FX Weekly: Should The Fed Really Stop Its Tightening Cycle?

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Includes: DCHF, DEUR, DGBP, DJPY, DRR, ERO, EUFX, EUO, FXB, FXE, FXF, FXY, GBB, JYN, UCHF, UEUR, UGBP, UJPY, ULE, URR, YCL, YCS
by: Rothko Research
Summary

Through the course of last year, there were many signs that were warning of a potential rise in price volatility before the October sell-off.

Global uncertainty should remain high in the coming months and we warned investors of an extended period of elevated price volatility in the beginning of this year.

We think that the current market pricing – no hikes for 2019 and 1 hike for 2020 – seems very pessimistic considering the current pace of the economic activity.

Macro News

Global: Through the course of last year, there were many signs that were warning of a potential rise in price volatility before the October sell-off in addition to the slowdown in leading economic indicators. A popular one that we like to watch is the Economic Policy Uncertainty (EPU) index developed by Bloom, Baker and Davis (2016); the chart shows that for the past three years, the relationship between the EPU index and the VIX broke down as the implied volatility did not react in periods of rising uncertainty, especially in 2016 and 2017. With the US experiencing its longest partial government shutdown, a rising number of speeches concerning Brexit and the degenerating situation in France, global uncertainty should remain high in the coming months and we warned investors of an extended period of elevated price volatility in the beginning of this year.

US: This week, banks should be on the target as they are the first ones to report their earnings. Equities rebounded by roughly 10% from the recent sell-off (according to Eikon Reuters), however we heard from market experts that the December hike may have been the last one of the cycle. With the 2Y10Y yield curve currently trading at 15bps, another hike would invert it and raise worries about a coming recession in the next 18 moths that follow. Is it really time for US policymakers to stop the Fed’s tightening cycle? We think that the current market pricing – no hikes for 2019 and 1 hike for 2020 – seems very pessimistic considering the current pace of the economic activity.

EZ: Industrial production fell sharply in November as the region’s core economies, Germany and France, continue to show a slowdown in the economic activity. The industrial output fell 3.3% YoY, raising investors’ doubt on the latest economic forecast for 2019 (where economists expect a 1.7% real GDP growth).

UK: The UK economy still faces a lot of uncertainty around Brexit negotiations, however Cable has been trending higher ahead of the parliament vote on Tuesday. At this stage, it seems very likely that the House of Commons will reject PM Theresa May’s Brexit deal, which means that uncertainty will remain as long as the parliaments finds a new solution. In case of a parliament failure to agree an alternative to May’s deal, the UK will end up in Hard Brexit.

Figure 1

Source: Eikon Reuters

Global Wage Inflation

As the Commitment of Traders report has not been updated due to the shutdown of the federal government, we share this week two charts on wage growth, which has been maintaining its sharp trend in the US, Euro zone and Japan. Our model has also been predicted a persistent rise in wages over the past few years.

Figure 2

Source: BlueBay Asset Management, Eikon Reuters, RR

FX Positioning

EURUSD: We saw some momentum in the euro last week on the back of a USD weakness ; EURUSD surged to 1.1570 before coming back towards 1.1450 (50 Fibo retracement of the 1.0340 – 1.2550 range. The trend looks still bullish, the next resistance on the upside is 1.1615 (200D SMA). We still like buying the euro on dips at the moment.

Figure 3

Source: Eikon Reuters

GBPUSD: Over the past couple of weeks, the trend on Cable has surprised a few traders as Sterling got strongly supported below the 1.25 level. The pair first broke its 1.2760 level (50D SMA), then continued its momentum to trade above 1.29 on Monday. It is now trading around 1.2870 – 1.2900, which corresponds to the 100D SMA and the 61.8% Fibo retracement of the 1.1980-1.4340 range. We stay aside for the time being as we may see a little sell-off following the results on Tuesday.

EURGBP: Sterling was on the play lately even though uncertainty around Brexit vote on Tuesday remains elevated. EURGBP broke its 0.89 – 0.8920 support zone and is currently flirting with the 0.8860 level (representing the 200D SMA). We think it may be worth buying EURGBP at current level (0.8880) with a ST target of 0.8980 and a tight stop at 0.8820.

Figure 4

Source: Eikon Reuters

USDJPY: As the volatility on the equity market seems to have eased over the past week, USDJPY has traded in a tight range. We bought some at 108 as we believe that a risk-on environment will tend to push the pair to higher levels. Uncertainty remains high, therefore being short yen is still risky at the moment, however we should see a little upside trend in the coming days.

Figure 5

Source: Eikon Reuters

USDCHF: The trend on USDCHF has been bearish over the past couple of months, the pair went down from 1.0130 to 0.9730 before edging back higher this week. The next resistance zone stands at 0.9890 – 0.9930, which represents the 200D SMA and the 61.8% Fibo retracement of the 0.9250 – 1.330 range. We don’t see any strong entry point for the time being.

Chart of the Week

The Wall Street Journal issued lately wrote an interesting article on Chinese corporate defaults. The rising cost of borrowing combined with a weakening Yuan could push more firms in difficulties in the coming years as the outstanding dollar-denominated Chinese corporate debt has more than doubled in the past 3 years. China total corporate debt is estimated at $4 trillion, of which $750bn is USD-denominated according to Nomura. As you can see it in the chart, 165 bonds worth CNY 157bn defaulted in 2018; even though it represents only 0.6% of the total outstanding value, it was more than the total default value of the 4 previous years.

This rise has strengthened the divergence between top quality AAA rated firms, which borrowing cost has decreased from 5.5% to 3.8% in the past year (5-year maturity), while AA- rate firms yield has remained flat at around 7%. A rising number of Chinese companies have been issuing new bonds to raise money to pay off their current obligations, and therefore a declining demand for new bond issuance combined with a tight domestic credit supply could accelerate the process in 2019. We don’t think there is an imminent to the Chinese corporate bond market, however investors should closely watch the credit spreads this year, especially the non-state-owned companies that tend to have a lower credit ratings (AA- or lower).

Figure 6

Source: Wall Street Journal

Disclosure: I am/we are long EURGBP, USDJPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.