Global Markets Weak USD and GBP Positioning
Following the release of the US non-manufacturing ISM falling to its weakest level since 2010, US rate expectations and USD have fallen. However, the Exhibit below illustrates that rate expectations adjusted less than USD, which makes sense, given that the Fed’s current strong rhetoric is almost providing calendar guidance towards higher rates. Similar to last autumn when the Fed prepared markets for a rate hike, even when the economy was weakening, it seems to be going ahead with its rate hike plans. Overnight comments by the Fed’s Williams making clear that September remains a live meeting adds to this impression.
With US rates trading only reluctantly lower, USD’s fall against low-yielding FX has been slower, but against high yielding currencies, the USD retreat is in full swing. While the weak US data may not stop the Fed from hiking – as illustrated last year – it may suggest a very slow adjustment of rates. This time is different from last year when the Fed’s dots predicted that the Fed would follow the December hike with four more 25bp steps in 2016 and the market was pricing in two to three rate adjustments.
In late 2014, the US money market curve was steep, increasing the attractiveness of USD. As a result, high-yielding EM FX had to suffer especially. This time, US data weakness almost guarantees the Fed will proceed very slowly. In addition, EM has become resilient. The EM-DM growth differential has widened over recent quarters, and approximately US$12trn of DM bonds being negative-yielding has especially increased the attractiveness of high yield EM fixed income. The 300bp real yield spread advantage of high yielding EM countries looks very attractive in light of the improving external balance sheets. Hence a ‘dovish’ Fed rate hike may not have the potential to derail the EM rally.
The BoE’s Carney will have the opportunity today to defend the bank’s aggressive easing stance despite the recent strength in economic data. The market has another 6bp of cuts priced by the end of the year, which could be taken out if Carney suggests that the BoE needs to wait and see for now. We like to be long GBPJPY and see potential for GBPUSD to even cross through 1.35. Analysis by our futures trading desk shows that only around a third of the GBP shorts entered at 1.3190 in the last 30 days have been taken off, indicating more room for a position squeeze-related upside.