USD Drivers, Draghi & the EUR, CAD and JPY action
There are two major drivers for the USD currently: monetary policy divergence and global capital flows. The USD started its recent leg higher just as the US 2y yield relative to the DM World broke out of a range it had been in since the start of the year. Initially it was the market pricing in the higher probability of the Fed hiking rates this year (now at 67%) but now it appears to have evolved into a theme of policy divergence coming from both sides, particularly supported the dovish ECB last week. However this dovishness (outside of the Fed) has also had the effect of flattening the US yield curve slightly (US 2s10s down 5bp). Since US data are strong, our interpretation is that there must be capital inflows into the US. These flows drive the USD higher and the curve slightly flatter. We have adjusted our strategic portfolio over recent weeks to capture USD upside vs both high and low yielding currencies.
The ECB’s Draghi may have hinted at extending the QE programme in December, i.e. adding to market liquidity, and oil is firmly above $50 but we saw equity and bond flows into emerging markets falling sharply over the past week. In fact, according to the IIF, the 7-day moving average of flows into EM declined to its lowest level since the China worries-induced selloff in August 2015. This downward shift in flows has triggered a reversal alert that began on October 13th. We calculate that EMs saw outflows of $1.33bn last week, driven mostly by the debt markets. This dynamic supports our view for a stronger USD. Our trade of the week is to be short the AUD which is dependent on foreign funding.
The USD has broken out of technical resistance areas, which we believe has added to upside momentum.2 weeks ago the DXY broke through a resistance formed since last November and in the near term there is another 1% before hitting the January high at 99.82. Sure, a large proportion of the DXY is EURUSD, which has recently gained downside momentum causing the 14-day RSI (24) to hit oversold levels on Friday. The last time EURUSD hit oversold levels on this measure was in November 2015,as the market was preparing for the Fed to hike rates the following month. While the FX markets may be reacting in a similar way today to a year ago, if the Fed does hike in December we don’t think January will see the same story play out for the USD.
EURJPY is about to breach the bottom of a triangular formation suggesting there could be further downside this week but we would use this dip to sell the JPY. This technical setup may also lead to a small setback in USDJPY, where we would buy towards the 102level. The slightly better than expected trade data out overnight, with exports only falling 6.9% vs an expected 10.8%, should not weigh on our medium term JPY view. According to the CFTC, net long JPY positions have almosthalved this month so as a further catalyst for continued adjustment, we will be watching Japan’s September CPI and employment data on Friday.
The CAD is currently trading weaker than its historical relationship with oil prices would suggest. We think this is because USDCAD continues to be strongly correlated with the 2y yield differential between the US and Canada, meaning the major driver will be policy rate divergence. In this respect, Friday’s Canadian CPI release, marginally missing expectations by a tenth on the headline figure (1.3%Y) but core CPI meeting expectations at 1.8%, doesn’t change our view that the bar for another BoC rate cut seems quite high. The market seems to agree with rate cut expectations only marginally changing for the November meeting from 7-13% probability. In addition, this morning the BoC’s Poloz is suggesting the government continue to run wide deficits (supporting fiscal easing),adding to the view that there could be less to do on the monetary easing side for now. USDCAD has hit the top end of a trend channel around 1.34, which is a level we watch closely. The Baker-Hughes oil rig count seeing its biggest weekly rise (of 11 to 443) since mid-August seems to have been expected by many in the market.
The only major data releases from the US this week are durable goods (Thurs) and the first release of 3Q GDP (Fri). We will be paying more attention to a long list of Fed speakers today: Dudley, Bullard, Evans and Powell. Fed’s Williams reiterated on Friday his view that there should be a Fed hike this year. This week will also see a large number of Q3company earnings announcements, with about 1/3 of the Dow and 1/3 of the S&P reporting. So far the earnings releases haven’t led to a large spike in equity volatility, potentially because 7 of the 11 S&P sectors have recorded profit growth, and earnings have beaten expectations by nearly 7% overall.