FX Weekly: Preparing For Easing Policies

by: Rothko Research

To the exception of global equities, it is clear now that most of the asset classes are pricing in a significant slowdown in the economic activity in the medium term.

Institutional investors’ sentiment is getting extremely bearish on the future of the economy and fear over a global 2020 recession is rising.

Could central banks prevail global equities from falling?

Macro News

Global: To the exception of global equities, it is clear now that most of the asset classes are pricing in a significant slowdown in the economic activity in the next few quarters to come. We saw last week the strong outflows in global equities, which totaled almost $140bn since December, while global bond funds have kept receiving inflows since the beginning of the year, up $261bn according to Deutsche Bank. Institutional investors’ sentiment is getting extremely bearish on the future of the economy and fear over a global 2020 recession is rising.

With the Dec19-June19 and Dec20-Dec-19 implied ST yield curves currently trading at -44bps and -27bps, the Eurodollar market is currently pricing in 3 rate cuts by the end of next year, diverging significantly from equities as you can see it in figure 1. Even though solid leading indicators have been pricing in a sharp slowdown in companies’ earnings within the next 12 months (i.e. semiconductor sales vs. global EPS), some practitioners have stated that global rate cuts in addition to a new round of QE could prevail equities from falling and therefore send them to new all-time highs. Could central banks really prevail global equities from falling?

Euro: Following the sharp fall in inflation expectations, with the 5Y5Y inflation swap trading below 1.3% this month, the ECB also followed the trend with policymakers mentioning that they are ‘determined’ to act if global uncertainty persists in the medium term amid the ‘rising threat of protectionism’. Even though the deposit rate is already at -0.4%, the ECB hinted the market that it will do whatever it takes (again) to prevail inflation expectations from falling. It seems that Euro policymakers are already trying to counter the potential appreciation of the euro in case the Fed starts cutting rates this summer. With European banks trading at depressed levels (with Deutsche Bank’s stock below EUR 6), what will happen if we have another ECB rate cut?

UK: Just as the BoE was preparing itself to a tightening cycle following months of elevating uncertainty due to Brexit, it looks like UK policymakers will be forced to follow global central banks’ move and maintain status quo for the time being. Global uncertainty, trade war, Fed excess reserves scarcity are all factors that could deprive the BoE from starting a hiking cycle. According to Short-Sterling futures, the Dec20-Dec19 is trading at -9bps, down from 20bps earlier this year.

Figure 1

Source: Bloomberg

US Treasuries Net Specs

Net shorts on US Treasuries continued to increase on aggregate in the week ending June 4, up 82K contracts with a significant rise in the 10Y (91.5K). Net shorts are approaching 1M contracts, which is still far from the 2.1M registered at the end of September but implies that speculators are comfortable in shorting Treasuries at current levels. Have LT yields bottomed in the US?

Figure 2

Source: CFTC

FX Positioning

EURUSD: Despite the ECB’s dovishness last week with EZ policymakers hinting the market that the central bank will do ‘whatever it takes’ to prevail inflation expectations from falling in the Euro area, the euro edged higher against most of the major currencies. EURUSD broke above 1.13 for the first time since mid-April, and the next resistance on the pair stands at 1.1365, which corresponds to its 200D SMA. We think that the recent euro strength could be perceived as a good opportunity to short the pair as fundamentals have not changed in the Euro area.

Figure 3

Source: Eikon Reuters

GBPUSD: After getting strong support below the 1.26 level, the pair is struggling to move higher in this risk-off environment. We remain favourable to the US dollar in the short run, hence we would wait for further improvement and stability in the parliament to start building a confident view on the British pound.

EURGBP: The pair keeps moving higher and is standing very close to its next resistance at 0.8925, which represents its 38.2% Fibo retracement of the 0.8310–0.93 range. The pair is slightly oversold according to the RSI indicator, hence we could see a small consolidation in the short run. We are already short the euro against the US dollar, hence we would stay out of the pair for the time being.

Figure 4

Source: Eikon Reuters

USDJPY: We took profit on our long-dated short position on USDJPY at 108, which we usually use as a hedge against a sudden rise in price volatility. The pair may consolidate on the upside if the situation eases with the US 10Y yield stabilizing around 2.10%. However, we would wait for further developments in order to start trading the pair. Cross AUDJPY has moved sideways in the past week as global equities recovered slightly from May’s sell-off.

Figure 5

Source: Eikon Reuters

USDCHF: We saw little movement in the pair in the past week with USDCHF oscillating around 0.9920, its 61.8% Fibo retracement of the 0.9250–1.0330 range. As for USDJPY, we could see a higher USDCHF in the coming days.

Chart of the Week

The 10Y US rate has fallen dramatically since the start of the year, down approximately 50bps to 2.1%, its lowest level since September 2017. Even though cross currency basis swaps (3M) for the major currencies (EUR, GBP, JPY) have narrowed significantly since the last quarter of 2018, the interest rate differentials are still weighing on the hedging costs for international investors. For instance, European and Japanese investors would get a yield of -82bps and -63bps for holding an FX-hedged US 10Y Treasury, which is significantly lower than their local 10Y bonds (the Bund and JGB 10Y yields are currently trading at -22bps and -12bps, respectively).

It is important to say that the main buyers of US Treasuries (net) switched from global public institutions (i.e. central banks, FX-unhedged) to global private institutions (i.e. banks, funds) which are mostly hedging their FX exposure. Hence, the 10Y yield would have to rise sharply in order to make those securities attractive for international buyers in the medium to long term.

Figure 6

Source: Eikon Reuters, Bloomberg

Disclosure: I am/we are short EURUSD. 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.