USD Strength trying to recover, ECB committed to low real rates, Japan bond buying and AUD outlook

Conditions for the USD rally have improved with three events becoming topical. First, ECB’s Praet and the BoE have made it clear that Europe is not aiming for early rate hikes and are comfortable with seeing real rates dropping further from here. Secondly, Japan’s money market operations have underlined its commitment to control the JGB yield curve, which we view as a step towards Japan’s commercial banking sector regaining profitability and thus creating conditions for a faster money multiplier growth. Within an environment of DM reflation, the side effect of this policy is JPY weakness working via widening rate and yield differentials. Thirdly, China tightened its monetary policy by 10bps overnight, reported slower January manufacturing activity, but fixed the RMB weaker compared to market expectations. USDCNY came off a moderate 0.2% while USDCNH rallied this morning by 0.24%.

 The next hurdle for the USD to overcome is the Fed. Wednesday’s interest rate statement left the impression it may be operating behind the curve by acknowledging that inflation ‘will’ reach 2%, but refusing to send a signal to turn March into a ‘live meeting’. Today’s release of the US labour market report is only important in respect of impacting the FOMC’s mind set. Concretely, a strong labour market report helping the Fed by sending hawkish signals will be USD supportive. However, should the Fed stay dovish then a strong US labour market report may only steepen the US curve, but do little to support the USD. Fed chairwoman Janet Yellen’s testimony on 14 February will be a key risk event. In between, today the Fed’s voter Evans will speak on the economy and monetary policy.

The BoE has upped its growth forecast, has kept its inflation forecast little changed and has maintained its neutral policy bias leading to sharp GBP losses. The BoE left the impression of possibly underestimating inflation risks and by doing so it may be able to run accommodative monetary conditions for longer. While the National Institute of Economic Research sees inflation reaching 4% by the end of this year, the BoE has found additional labour market slack allowing it to project wage growth staying muted. The BoE sees inflation averaging 2.7% this year and 2.6% in 2018, little changed from its November projections. Its long-term economic projections are based on the assumption of rates rising early 2019, differing significantly from current market pricing, and suggesting rates going up by 25bp by August 2018.

ECB’s Praet as presented an equally dovish message suggesting that the recent upward trend in inflation was due to temporary factors including energy and food prices and the ECB would continue to “look through” factors contributing to the underlying trend.” With the Maastricht contract framework becoming less effective and EMU remaining fragmented in fiscal and regulatory terms (lack of fiscal and banking union) the ECB has to conduct policy according to the needs of its weakest link (see here for more). Italy seems to fall into this category. EMU’s equity markets and volatility curves have steepened recently. While some of this steepening may be related to upcoming general elections in Holland and France, the recent widening of EMU sovereign bonds spreads has added to concerns. EURUSD is a sell at current levels with a stop at 1.0840 and a target 0.9700. The risk to this trade is Italian data turning better, but given the continued weak credit creation by Italian banks we regard this risk as minor.

Some investors link bullish AUD strategy into a global reflation framework. Associating reflation with rising commodity prices may provide support to this idea. However, reflation and commodity prices are unlikely to stay linked for long should our view prove correct that part of DM is developing into a cost push inflation environment comparable to the 70s. The 70s did see precious metal strength while other raw materials stayed lacklustre. Opposite, the deflationary past 15 years were accompanied by periods of excessive raw material strength. So far, the CRB Rind has kept on rising, but with China tightening its policies while its manufacturing sector is weakening (Jan Caixin PMI eases to 51.0 from 51.9) it may not take too long from here to see commodity prices topping out.