Daily Comment

Trying to understand FX markets....

These are not being easy days for Fx Trading ....... In terms of assets pricing everything looks awesome,  bond yields up, equities up, commodities up, bitcoin up, and usd.....DOWN!. This move has perplexed markets (myself included) and we are racking our brains trying to understand why.

Yesterday's price action is  a great example to (not) understand this uncorrelated USD behavior, after stronger US inflation numbers were released we saw the expected price action, yields up, s&P500 down 1% and USD slightly stronger vs G10 currencies. In the afternoon stocks bounced back strongly and managed to end up positive  on the day, yields continued rallying but UsdJpy surprisingly sold off from 107.40 to 106.5 which is a quite unusual price action for this pair given its high correlation with yields and stocks.

S&P / US 10Y  / USDJPY

The fast rise in Bond yields makes sense to me given the pickup saw in recent inflation figures, Trump`s fiscal expansion and Fed balance sheet reduction program. Market consensus forecast for 10Y for 2018 was 3%; in my opinion it is probable that we get overheating and break higher on these levels if we keep seeing strong US data mainly on wage growth. Fed Funds market has now almost fully priced 3hikes by the end of 2018 and there are considerable risks in my opinion that we move towards 4 hikes, so there is still room for rates going even higher.

In this environment of selling bonds, dollars and an increasingly less liquid market I expect US equities to adjust lower adding more volatility (opportunity) to markets, which ultimately in my opinion should give some support to the greenback, additionally interest rates differentials should play in favour of the usd also.

However as it´s said the trend is your friend and USD remains under heavy pressure, USD index trades close to 4 year lows and breaking 88.50 support area could trigger another selloff up to 85 (-4% ). From a pure interest rate differential this USD weakness seems irrational but there could be some reasons behind:

*         Investors fears regarding the huge increase in US budget deficit and erosion of US creditworthiness and ultimately a loss of real yield. Shorting the usd is a safety trade against that risk.

*         Central Banks reserve portfolio adjustments. There have been rumours regarding China selling UST in the past and given political tensions between Trump and China, this could be a possibility.

*         White House seems a much bigger factor in Fed and Treasury policy making that at any time in the past years. There are concerns regarding Trump interfering in Fed´s independency. Some interpreted Mnuchin´s comments as indicating that the Trump administration wants a weak DXY as a boost to export competitiveness.

We must take into account that recent selloff in usd is affecting the rest of the Central Banks within G10 space, those would have expected ( like me) that higher US yields would lead to a stronger usd helping them to create inflation given that their respective currencies would weaken vs the USD. That's not happening and this will  make their monetary policy actions more challenging and maybe they will have to lean to a more dovish approach ( ECB and BoJ main suspects).

On the contrary of what we are seeing on Spot markets,  FxSwap (Cash) markets remain strong USD buyers  vs G10 currencies, the extreme volatility we experienced back in December for year turn has spooked markets and everyone wants to hoard dollars mainly over turn periods. There is less liquidity available from US lenders and I expect this move and volatility to continue over the next months.

So far eurusd FxForward market has been one way traffic being driven by higher usd yields which I expect to continue. If USD weakness persists in the coming weeks (spot is 5 figures up YtD)  I think there could be a potential window opportunity for importers to hedge their exposure at even longer periods. For instance at the time of writing 5Y eurusd fx forward trades at 1.4260, which given the interest rate differential dynamics between both currencies and expansionary monetary policy from ECB ( I don´t expect any hike before 2020) with ample liquidity buffers makes those levels attractive to me thinking over the medium term.

Note: This analysis is a personal opinion based on my experience, not a professional signal service. For trading, you must base your decisions on your own criteria