USD Bond Markets, Emerging Markets FX, GBP recovery, ECB

The USD bond markethas provided the signal for a USD downward correction. On Monday we discussed that US bond yields had risen too far, too quickly.Late last week volumes were higher for bond option investors to sell (put) rather than buy (call), reaching levels which in the pasthave signalled markets correcting their recent surge towards higher yields. While this extreme has come down somewhat, we still think there could be a pre-Christmas USD correction, which has been supported by China taking measures to curb FX outflows.

From its November 24 top, the Fed’s broad USD indexhas lost 1.3%, with most of the decline seen over recent trading days. In line with our projections, ithas been high-yielding EM currencies benefiting most from this USD correction, which makes sense with downward correcting US nominal bond yields pushing US real yields lower too. US real yield is the most important ‘external’ variable steering the performance for high-yielding EM FX. Over the course of the next couple of weeks we think this USD downward correction has further legs to run, with FX markets continuing to take the lead from the US bond market. Within the G10 we continue seeing value in GBP and CAD.

GBP has been helped with the UK government showing increasing sensitivities to avoid a ‘cliff edge’. Yesterday, PM May agreed to publish her negotiation plans and promised that MPs could vote on the final exit deal. A hard or closed Brexit will be more difficult to achieve under these conditions, suggesting GBP reducing some of its Brexit risk premium. Other ways the Brexit premium could be reduced are via the UK’s Supreme Court asking the ECJ to decide whether Article 50 is ‘irrevocable’ or Britain finding its negotiation enhanced by a possible interpretation of Article 127, suggesting that leaving the EU would not automatically cut the UK out of the single market. While yesterday’s release of weak November industrial production led towards a GBP setback, this morning’s release of a strong RICS house price indicator should provide GBP with some cyclical strength. GBPUSD should see 1.30/31.

Today’s focus will be on the ECB, which may steer its communication towards keeping EMU’s financial conditions stable. Click here for our ECB scenarios. The volatility of the peripheral bond market should be watched by markets. At this critical juncture, where Italy’s banks try to recapitalise any peripheral bond volatility, this would be unwelcome and expose long-term stability risks, with peripheral banks’high claims against their national sovereign providing the link. Note that yesterday Moody’s revised Italy’s outlook to negative. Hence PM Draghi may welcome better economic data releases, but these better data have not compensated for political risks when it comes to sovereign bond market spreads.