USD has potential to rally further, helped by hawkish Fed commentary, rising US bond yields and, last but not least, investors adjusting their super-bearish USD book. The Fed’s Dudley said he is confident that the economic expansion has a long way to go and that a strong labour market will eventually trigger a rebound in inflation. Precious metals have turned lower, with a potential of developing a ‘double top’ formation, pushed lower by the recent rise in US real rates. Importantly, rising US real rates did not prevent risk appetite from staying supported, which we attribute to the new availability of capital.

There are two new sources of capital and liquidity which will keep risk assets supported for now. First, US banks now running solid balance sheets seem to benefit from potential deregulation imposed by the US Treasury. In order to enact its ambitious fiscal plans, the US administration needs the economy to accelerate from here urgently. Only with growth getting closer to 3% will its current budget plans have a chance of being viewed as credible by markets, in our view. The upcoming mid-term election in November 2018 adds to this urgency. Hence, the US administration has significant interest in boosting the economy with the help of better capital availability provided by the US financial sector.

USDJPY has reached levels near 111.80, trying to reenter its previous upward channel. The importance of last Friday’s BoJ statement for the valuation of JPY has not yet been fully priced in by markets. The BoJ suggesting that it stood by its JPY80trn QE target has not only dashed hopes that the central bank was in the middle of ‘stealth tapering’, it has also underlined that compared to the size of its current effective QE operation of JPY60trn, it seems ready to increase its Rinban operations by 25% should upward pressure on BoJ yields become undesirably strong. The BoJ’s intention is to keep real rates low, allowing local asset prices to stay supported and JPY to weaken.

USDJPY has rebounded, but still needs to overcome the 110.20/40 resistance zone to stabilise medium-term prospects from a technical perspective. Fundamentally, chances of a USDJPY rebound have improved. James Comey’s statement released yesterday was non-controversial and today’s hearing is unlikely to go beyond what has been stated yesterday. This morning’s Q1 GDP release showing nominal GDP shrinking by 0.3%Q and the deflator declining by 0.8%Y suggests that Japan may need continued monetary accommodation support. BoJ’s Kuroda seems to be in a similar position as ECB’s Draghi in being pressed by hawkish politicians to define its exit strategy from monetary stimulus. In light of the disappointing Q1 GDP report, the BoJ is thinking how to re-calibrate its communications to acknowledge that it is thinking about how to handle a future exit from monetary stimulus, without giving the impression that this is on the agenda anytime soon.

MoF flow data. The release of April’s MoF security flow data revealing a JPY4.2trn repatriation from foreign bond markets including the US and Europe is making headlines, but is water under the bridge. It is ‘yesterday’s story’ related to French election uncertainties, fading the Trump trade, Japanese lifers’ fiscal year end window dressing, and the Japanese banking sector dealing with an expected adjustment in the regulatory regime. The MoF’s weekly security flow data covering the month of May showed sizeable foreign bond buying interest. It was only last week when Japan-based accounts were selling foreign bonds again. The more interesting part of the MoFreport reveals that foreign flows into Japan’s money market funds has sharply reversed, suggesting that the ‘monetization’ of the USDJPY basis may have slowed, nd that Japan’s USD hedging costs may not fall much further from here.

Growth in Japan is holding up nicely and economic activity has gained momentum since 4Q16 with the pickup in the global capex and manufacturing cycle. Inflation has started to push back above the waterline. But as Governor Kuroda emphasized at a press conference last week, inflation expectations remain stuck, something highlighted by this year’s spring wage negotiation projected to produce only modest wage increases. With price pressures nailed to the floor, the Bank of Japan (BoJ) doesn’t seem to be in a hurry to raise rates.

“With our USD rates forecasts pushed upward, we now expect that the BoJ will taper its asset purchases at a somewhat slower pace than previously and that QE will end in H2 2019, instead of mid-2019. JGB rates unchanged,” said DNB markets in a research note to clients.

There is an ongoing debate whether the BoJ will have to raise its 10-year bond yield cap because of the lack of JGB liquidity. There seems to be still a split of views inside the BoJ on whether the Bank should or should not raise the 10-year yield target when the real interest rates decline further. The longer the BoJ keeps the 10-year yield target unchanged, the more rapidly it will have to adjust the target later.

Analysts expect the BoJ to maintain the current 10-year yield target through year-end, but if it sees greater yen weakness, it would adjust the target in 2H17. BoJ will have to strengthen communication strategy with forward guidance on its yield curve control (YCC) policy to manage market expectations. It would probably provide the conditions under which the BoJ would raise the 10-year yield target.

“While we expect the BoJ to introduce forward guidance on its yield curve control (YCC) policy relatively soon, we think it would do so in July at the earliest, when the BoJ reviews its economic outlook and discusses its monetary policy stance in the Outlook Report. If it may take time to build a consensus among the board members on this issue, delaying its introduction until October,” said J.P. Morgan in a report.

USD/JPY trades below 100-day moving average. The pair is tracking DXY lower, amid holiday-thinned markets (Japan closed for Vernal Equinox Day) and lack of fresh fundamental drivers. Technical studies are bearish, RSI and stochs are biased lower and MACD has shown a bearish crossover on signal line. 112 levels in sight, violation there could see test of 111.60 and then 111 levels.

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US Equity Markets, USD Strength, GBP and China

US equity markets have reached new cycle highs overnight with inward looking and cyclical stocks such as financials leading the rally. The VIX index has declined towards its lowest level since August helped further by US real yields no longer rising. Markets have undergone a significant change with many correlations, which were ‘alive and kicking’ in August, either no longer in place or completely reversed. For instance, the higher USD has not prevented US inflation expectations or commodity prices from rising. Today the UK government will release its Autumn Statement. The GBP reaction should be positive if the tone of the government is to help UK businesses.  

 Investors are trying to get a handle on the growth and inflation effect of President elect Trump’s economic program. Some see these measures in the context of what has been claimed by Neo-Keynesians for a long time, i.e. to use fiscal expansion to overcome US investment weakness and hoping these fiscal measures may increase the effectiveness of accommodative monetary policies tools. A second group expects higher inflation, but growth staying subdued as the supply side of the economy may fall behind the demand expansion fuelled by increasing the money multiplier coming on the back of banks growing their balance sheets fast from here. The third group of investors expects the economy to maintain its low growth/low inflation profile citing substantial capacity reserves provided by the US’s main trading partners.

Confusingly, these three potential outcomes offer very different investment conclusions reaching from risk seeking towards risk aversion. What investors often overlook is that strong September and October US data releases currently hitting screens were achieved when markets were under a working assumption that Hillary Clinton was winning the Presidential election. It seems that something happened to the US economy over the summer months pushing it towards acceleration. Fading global headwinds with China’s growth rates stabilising and non-China EM growth accelerating had a supportive impact, but it may not fully explain the magnitude of the improvement. However, should the US have finally closed its output gap at a time when its household sector has completed balance sheet restructuring seems to provide the better explanation. Importantly, this explanation finds support in the way markets have changed trading from late summer onwards. In August, it was all about a liquidity imposed risk rally with the ‘hunt for yield and dividend’ driving markets. The USD was inversely correlated to US inflation expectations and commodity prices. Nowadays, we see the USD staying bid even when commodity prices move sharply higher. Overnight saw an 8% jump in iron ore prices. This new market regime makes sense should the US economy have closed its output gap.

The USD has entered a regime similar to what we saw in 1984 and 1999. In both cases, the US economy ran beyond its optimal capacity use, pushing its return expectations higher allowing the USD to gain exponentially. Only a few months ago, better non-US data would have weakened the USD. This is no longer the case as today’s release of the European November flash PMI’s may prove. Overnight, China’s Business Sentiment Indicator rose to 53.1 in November from 52.2in October. Both production and new orders picked up strongly in November, with the production indicator rising to a thirteen-month high of 58.0. Nonetheless, USDCNY has reached a new high at 6.8925 gaining 2% since the US election day.

CNY put option premiums have doubled over the past couple of weeks reaching their highest levels since 30th June. There are increasing voices in China warning about the impact of USD strength. Today it was Economic Information Daily warning about potential capital outflows from other countries should the USD become too strong. Meanwhile, Chinese reallocation efforts out of RMB deposits into alternative investments seem to have rediscovered the equity market. Outstanding margin trading on China’s domestic equity exchanges rose to RMB950 bln ($138 billion) on Monday, the highest in 10 months, while the Shanghai Composite Indexhas rebounded 22 percent from its January low.

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gfx

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.