FX Weekly: Watch The Little Rebound In Yields

by: Rothko Research

Higher uncertainty and technical factors such as convexity buying have been the major drivers of interest rates in the past 9 months.

The little US dollar weakness we saw in the past week has levitated 'oversold' currencies, especially the British pound.

ECB dilemma: choose between keeping the euro cheap (hoping for inflation expectations to rise) and increasing banks’ profitability.

We would expect a small consolidation in global yields in the short run.

Macro News

Global: The negative sentiment with market participants pricing in a significant deterioration of the global economic activity within the next few quarters has been the main driver of interest rates in the past 9 months. For instance, we recently saw Societe Generale's (OTCPK:SCGLF) global leading economic indicator, which is a news flow indicator built for a total of 42 EM and DM economies, falling well below the 50-line threshold which separates growth from contraction (figure 1, left frame). However, we think that the rate trade on this ongoing belief that we are accelerating into a recession is currently very crowded, and therefore could be subject to a significant re-pricing to the upside (i.e., higher yields) in the months to come. Since the beginning of the year, the trend in bonds has been mainly driven by the reflexivity of the market constantly repricing lower growth expectations in addition to other technical factors known as convexity buying with fund managers looking to buy more Treasuries as yields continue to decrease. We would expect a small consolidation in global yields, especially in the US as we think Treasury bond yields have plunged too much relative to other developed economies.

Euro: The ECB meets on Thursday and nearly 70 Wall Street economists are expecting a 10bps rate in addition to a restart of QE according to a Reuters poll. With a variety of leading indicators trading at their lowest levels since 2009 and inflation expectations diverging significantly from their 2-percent target (5Y5Y inflation swap is currently trading at 1.2%), it is clear that euro policymakers are under pressure and need to go big in order to protect the euro from rising as the Fed starts its easing cycle. However, we mentioned that running an aggressive policy will continue to weigh on banks’ profitability in the medium term. According to Scope Ratings’ calculations, negative interest rates in the euro area have cost banks over EUR 23bn since 2014, and an additional 10bps cut will increase costs by another EUR 1.7bn. The tiered system that exempts banks from some of the ECB’s punitive charges for holding overnight deposits may attract a few marginal buyers in the short run but it seems that the ECB will have to choose between keeping the euro cheap (hoping for inflation expectations to rise) and increasing banks’ profitability.

UK: The faster-than-expected GDP growth in the UK (0.3% in July vs. 0.2% exp.) on the back of a rebound of services sector lowered the probability of a recession in Q2/Q3 and therefore levitated the pound higher against the major currencies. However, we would not get overexcited about the little GBP recovery as political uncertainty could trigger a sudden sell-off in the currency.

Figure 1

Source: Eikon Reuters, Societe Generale

US Treasuries Net Specs

Net shorts on US Treasuries have remained steady at 989K contracts in the week ending September 3rd. The 97.9K fall we saw in the 2Y Note was compensated by an increase in shorts in the 5Y (+27.2K) and the 10Y (+67.9K).

Figure 2

Source: CFTC

FX Positioning

EURUSD: The recent US dollar weakness pushed the currency pair above the 1.10 level last week, but the single currency remains vulnerable in the short run. Momentum looks definitely bearish; however, we would wait for the ECB's decision on Thursday to start taking a directional position on the single currency.

GBPUSD: Cable recovered strongly in the past week, raising more than 350pips above 1.23 on the back of easing uncertainty over Brexit and stronger fundamentals. We went long at 1.20 as we thought that the pound was strongly oversold last week against both the US dollar and the euro. We still like being long but we increased our stop loss to 1.2250 as a little bearish news on Brexit could easily generate a GBP sell-off in the coming days.

Figure 3

Source: Eikon Reuters

EURGBP: After surging above 93cents in the middle of August, EURGBP experienced a sharp correction on the back of a little GBP recovery. We took profit on our short position at 0.90 and are waiting for further developments to start trading the pair again. EURGBP is currently trading slightly above 0.8920, which represents a strong support (38.2% Fibo retracement of the 0.8310–0.93 range and the 100-day SMA).

Figure 4

Source: Eikon Reuters

USDJPY: The little US dollar weakness did not benefit the yen as USDJPY has been up more than 200pips in the past two weeks. The pair is currently trading above 107, which represents the 61.8% Fibo retracement of the 99.60–118.70 range. AUDJPY, our barometer of risk-off aversion, has been also rising, implying that equities should trend higher. We will need to see further yen weakness in order to be confident that a trend is forming.

Figure 5

Source: Eikon Reuters

USDCHF: The Swiss franc has also been weakening and is currently trading at around 0.99, which corresponds to the 61.8% Fibo retracement of the 0.9250-1.0330 range. Next resistance on the upside stands at 0.9950, its 200D SMA.

Chart of the Week

Recent empirical studies have found that the abrupt downgrade in growth expectations has been mainly associated with the rise in uncertainty around the world. For instance, Ahir et al. (2019) estimated that the increase in uncertainty in the first few months of this year could reduce global growth up to 0.75% in 2019, originally estimated at 3.3% in the IMF’s April World Economic Outlook. As a consequence, the rise in uncertainty increases the demand for safe havens such as the US dollar, gold and US Treasuries.

This chart shows a strong co-movement between the yearly change in the Economic Policy Uncertainty (EPU) index developed by Bloom et al. (2016) and the yearly change in the US 10Y yield. We can notice that the strong increase in uncertainty between January 2018 and mid-2019 was shortly followed by a 1.5% decrease in US LT interest rates. Hence, if the annual change in EPU starts to decrease, US 10Y should rise.

Figure 6

Source: Bureau of Economic Analysis

Disclosure: I am/we are long GBPUSD. 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.