevent any adverse market reaction. As for monetary policy, we didn't hear much new from Governor Carney last week. He reiterated that tightening will start with the Bank Rate and not by selling down the BoE's stock of asset borrowing. Asset sales will also not start until government borrowing is "materially lower". This suggests at least 3-4 years away on current OBR projections. Wednesday's BoE MPC Minutes are likely to reinforce the near-term consensus around unaltered policy settings and a unanimous vote in favour of unchanged policy at the March meeting. As with the US, the key theatre for policy and GBP is expected to be the labour market. Wednesday's labour market report is widely expected to see a tick down in the unemployment rate and tick up in wage growth. This sets the bar a little higher for a possible positive sterling reaction this week. The market's bias last week appears to be to cover long GBP positions that may have been established ahead of well publicised shareholder payments from the US to the UK. This may follow through to this week. However, we believe that investors may have placed too much faith in such flows supporting GBP. Rather, we see GBP strength partly driven by a re-rating of the UK's macro economic position. This leaves us looking to fade any initial move lower in GBP this week. This will remain our modi operandi while technical levels for GBP/USD (1.5960) and EUR/GBP (0.8380) hold.
China's Financial Instability | In recent months we've had periods of higher money market rates, increased CNH volatility and the first corporate default. There's also been market chatter about more defaults to come. Are recent falls in metal prices a sign of financial stress? Newswire stories suggest that the falls have been driven by small steel mills struggling to get finance, partly as a result of a government policy to consolidate the industry, and that a large share of iron ore in inventory has been used as collateral to finance lending. We'll be watching the CNY forward curve for evidence of potential financial stress to come.
NZD loses Race Not to Be First | So there may be life after ZIRP after all. The RBNZ delivered its expected rate hike and said there is more to come. While this has been well-heralded in their forecasts and statements for some time, 2yr swap rates still rose. While this helped support the NZD, investors are likely to have been disappointed that the central bank didn't sound hawkish on excessive exchange rate valuations. We expect strong technical resistance for the NZD/USD at 0.8600. However, with FX vols staying low more broadly, the NZD's carry is likely to remain attractive.
Go with the stronger AUD | Australian employment was stronger than expected in February. This is largely a pay-back for accelerated weakness in recent months that looked out of place against improved economic activity in Q4. It's wrong to see this as a turn in the weakening trend in the labour market, but it suggests the rise in unemployment remains gradual and the jobs market was better balanced in recent months. The RBA should remain firmly on hold, although with the housing market pointing to a rapid rise in residential building over the coming year, the bar is very high for a further rate cut. For now, we favour AUD/USD gains. However, the 200d moving average at 0.9153 may be a tough nut to crack.
CAD Ranges Persist | Our near-term bias still favours USD/CAD to trade lower as spot catches up with rate spreads, but mixed data in Canada and increased focus on elections in Quebec may keep USD/CAD firmly in recent ranges. CPI, on a y/y basis is likely to drop back to or below the bottom of the Bank of Canada's 1-3% range for inflation due largely to very restrictive base effects. Retail sales, coming off a weather impacted month, may be due for a sharp rebound in January. The upcoming April 7th election in Quebec may also start to garner increased attention as possible succession causes market jitters, but a recent poll from the Montreal based polling firm CROP found that 61% of Québécois oppose independence and the opposition Liberal party have improved in the polls in light of renewed discussion or a referendum."