Great Chart: ECB Total Assets vs. EuroStoxx50 (18M Lag) – Yearly Change

One of the main topics of the year is the central banks’ balance sheet unwind, and the potential effect it can have on asset prices. As JP Morgan (and other sell-side institutions) pointed out, if we look at the annualized monthly net bond flows, the top 4 central banks (Fed, ECB, BoE and BoJ) will switch to net sellers in October 2018 (here). BNP Paribas published an interesting chart lately of the weighted average 10-year G4 bond yield overlaid with the G4 monthly bond purchases (here); we can clearly see that the increase in the total purchases has helped to push overall 10Y yields on the downside since 2010, hence eased financial conditions and stimulated the refinancing activity. However, what will happen to LT yields now that the purchases are expected to fall in 2018?

Many market participants have argued that the constant increase in central banks’ balance sheet has levitated all asset classes, and particularly the stock market; therefore, one economic area we are watching closely during the unwind is the Euro zone. If we look back three years ago, when Mario Draghi announced the launch of the 60-billion Euro bond-buying program on January 22nd, 2015, the ECB balance sheet was totaling 2.15tr Euros and the equity market EuroStoxx50 was trading at 3,400. As of today, the central bank’s assets are north 2.3tr Euro (the ECB balance sheet surpassed the Fed’s one last summer and is now worth 4.5tr Euros), while the EuroStoxx50 Index is up a mere 200pts, currently trading at 3,600 (here). We can clearly notice that the ECB effect on European equities was non-existent. It looks like the European equity market has been a dead market over the past couple of years; the Eurostoxx 50 has been trading sideways within an 800-point range between 2,900 and 3,700 and sits at its 50% Fibonacci retracement from its mid-June-2007 peak to Feb-2009 trough.

Hence, we chose this week to overlay the yearly change in the ECB balance sheet’s total assets with the yearly change in the equity market (18-month lag). As you can see, the two times series have shown some co-movements since the Great Financial Crisis; a decrease in the ECB assets is usually associated with a negative YoY performance in the EuroStoxx50 18 months later. For instance, the ECB balance sheet yearly change switched from +60% in June 2012 to -24% in January 2014 amid early LTROs reimbursement by European banks. If we look at the lagged performance of the equity market, the yearly change in the EuroStoxx50 index went from +20% in the summer of 2012 to -18% in June 2014.

In October 2017, the ECB cut its bond-buying program to 30bn Euros a month starting January 2018 for a period of 9 months, and the market expects that the central bank will taper QE to final three months of the year. With the yearly change on the ECB assets starting its downward trend, our question is the following: will the growth and investment story in the Euro area offset the expected downturn in equities?

Chart: ECB Total Assets vs. EuroStoxx50 (18M Lag) – Yearly Change (Source: Reuters Eikon)

ECB vs Asset.png

Great Chart: Gold vs. US 5Y Real Yield

We showed in many of our charts that 2017 was the year where some of the strong correlations between assets classes broke down. We showed USDJPY vs. TOPIX (here, here), Cable (here) and EURUSD (here) vs. the 2Y and 10Y interest rate differentials, and this week we chose to overlay Gold prices with 5Y US real interest rates. As we explained it in our study on Gold (here), the relationship between Gold and US [real] rates is easy to understand. The precious metal is a non interest-bearing asset, meaning that a typical investor doesn’t get any cash-flow from owning it (unlike dividends for stocks and coupons for bonds), and has usually a storage cost associated with it. Therefore, the forward curve of the ‘currency of the last resort’ (Jeffrey Currie) is usually upward sloping, in other words Gold market is in contango, with the forward price equal to the following:

Reg.PNG

Hence, if real interest rates start to rise, a rational investor would prefer to reallocate his wealth to either US Treasuries or Treasury Inflation Protected Securities (TIPS) and receive coupons rather than keeping a long position in a commodity that has a ‘negative carry’.

As you can see it on the chart, Gold prices (in US Dollars) and the 5Y TIPS real yield have shown some strong co-movements over the past 5 years, until the summer of 2017 when the two times series diverged. If we would follow recent moves on the market, the late surge in Gold prices (currently trading at 1,340 $/ounce) would imply a 50 to 60 bps decrease in US real interest rates (note that if we regress the change in Gold prices on the change in the 5Y real yield using weekly data since 2013, we find that a 1% increase in real yields lead to an 8.7% depreciation in Gold prices). And lower real rates would either come from higher inflation expectations or lower nominal interest rates. With the 5Y5Y forward inflation swap currently trading at 2.11% and up 30bps over the past 6 months, core inflation and core PCE YoY rates at 1.8% and 1.5% slightly moving to the upside, and oil prices still trending higher with WTI front month contract trading at $64.5, there is room for higher inflation prints coming ahead. However, if the two curves were to converge in the short term, the [sharp] move would come from either [lower] Gold prices or [lower] Treasury rates.

Our view is that the divergence will persist in the beginning of 2018, with inflation remaining steady / slightly increasing and US interest rates failing to break new highs on the long end of the curve (5Y and 10Y). The main reason for that is that we think market’s confidence on the Fed’s 4 or plus hikes will slow down in the coming months on the back of lower-than expected fundamental, depriving the yield curve from steepening too much.

Chart: Gold prices vs. US 5Y TIPS (inv.) (Source: Reuters Eikon) 

WeeklyGold.PNG

 

Great Chart: SP500 vs. US 2Y10Y Yield Curve

Historically, research has shown that the difference between long-term and short-term interest rates (‘Yield Curve’ or ‘Time Spread’) has shown some significant negative relationship with subsequent real economic activity in the United States, with a lead of about four to six quarters. Hence, with the current low levels of the US yield curves (2Y10Y or 5Y30Y), we chose today this week to overlay the 2Y10Y yield curve with the SP500.

If we say that low yield curves tend to predict recessions, then the question now relies on quantifying a low level of the yield curve. We hear from many analysts that the current levels are very low, however if we look back at 40 years of data, the US yield curve levels are not that far away from their long-term averages. For instance, the 2Y10Y and 5Y30Y slopes are currently trading at 51bps and 53bps, while their LT averages stand at 95bps and 82bps, respectively (see here). One main reason why yield curves have been crashing over the past few months is mainly due to an increase in the front-end of the US curve on a back of a shift in expectations of monetary policy. The US 2Y interest rate is now trading at 1.96%, its highest level since September 2008. On the other hand, the 10Y yield stands at 2.46%, has been ranging between 2% and 2.6% over the past year and is up 110bps from its historical low of 1.36% reached in July 2016.

The chart below shows the importance that even if the yield curve turns negative in the US, the equity market has still upside potential in the following months. In our first observation, the 2Y10Y time spread went negative in February 2000, while the SP500 continued its rally and reached a peak in September the same year. In the second one, the yield curve inverted in June 2006 (if we ignore the Jan-Mar 2006 episode) while equities continued to rise for more than a year, peaked in October 2007, and the US plunged into the Great Depression in December 2007.

We don’t think that the current levels of the yield curves are actually alarming for the US economy and we may see a potential floor in the first quarter of this year as we believe that market participants’ (over)excitement on the Fed potential hikes will ease in the medium term. The probability of 4 or more hikes has soared to 12.1%, which pushed the front end of the US curve on the upside and explains the sharp flattening we saw in 2017 (from 1.27% to 0.5%). However, if we look at the EuroDollar futures market, the December 2018 contract currently trades at 97.81, suggesting that investors are pricing in a ST interest rate of 2.19% by the end of the year (see here). This analysis also confirms our bearish view on the US Dollar for 2018 (especially against the Euro).

Chart: SP500 (yellow, rhs) vs. US 2Y10Y Yield Curve (Source: Reuters Eikon)

Yield Curve.PNG

Great Chart: Cable vs. 2Y UK – US IR Differential

As for EURUSD and the 10Y interest rate (IR) spread (here) or for USDJPY versus the equity market (TOPIX, see here), the same interesting divergence has been occurring between Cable and the 2Y IR differential. We mentioned in many of our posts that the interest rate differential (either short term 2Y or long term 10Y) has been considered as one of the main drivers of a currency pair for a long time. For instance, in our BEER FX Model, we used the terms-of-trades, inflation and the 10-year interest rates differentials for our cross-sectional study, using the US Dollar as the base country and currency (see post here).

Hence, if you look back over the past few years, there is a significant co-movement between the two times series. As you know, the ST 2Y IR differential reflects the expected announcements from either UK or US policymakers concerning the future path of the target IR set by the central bank. For instance, between summer 2013 (when Governor Carney took office at the BoE) and summer 2014, the 2Y IR differential went up from 0 to 45bps on the back of strong UK fundamentals (fastest growing economy in G7 in 2014) and market participants starting to price in a rate hike as early as Q4 2014 or Q1 2015 according to the short-sterling futures contract (see July 2014 update). The increase of both the 2Y IR differential and the short-sterling futures implied rate brought Cable to its highest level since October 2008 at 1.72 in July 2014. However, both trends reversed that summer with the US Dollar waking up from its LT coma and the UK starting to show some weaknesses in its fundamentals. At that time, we entered a 2Y+ Cable bear market, and if we omit the pound ‘flash crash’ in early October 2016 and set the low at 1.20, Cable experienced a 30-percent depreciation. Therefore, this fall moved the British pound from being a slightly overvalued currency to a clearly undervalued currency if we look at some broad measures such as the real effective exchange rate (REER). According to the REER, the Pound is 15% far away from its 23Y LT average (GBP REER).

If we look at the last quarter of 2017, despite a 50bps drop in the 2Y differential (currently trading at -1.44%), Cable found support slightly below its 100D SMA each time and the pair has shown strong momentum since the beginning of the year. We believe that the strong decrease in the IR differential lately comes from an (over) confident market pricing in three Fed hikes next year (probability of 4 or more rate hikes stands at 9% in 2018). However, we think that this current excitement may slow down in Q1 2018, hence readjust the IR differentials, which is going to be positive for the British pound against the greenback. In our view, the 1.40 level seems reasonable for Cable in the medium term (1-3M), which corresponds to the 38.2% Fibonacci retracement of the 1.20 – 1.72 range.

Chart: GBPUSD vs. 2Y IR differential (blue line, rhs) Source: Reuters Eikon

Cablevs2Y.PNG

Monetary Policy Coordination: From Global Easing to Global ‘Tightening’

Abstract: An interesting series of central-bank announcements over the past semester confirmed our view of a global central banking monetary policy coordination. The first two major players that hinted in a speech that the central bank might slow down their asset purchases were the ECB and the BoJ; but more recently we heard hawkish comments coming from the BoC, RBA and even the BoE. In this article, we first review the quantitative tightening (or the Fed balance sheet reduction program), followed by some comments on the current situation in the other major central banks combined with an FX analysis.

Link ==> US Dollar Analysis 2

Introducing the 3D challenge – Debt, Demographics and Disruption (with a US case study)

Abstract: As a response to the Financial Crisis of 2008, central banks have been running persistent loose monetary policies (NIRP and aggressive asset purchase programs) in order to generate some growth and inflation. Even though the measures chosen by policymakers mainly came from the burst in the housing market (US and Europe), developed economies have also been cornered with another long-term big issue: the 3D problem – Debt, Demographics and Disruption. Demographics reveal a dramatic aging of the developed world’s population (‘Baby Boom effect’), which has been playing a role in the desire of consumers to save more than actually spend. In addition, the long-term solvency of public and private plans has also been a growing concerns across the developed nations, adding pressure on current workers to increase their amount of savings based on a shift in expectations of higher taxes to sustain the secular change in demographics. The effect of an increase in savings have been one of the main factors of a decrease in inflation expectations across the world in addition to a sluggish growth, forcing policymakers to maintain a loose monetary policy, cutting rates to even negative territory and diversifying the asset purchase programs (corporate bonds, ETF and Real estate). The slowdown of inflation, and even deflation for some countries, is an issue for developed nations as it increases the country’s debt in real terms, putting the country under pressure and questioning its long run sustainability.

We then look at the US economy for our case study on the 3D problem. Our analysis is composed of three sections: in the first one we quickly review US demographics challenge, then in the second section we present the US Federal and Household debt, and in the third part we introduce Disruption in different sectors of the US economy.

Link ==> 3D Problem

Rising US corporate default rates during a tightening monetary policy cycle

In this study, we mainly focus on the refinancing issues that US [non-financial] companies will face within the next five years as a lot of corporations are trading at a distressed price (or yield) due to the lack of global growth and low commodity prices. In the first session, we review the US credit market structure. Then, the second session introduces a two-state Markov switching model (Hamilton, 1989), followed by a presentation of the paper Corporate bond default risk: a 150-year perspective (Giesecke & al., 2011), a study that uses a set of macroeconomic and financial variables to forecast default rates in the US. In the third Section, we comment the potential change in the explanatory variables since 2009 and we discuss a solution to avoid a new clustered default event over the next five years.

Link ==> Studies on Corporate Defaults

Retracing the US Dollar Q4 rise…

An important topic that has been making the headline over the past few weeks is the new surge of the US Dollar (vis-à-vis the major currencies) in the last quarter of 2016. Since its Obama Rise peak that occurred in mid-March 2015 (after a 25% appreciation), the US Dollar has been ranging against most of the major currencies (except the British pound due to political uncertainty and post-Brexit effect in June, and more recently the Mexican peso). The main reason for that long period of stagnation, in my opinion, was a shift in expectations of monetary policy in the US. After the Fed stepped out of the Bond Market (on October 28th 2014), market’s participants have been mainly focusing on the short-end of the curve, questioning themselves if the Fed was going to start a tightening monetary policy cycle. We saw a hike in December 2015 (25bps), which was immediately halted due to the market sell-off that followed afterwards (13% drawdown in US equities, 20% in Europe and Japan…). Therefore, the implied probability of a second hike in 2016 crashed, which was confirmed by the 7 FOMC meetings that followed (i.e. status quo).

Then, interest in the US Dollar started to emerge again in Q4 2016; the greenback experienced a 8%+ appreciation between October 1st and its December high of 13.65 (28th) according to the DXY index (Chart 1). There are a number of explanations to that recent surge: market was gradually pricing in a rate hike for the December meeting, political uncertainty rising in Europe or Infinite QE in Japan to protect the yield curve. All these stories make sense to explain the Dollar appreciation, therefore let’s retrace the important events that occurred in the last quarter of 2016.

Chart 1. US Dollar index in 2015-2016 (Source: Bloomberg)

usdollarhis

  1. Higher inflation and a positive post-Trump effect

First of all, the rebound in oil prices relieved pressure on energy-related companies [that have been falling one by one, applying to Chapter 11 bankruptcy] and had a positive effect on expected inflation. The price of a barrel has doubled since its February’s low of $26 and is currently trading slightly below $54 (Chart 2, red line) and obviously relieved US policymakers’ inflation anxiety. The 5Y5Y inflation swap forward (Chart 2, white line) stands now at 2.42%, higher than the 1.80% recorded last June. As a consequence, US long-term yields followed the move and the 10-year Treasury yield surged from a low of 1.36% reached in July last year to 2.44% today. With the unemployment rate below 5% and a Q3 GDP growth of 3.5% (annual QoQ), it seems inflation had been the main concern of the Fed’s officials in order to start tightening [again].

Therefore, on December 14th, US policymakers decide to raise the federal funds rate by 25bps to 0.5%-0.75% [and the discount rate from 1% to 1.25%], repeating a gradual policy path plan with three potential hikes in 2017. Even though it was considered to be the most ‘priced in’ hike of any Fed meeting ever, it pushed the implied rates to the upside with the current OIS (Chart 3, purple line) trading almost 1 percent above the OIS at the September meeting (Chart 3, red line). This change in implied rates was reflected in the Dollar appreciation.

Chart 2. US inflation overlaid with Oil Prices and US 10-year yield (Source: Bloomberg)

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Chart 3. Fed’s dot plot and implied rates (Source: Bloomberg)

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We were not very surprised when the Fed officials announced the rate hike, however we were wondering if we would have seen such optimism if equity markets ‘followed’ the global bond sell-off after the election (Trump effect). The positive US equity market reaction to Trump’s victory also comforted US policymakers for the December’s hike; we strongly believe that the decision would have been much harder if they had to deal with a sudden equity sell-off. Instead, the SP500 reached new record highs (2,277) last months.

One explanation of this development is based on investors’ expectation of an expansionary fiscal policy that will boost economic growth and inflation in the future, which are usually positive news for equities and negative news for bonds in theory (see Four Quadrants matrix – image 1).

Image 1. The ‘Four Quadrants’ framework (Source: Gavekal Research)

  Quandrant.png

   2. Political uncertainty rising in Europe, the rigger of many ‘forgotten’ problems

A popular trade that was running in the last quarter of 2016 was to be long the Italian-German 10-year spread ahead of the Italian referendum that occurred on December 4th. Market was pricing a potential rejection (55% chance), leading to an increase in political uncertainty in Europe, rising spreads between periphery and core and weakening the Euro.

If we look at Chart 4, we can see that the spike in the Italian 10-year yield (Chart 4, white line) could explain the Euro weakness (hence, USD strength). While the 10-year yield increased from 1.20% to 2.20% in two months (October and November), EURUSD (Chart 4, red line, inverted) went down 7 figures and reached a new low of 1.0350 post-referendum (59.1% of voters rejected the reform bill, which was followed immediately by PM Renzi’s resignation).

Even though yields have been decreasing over the past month (the 10-year now standing at 1.73%), political uncertainty could be the trigger of the two ‘delayed’  and ‘forgotten’ issues [or Black Swans] in Europe: the weak banking system and the Sovereign debt crisis. Not only Italy (in this case) cannot survive with higher yields (the country has 2.34 trillion EUR of outstanding debt – 132.6% of GDP – which needs to be rolled with low yields), but a sell-off in equities will increase the percentage of NPLs and potentially forced their banks to bail-in their depositors. The failure of Monte Paschi di Siena’s plan to raise 5-billion euros in capital from the market was ‘solved’ by a Nationalization (the bank’s third bailout). It was announced that the government will own at least 75% of the common equity after the bank is nationalized, a rescue that will cost the Italian government (i.e. taxpayers) about 6.6bn Euros according to the ECB (4.6bn Euros are needed to meet capital requirements and 2bn Euros to compensate the retail bondholders).

Therefore, We strongly believe that we will hear other similar stories in the year to come, as Italy is not the only country facing non-performing loans (NPLs) issues that affect the banking sector. Therefore, political uncertainty in Europe will weigh on the single currency and increase investors’ interest to the US Dollar.

Chart 4. Italian 10-year yield versus EURUSD (inv.) (Source: Bloomberg)

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   3. The weakness in the Japanese Yen

In Japan, the BoJ introduced the ‘Yield Control’ operation in order to stabilize the steepness of the JGB yield curve, offering to buy an unlimited amount of debt at fixed yields to prevent a significant surge in rates. This is kind of a puzzle, as Japan Officials cannot afford higher yields [as many indebted developed nations], however too-low yields impact revenues of the banking system and the pension / mutual funds.

We don’t think the particular surge in USDJPY was explained by this new ‘BoJ Operation’ and We prefer to say that the Yen depreciation was a result of a Risk-on effect post-US election result in addition to the recent spike in US yields. USDJPY (Chart 5, candlesticks) trades above 117 and equities (Chart 5, red line) are above the 19,000 level for the first time since September 2015; and you can see how the increase in US yields (Chart 5, blue line) is ‘responsible’ to the Yen weakness.

The question now is to know if the late Q4 Yen weakness will persist in early 2017, with USDJPY pair attracting more and more momentum investors looking to hit the 125 resistance. We know historically that the [positive] trend on the USDJPY can halt [and reverse] very quickly if investors are suddenly skeptical about the global macro situation (Fed delaying its 2017 hike path, China liquidity issues or rising yields in peripheral European countries). On the top of that, if market starts to price in inflation in 2017, will the BoJ be able to counter a JGB tantrum and keep the 10-year JGB yield at around 0%?

One important thing about this recent Yen weakness though is that it allows the Japanese government to buy time in order to implement new reforms and increase productivity. If you remember well, Abe stated in September 2015 his 20% increase in Japan GDP in the medium term (increase from 500tr to 600tr Yen in 5 years).

Chart 5. USDJPY, Nikkei 225 and US 10-year yield (Source: Bloomberg)

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   4. The Chinese Yuan devaluation

Another currency that has been making the headlines is the Chinese Yuan. Over the past year, the Chinese Yuan has shed roughly 7 percent of its value against the greenback (Chart 6, USDCNY in candlesticks). At the same FX reserves (Chart 6, blue line) have been shrinking; reserves plunged by $69.1bn to $3.05tr in November (most in 10 months), bringing the reduction in the stockpile to almost USD 1tr from a record $4 trillion reach in June 2014. As Horseman Capital noted in their article on China (Is China running out of money?), if FX reserves continue to plummet and the PBoC wants to maintain control of the exchange rate, Chinese officials will face some difficult choices. One option would be to raise interest rates (the benchmark one-year lending rate stands currently at 4.35%) in order to reduce outflows and attract interest in the Yuan (high interest rate differential vs. the other countries). This would have a negative effect on the country’s growth outlook, which is already concerning the developed economies due to the high levels of corporate debt and overheated property markets. Another option would be to reduce the holding of deposits by cutting the reserve requirement rate (RRR) which stands currently at 17%. We can see in Chart 7 that the Asset-Liabilities spread (represented by Foreign Currency Assets and Deposits from Other banks) has narrowed drastically over the past year, therefore cutting the reserve rates for banks could be a temporary solution for the PBoC. The problem of the second option is that it will continue to weaken the Chinese Yuan vis-à-vis the US Dollar, which could increase political tensions between US and China.

Interestingly, an asset that has [sort-of] tracked the USDCNY move this year is the Bitcoin (Chart 6, red line) , which raised from $400 in January last year to over $1,000 today. The cryptocurrency was described as the ‘good’ instrument to circumvent capital control in China in periods of large capital outflows like today. Like gold, Bitcoin is readily available in China and can be sold for foreign currencies without problems and therefore have attracted a lot of buyers over the past year.

Chart 6. USDCNY, Bitcoin and Chinese FX reserves (Source: Bloomberg)

Chart 7. PBoC Balance Sheet (Source: Horseman Capital)

PBoCBaS.JPG

To conclude, there are several factors explaining the US Dollar strength in the last quarter of 2016, and it looks like the trend should continue in early 2017 (extreme monetary policy divergence to persist in 2017, black swan events coming from Europe, difficulties of Chinese officials to deal with the capital outflows…). However its trend cannot persist indefinitely as we know that it will eventually have negative effect on the US economy in the long term. For instance, we know that a strong dollar hurts US companies’ earnings, which is already a problem if we look at the 12-month forward earnings (Chart 8, green line). In addition, if long-term interest rates increase persistently in the future (breaking through the 3-percent level seen in the 2013 taper tantrum), the US could face a budget crisis: how is the government going to fund its budget deficit [which is expected to grow over USD 1 trillion again under Trump presidency] if China and other central banks are liquidating US Paper at record pace?

Chart 8. SP500 overlaid with 12-month forward earnings (Source: Bloomberg)

ForwardEarnings.JPG

FX positioning ahead of the September FOMC meeting

As of today, most market participants are getting prepared [and positioned] for the FOMC meeting on September 20/21st in order to see if policymakers stick with their Jackson-Hole hints, therefore we think it is a good time to share our current FX positioning.

Fed’s meeting: hike or no-hike?

We think that one important point investors were trying to figure out the last Jackson Hole Summit last week was to know if US policymakers were considering starting [again] their monetary policy tightening cycle after a [almost] 1-year halt. If we look at the FedWatch Tool available in CME Group website, the probability of a 25bps rate hike in September stands now at 18% based on a 30-day Fed Fund futures price of 99.58 (current contract October 2016, implied rate is 42bps).

CME.png

(Source: CME Group)

In addition, if we look at the Eurodollar futures market, the December Contract trades at 99.08, meaning the market is pricing a 1% US Dollar rate by the end of the year. We can clearly notice that the market expects some action coming from US policymakers within the next few months. However, recent macroeconomic data have shown signs of deterioration in the US that could potentially put the rate hike on hold for another few months. Following last week disappointing manufacturing ISM data that came out at 49.4 below its expansion level (50), ISM Service dropped to 51.4, its lowest number since February 2010 and has been dramatically declining since mid-2015. We strongly believe that there are both important indicators to watch, especially when they are flirting with the expansion/recession 50-level. We can see in the chart below that the ISM manufacturing PMI (white line) tracks really ‘well’ the US Real GDP (Annual YoY, yellow line), and as equity markets tend to do poorly in periods of recession we can say that the ISM Manufacturing / Services can potentially predict sharp drawdowns in equities.

Chart 1. ISM – blue and white – and Real US GDP Annual YoY – yellow line (Source: Bloomberg)

ISM_US.JPG

Another disappointment came from the Job market with Non-Farm Payrolls dropping back below the 200K level (it came out at 151K for August vs. 180K expected) and slower earnings growth (average hourly earnings increased by 2.4% YoY in August, lower than the previous month’s annual pace of 2.7%).

This accumulation of poor macro figures halted the US Dollar gains we saw during the J-Hole Summit and it seems that the market is starting to become more reluctant to a rate hike in September. The Dollar Index (DXY) is trading back below 95 and the 10-year rate is on its way to hit its mid-August 1.50% support (currently trades at 1.54%). What is interesting to analyse is which currency will benefit most from this new Dollar Weakness episode.

FX positioning

USDJPY: After hitting a high of 104.32 on Friday, the pair is once again poised to retest its 100 psychological support in the next few days. This is clearly a nightmare for Abe and Kuroda as the Yen has strengthen by almost 20% since its high last June (125.85). If we have a look at the chart below, the trend looks clearly bearish at the moment and longs should consider putting a tight top at 105. we would stay short USDJPY as we don’t see any aggressive response from the BoJ until the next MP meeting on September 21st.

Chart 2. USDJPY candlesticks (Source: Bloomberg)

EURUSD: Another interesting move today is the EURUSD 100-SMA break out, the pair is currently trading at 1.1240 and remains on its one-year range 1.05 – 1.15. As a few articles pointed out recently, the ECB has been active in the market since March 2015 and has purchased over 1 trillion government and corporate bonds. The balance sheet total assets now totals 3.3 trillion Euros (versus 4 trillion EUR for the Fed), an indicator to watch as further easing announced by Draghi will tend to weigh on the Euro in the long run. The ECB meets in Frankfurt on Thursday and the market expect an extension of the asset purchases beyond March 2017 (by 6 to 9 months). We don’t see a further rate cut (to -0.5%) or a boost in the asset purchase program for the moment, therefore we don’t think we will see a lot of volatility in the coming days. we wouldn’t take an important position in the Euro, however we can see EURUSD trading above 1.13 by Thursday noon.

Chart 3. EURUSD and Fibonacci retracements (Source: Bloomberg)

Another important factor EU policymakers will have to deal with in the future is lower growth and inflation expectations. The 2017 GDP growth expectation decreased to 1.20% (vs. 1.70% in the beginning of the year) and the 5y/5y forward inflation expectation rate is still far below the 2-percent target (it stands currently at 1.66% according to FRED).

Sterling Pound: New Trend, New Friend? The currency that raised traders’ interest over the past couple of weeks has been the British pound as it was considered oversold according to many market participants. Cable is up 5% since its August low (1.2866) and is approaching its 1.35 resistance. We would try to short some as we think many traders will try to lock in their profit soon which could slow down the Pound appetite in the next few days. If 1.35 doesn’t hold, then it may be interesting to play to break out with a new target at 1.3600.

Chart 4. GBPUSD and its 1.35 resistance (Source: Bloomberg)

GBP.JPG

We would short some (GBPUSD) with a tight stop loss at 1.3520 and a target at 1.3350. No action expected from the BoE on September 15th, Carney is giving the UK markets some ‘digestion’ time after the recent action (rate cut + QE).

USDCHF: For the Swissie, our analysis stands close to the Yen’s one, and therefore we think the Swiss Franc strength could continue in the coming days. we like 0.96 as a first ‘shy’ target, and we would look at the 0.9550 level if the situation remains similar (poor macro and quiet vol) in the short term.

AUDUSD: Australia, as many other commodity countries (Canada, New Zealand), remains in a difficult situation as the deterioration of the terms of trade will tend to force RBA policymakers to move towards a ZIRP policy. However, lower rates will continue to inflate housing prices, which continue to grow at a two-digit rate. According to CoreLogic, house prices averaged 10-percent growth over the past year, with Sydney and Melbourne up 13% and 13.9%, respectively. Australian citizens are now leverage more than ever; the Household debt-to-GDP increased from 70% in the beginning of the century to 125% in Q4 2015 (see chart below). This is clearly unsustainable over the long-run, which obviously deprives policymakers to lower rates too ‘quickly’ to counter disinflation. As expected, the RBA left its cash rate steady at 1.50% today, which will play in favor of the Aussie in the next couple of weeks. One interesting point as well is that the Aussie didn’t react to an interest rate cut on August 2nd, something that Governor Glenn Stevens will have to study in case policymakers want to weaken the currency. There is still room on the upside for AUDUSD, first level stands at 0.7750.

Australia.png

(Source: Trading Economics)

Chinese Yuan: The Renminbi has been pretty shy over the past two month, USDCNH has been ranging between 6.62 and 6.72. The onshore – offshore spread is now close to zero as you can see it on the chart below (chart on the bottom). We don’t see any volatility rising in the next few weeks, therefore we wouldn’t build a position in that particular currency.

Chart 5. CNY – CNH spread analysis (Source: Bloomberg)

CNH spread.JPG

 To conclude, we think that we are going to see further dollar weakness ahead of the FOMC September meeting as practitioners will start to [re]consider a rate hike this time, especially if fundamentals keep being poor in the near future.