July 29

Hikers Vs Holders

Today is the first day in some time that there has been obvious and even broad dollar strength. The Dollar rally began during the London session and took another leg higher after the great consumer confidence numbers that came out at 10am. The trends we see with today’s price action should provide valuable clues for how markets will react to broad dollar outperformance. Dollar strength has been seen against all G10 currencies as well as EM, while stocks are flat after giving up early gains. Gold is down about a half percent. Most strangely US rates are tame in the long end as 10 yr yields are almost unchanged at 2.46%. In the last 24 hours most of the action has been seen in the 2 year area of the curve, with yields popping from 0.49% to 0.54% after the treasury auctioned off $29bn in 2 year notes at the lowest bid to cover ration since March. Demand for short end notes seems to be on the decline as the market starts to position for a more hawkish Federal reserve.

As the Fed and BoE move away from easy money, it will be interesting to watch the overall dynamic of FX markets change from a low volatility environment to a situation in which trends will likely be long and pronounced. I like to categorize the major G10 currencies into hikers and holders.

HIKERS:

GBP:  The Bank of England is preparing for what will likely be a November start to hiking rates, as recent key data points have seen the unemployment rate at 6.5% and an inflation rate of 1.9%. The latetest MPC minutes have still shown unanimous support for the current 0.50% rate, but new economic projections are due out during the August meeting which will likely prompt an shift towards outlining when the first hike will occur. Markets are currently pricing in 17bps of hikes for the November metting, so a little better than 50% chance.

USD: FOMC centrists Bullard and Fisher have adjusted their stance in recent weeks to reflect the overall attitude that the FOMC is significantly closer to its mandate targets than its own policies would suggest. Members of the committee are now openly implying that the Fed s already behind the curve. With CPI at 2% and Unemployment at 6.1%, the Fed must make a shift in language to observe the improvements in the economy that have been occurring. There are 18bps of hikes priced in for April 2015, with the first full hike not priced in until the June meeting.

Generally I see the market as slightly too hawkish on the GBP and much too dovish on USD, therefore I will remain short GBPUSD until expectations are a little more sensible.

HOLDERS:

AUD: RBA Governor Stevens shifted towards a slightly more dovish stance in recent weeks, stating that the AUD is not responding as it should to declines in iron ore prices. Markets are starting to price in possible rate cuts from the RBA around the turn of the year with 50% chance of a rate cut priced into December futures. We could see a return to the January 2014 situation in which Stevens is jawboning the Aussie lower while the Dollar is supported by expectations of a strong US economy. The Aussie economy is seeing a rising unemployment rate, but a booming housing sector that has likely been boosted by easy Fed policies. Governor Stevens himself has stated that the AUDUSD is likely to decline significantly once the FOMC moves to normalize policy.

EUR: Mario Draghi must be pleased to see the EURUSD nearly 600 pips lower from where he originally uttered that the governing council was comfortable acting. The ECB will be firmly on hold to observe the impacts of its recent easing measures. September will see the first round of TLTROs go out to banks and the stress test results will be released in October. It is debatable how much the market currently expects government bond buying QE program, while you can be sure that ABS buying QE is likely already priced in. The one danger with the EUR, is that if inflation recovers more quickly than markets currently expect the EUR may squeeze what has become a crowded short trade but EURUSD will remain a sell on rallies.

JPY:  The Bank of Japan is in an awkward position as recent data has showed that its progress on stimulating inflation has slowed. Core CPI is at 1.3% (after stripping out sales tax effects), down from the recent 1.5% April high. The trade deficit is also expanding unexpectedly with June showing a deficit of $8bn as the first half of 2014 saw the largest total traded deficit on record (since 1979). The small bump in exports has been outweighed by the massive increase in the cost of energy as nearly all nuclear plants have closed down. Prime Minister Abe is likely to proceed with another increase in the national sales tax next year, which could add to headwinds for the economy. Gains in CPI from a weaker Yen have waned as USDJPY has been in a tight range for nearly 8 monthsThe bottom line here is that the BoJ still desperately needs its QE program in place, and this will continue to be the case for some time.

EUR and JPY now sport a nearly even overnight rate of around 0.05bps and will likely be a great vehicle to express any views on a possible rebound in Eurozone inflation.

As we close in on the Bank of England and the Federal Reserve normalizing policy, enormous opportunities will be available as global monetary policies diverge. Buying hikers and selling holders seems to be a very sensible way to play these upcoming trends. Relative value opportunities are also available with currencies that have similar interest rates.

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