FX Weekly: Institutional Sentiment Is Telling Us A Different Equity Story

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Includes: FXB, FXE, FXF, FXY, UUP
by: Rothko Research
Summary

Markets are still under pressure globally in this early week; the Japanese yen remains the favored currency in this current economic environment.

The fall in equities, yields in addition to the significant correction in oil prices have pushed down inflation expectations in the US.

With the 3M10Y yield curve currently trading at -30bps, fear over a 2020 economic downturn in the US has been surging.

The ECB is meeting on Thursday and is expected to extend its forward guidance, which could add more pressure on the single currency in the short run.

Macro News

Global: Following weeks of trade dispute, China issued a white paper on Sunday blaming that the escalating trade war has not ‘made America great again’ and have been actually impacting the US economy, increasing prices and production costs. Markets are still under pressure globally in this early week; Chinese and Japanese equities are down 11% and 8% in the past 6 weeks. The Chinese Yuan keeps trading within the 6.90 – 7 level as Chinese fundamentals have strongly disappointed, while the Japanese yen remains the favored currency in this current economic environment.

US: The rise in uncertainty and price volatility last month pushed investors out of risky assets; the SP500 index was down over 6% in May. A striking observation was the collapse in global yields, especially US Treasuries with the 10Y down almost 50bps. The US 10Y is trading slightly below 2.10, which corresponds to the 38.2% Fibo retracement of the 1.38% - 3.25% range. Hence, the fall in equities, yields in addition to the significant correction in oil prices (WTI front-month contract is down almost 22% since mid-April) have pushed down inflation expectations in the US. Figure 1 shows that after the Q1 rebound, the 5Y5Y inflation swap is trading at 2.08%, below its December levels. With the 3M10Y yield curve currently trading at -30bps, fear over a 2020 economic downturn in the US has been surging, with some economists estimating the probability of a recession at 60% by the end of next year.

Euro: Even though fundamentals have surprised positively in the Euro area since the beginning of the year, the interest-rate differential in addition to the political uncertainty have been weighing on the single currency in the previous months. The ECB is meeting on Thursday and is expected to extend its forward guidance, which could add more pressure on the single currency in the short run.

UK: Theresa May will meet Donald Trump on Tuesday for one of her last acts as she will step down as a leader of her party on Friday. The British pound has been weak in May against major currencies, but Cable’s weakness has not managed to lift up equities as the FTSE100 index has followed global equities in the past few weeks, down 7% since the end of April and now flirting with the 7,000 psychological support.

Figure 1

Source: Bloomberg

US Treasuries Net Specs

We saw a little decrease in net shorts in the past week (ending May 28) of a total of 37.6K contracts, mostly coming from a decrease of the 5Y and 10Y. The surprise was the large increase in shorts for the 2Y, up 69K contracts in the past week. The 2Y yield currently trades at 1.87%, down 110bps since its high reached in November, which is 50bps below the effective Fed Funds rate. Have we hit a low yet?

Figure 2

Source: CFTC

FX Positioning

EURUSD: The euro has been gradually weakening against the dollar since the beginning of the year on the back of rising pressure in Italy (pushing up the Italian-German spread) and a preference for the greenback in this period of elevated uncertainty. The pair is trading at around 1.1185, its 61.8% Fibo retracement of the 1.0330 – 1.2550 range. The trend still looks bearish and remain negative on the euro for the weeks to come.

Figure 3

Source: Eikon Reuters

GBPUSD: Cable looks slightly oversold according to the RSI indicator following the sharp sell-off in May. The pair is down almost 6 figures and currently trades at 1.2630, approaching its LT strong support at 1.25. Even though there is still strong uncertainty around the UK parliament, we think it would be good to start building a long position below the 1.25 level.

EURGBP: The pair has increased slightly in the past week, slowly approaching its next resistance at 0.8920, its 38.2% Fibo retracement of the 0.8310 – 0.93 range. EURGBP is overbought, however betting on a short-term pound rebound may be premature ahead of this week. We would stay out of it for the time being.

Figure 4

Source: Eikon Reuters

USDJPY: We are still short the pair as we like safe-havens such as the Japanese yen in this environment. The pair broke its ST support at 109.15 last week (the 50% Fibo retracement of the 99.60 – 118.70 range). All the major crosses (AUDJPY, EURJPY, GBPJPY) are also trending lower and seem to be on their way to retest their December lows.

Figure 5

Source: Eikon Reuters

USDCHF: The swiss franc also strengthened in the past week and is currently trading at 0.9960, which corresponds to its 200D SMA. We did not manage to go short, but we remain slightly bullish in the short run. We will try to short some at higher levels.

Chart of the Week

This chart from Deustche Bank shows the dynamics of global equity fund flows in US dollar terms since January 2008. With almost -$140bn of outflows since December, the total of outflows in the past 6 months have been larger than any prior period. It is interesting to notice the global equity rebound in Q1 did not stop the collapse in institutional sentiment, and that the record in stock buybacks combined with short covering and some limited re-leveraging were the main drivers of equities before May.

On the other hand, bond flows have experienced inflows of $220bn in the last 5 months, which was reflected by the fall in global yields. Trend-following strategies such as CTAs, which are usually built using simple momentum indicators, are still net long the SP500 on aggregate but have been starting to sell as the index has been hitting new support levels. Which institutional sentiment has the right economic view: equity or bund flows?

Figure 6

Source: Deustche Bank

Disclosure: I am/we are short 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.