FX Focus: What you should be watching as sterling dives

It is all eyes on the US dollar (USD) at the moment, and discerning whether the ongoing rise is part of a continued reversal of the heavy short positioning seen since the start of the year – and much of last year – with the US Dollar Index (DXY) now tipping the 94.0 mark.

At the start of 2018, the omens were not good for the greenback, as fears that a US fiscal blowout would have marked consequences for the economy dominated the outflow of Treasuries, which, as we now know, was predominantly at the hands of the Japanese.

Once this fed through, USD losses started to fade, and led by EUR/USD, we now see the USD up close to 2% on the year so far with the markets having firmly re-coupled with rate differentials.

(DXY Daily Chart)

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Looking ahead to the week, we see little top tier data out of the US which can change this strong mindset; unswerving as both Asia and thinned European markets on Monday have pushed EUR, GBP and the Japanese yen (JPY) to new lows against the greenback.

Notable is the pullback in US Treasury yields with the benchmark 10yr Note below 3.10%, but, as long as we hold above 3.00-3.05%, USD bulls are unlikely to be too concerned.

The gradient of the curve has also been a bone of contention as the correlation with economic downturns in the past has cast a dark cloud over risk assets in these instances, but we have been pretty stable, with cautious gains seen on Wall Street to further add support to the carry trade which continues to pressure the JPY and Swiss franc (CHF), though the latter looks to have found a base with heavy reliance on the EUR rate which has backed off significantly from the 1.2000 level.

This pulls USD/CHF back under parity, but the resilience is notable for now.

On the curve, the 2 vs 10yr spread fell as low as 42 basis points (bps) early last week, drawing comparisons to levels seen in 2007, but this has widened back out to 50bps since and as above, stockmarkets are unnerved by the impact on funding costs of the general rise in yields.

Midweek, the Federal Reserve meeting minutes are the major highlight in the absence of any noteworthy data, but the regional activity indices are worth watching for background evidence, with the Philly Fed manufacturing index last week putting in a stellar rise from circa 23 to 34-plus.

Little fresh insight is anticipated – from the minutes – as the Fed seems more comfortable to stick with the three-hike profile projected in the current dot plot.

There is the temptation to suggest we may get four hikes this year, but USD gains may have played a significant part in tightening financial conditions in this respect.

Fed speakers are also pretty relaxed on the pick-up in inflation, with few if any seeing a runaway move beyond the 2.0% target level achieved recently.

With a host of trade talks underway for the US, the USD is also showing no signs of fear as to how these will play out.

Over the weekend, Treasury Sec Mnuchin has said that the tariffs will be ‘on hold’, and, while this may spell good news for risk sentiment, there is a view that the US may have lost some leverage in the talks.

As we have already mentioned, the risk and the carry trade are in buoyant mood, and USD/JPY has started on the front foot to extend the rally into the mid 111.00’s at the start of the week.

Normalisation fears at the bank of Japan (BoJ) have all but evaporated, and more so now with inflation falling back again, and this alongside a soft Q1 which underpins the central bank’s intentions of continuing with powerful easing.

At some point, the debt to GDP ratio will unnerve JPY shorts, but for now, the ingredients are there for continued weakness outside of the extended levels seen so far.

Technically, 112.00 is set to provide some resistance in the USD rate, but the current market narrative seems more than comfortable enough to see this tested.

(USDJPY Daily Chart)

Source: TradingView                  Past performance is not a guide to future performance

The EUR, however, is coming under added pressure from political fragmentation (as ECB governor Draghi put it), with Italy’s new coalition government having proved unsettling to investors and prompting losses in both FI and equities.

10yr spreads have naturally been widening with Bunds to quantify the impact of this outflow, and EUR losses have followed in tow, though largely against the CHF. With EUR/USD, much of the weakness is down to the USD and the large-scale positioning we mentioned above, and the lead spot rate is now cleanly through 1.1800 and now eyeing another leg lower below 1.1700.

(EURUSD Weekly Chart)

Source: TradingView                  Past performance is not a guide to future performance

The eurozone economy has also been a source of concern for EUR longs with the pace of growth levelling off. Some of this has been down to the strength of the EUR at the start of the year, but this fell on deaf ears at the time.

Now that the impact has fed through to the data, the market is sitting up a taking notice, but we get the May PMIs out this week so it will be interesting to see what the surveys pick up from the latest market developments. The German IFO at the end of the week will provide much of the same, with the Q1 GDP number set to be confirmed at 1.6% yoy.

ECB meeting minutes on Thursday cannot really offer more than the market already knows. The governing council has covered all bases with the market still largely erring on the side of a QE cessation this year, or perhaps a small taper into December.

Either way, focus is now on the next rate move and whether there will even be one next year – at the earliest. European Central Bank’s Villeroy has said that this is more a case of quarters rather than years past the QE end date, but all is data dependant, with inflation also slipping again – as it is in Japan.

For the GBP traders, the Monetary Policy Committee will be watching keenly to the data series this week which includes inflation and retail sales for the most part. The latter is a key concern for the usually consumer-happy UK economy, so at least the jobs report last week was supportive to some degree.

Inflation is less of a concern now that CPI is moving away from the 3.0% limit, and also improves positive for real earnings and disposable income, but as the Bank of England is keen to re-emphasise, productivity levels remain worrisome for the health of the economy as a whole.

Add in the Brexit impasse, which many saw coming, and the justification for a rate rise looks even more stretched; not that this stopped Messrs McCafferty and Saunders voting for a 25bp hike last time around.

Pricing is now steadily moving towards an August move, but if the government cannot agree on an approach to the customs union issue – and Ireland thereon – the talks with the EU are set to prove academic at best.

The PM is caught between a rock and a hard place, and with Q1 growth underwhelming the already low forecasts, it is not hard to see why the pound is coming under such pressure. EUR/GBP is also pushing higher which reflects the level of negativity, given EUR based weakness in itself.

We get the second reading of Q1 GDP on Friday, and deputy governor Ben Broadbent for one will be hoping there is a revision given his assertions at the BoE meeting last month.

(GBPUSD Daily Chart)

Source: TradingView                  Past performance is not a guide to future performance

Canadian dollar (CAD) strength has been notable in the face of some data misses, which on balance look a little churlish based on some of the more positive factors for the Canadian economy.

Inflation is still above 2.0%, but, as the headline number missed the 2.3% expected read on Friday, traders starting to lessen the odds for a Bank of Canada rate hike next week.

This was already in the balance given the central bank have been a lot more active than other central banks, so no surprise to see gains vs the likes of the EUR and GBP maintained and indeed extended.

There is, however, the not so small matter of NAFTA and, after some positive comments from president Trump and Commerce Sec Ross out of the US and PM Trudeau and MoFA Freeland from Canada, the talks are nowhere near close to an agreement according to US Trade Rep Lighthizer, so the gloss has been taken off this positive backdrop, but not too much damage on the CAD.

Traders have likely become immune to the rhetoric and are perhaps even acclimatised to the trade tensions globally.

Indeed, these were a source of USD weakness earlier in the year, so focal points are proving arbitrary in the current climate. USD/CAD looks well offered above 1.2900, but is finding buyers in the mid 1.2700’s for now.

(USDCAD Daily Chart)

Source: TradingView                  Past performance is not a guide to future performance

Greater resilience it seems for the AUD, as acclimatisation here is to the lack of Reserve Bank of Australia movement until next year.

The board still believe the next move is up, the backdrop is still tilted to the hawkish side of neutral, and the market is resigned to data watching as a result.

The employment report again saw a modest gain in jobs to offer the prospect of an eventual feed-through in wage growth, but it is proving a long wait, as it was for the Fed lest we forget.

Trade and exports are the lifeline of the economy, however, and, as we saw in the March data, the strong A$1.5 billion surplus should help to achieve the 0.6% rise in GDP forecast for Q1 – due for release in early June.

This week, Q1 construction work done is expected to rise by a modest 1-1.5% after the 19.4% fall in Q4. Anything above this will also bolster the GDP input also.

(AUDUSD Daily Chart)

Source: TradingView                  Past performance is not a guide to future performance

In New Zealand, the government has again raised its forecasts on budget surpluses ahead, but currency weakness has been exacerbated by the Reserve Bank of. New Zealand’s explicit acknowledgement that the next rate move is equally balanced between up and down.

On Sunday night we saw a pretty paltry 0.1% rise in retail sales over the first quarter this year, but all for a modest dip back in NZD/USD, there was little impetus to challenge the lows in the mid 0.6850’s. The pair looks exhausted here on the downside, but is also finding buyers ahead of the psychological 1.1000 mark against the AUD.

Trade data due out on Wednesday, but the yoy balance stands at a N$3.42 billion deficit, and April is not expected to make much of a dent, if any, into this.

(NZDUSD Daily Chart)

Source: TradingView                  Past performance is not a guide to future performance

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