USD Curve, GBPUSD and the BOC easing



Finally, the anticipated GBP upward correction has set in, triggered by the UK High Court clearing the way for the Parliament to vote on the exit agreement once negotiations with the EU are completed. The Exit Negotiations (21 Jul 2016). GBP has seen its strongest gain since ‘hard Brexit’ fears gripped markets a couple of weeks ago. GBPUSD has potential to 1.2650, but investors may soon have to deal with increasing uncertainties again. Parliament still does not have the right to vote on triggering article 50 which is likely to happen in spring starting a two year period of intense negotiations between the UK and the EU. Investment uncertainties will remain high, not boding well for the supply side of the UK economy and suggesting the economy may enter an underperforming position within the G10. Hence, GBPUSD near 1.2650 offers a selling opportunity targeting 1.15 which we think may be reached in Q1. Today will see the release of UK labour market data and tomorrow retail sales.

Overnight the US rates curve bull flattened, seeing markets reducingFed rate hike probabilities for next year. By now, the consensus sees Fed funds rates rising by 18bps in 2017 marking a substantial difference to last year. In late 2015, rate expectations for 2016 rose progressively with markets pricing in the Fed hiking rate by 2.5 times 25bps. The result was a front-loaded USD rally peaking in January 2016 followed by a multi-month USD correction driven by the Fed actively reducing rate expectations. Nowadays, the situation seems diametrically opposed to how the market progressed last year, suggesting the anticipated USD rally may start slowly, but accelerate over the course of 2017.

Overnight two Chinese insurance companies issued profit warnings citing lower investment returns due to low yield income. However, it might have been Japan’s financial sector seeing most of the financial stress this year So far, Japan’s equity market experienced an USD59bln outflow in 2016, underlining that the BoJ’s ETF purchases did not have the desired impact. It is clear that Japan may have to explore new tools to reflate its economy. Ithas to find ways to allow the increasing pool of central bank liquidity to find its way into the economy. What Japan has experienced over the past few quarters is a decline of monetary velocity endangering ‘Abenomics’. The BoJ moving towards ‘yield curve management’ may help to support financial sector profitability which over time should increase monetary velocity. Steeper international yield curves help this strategy, which is one reason why the JPY takes its guide from the evolution of bond markets.

We remain USDJPY bullish and regard the current setback as providing a buying opportunity. The release of the solid 6.7% Q3 GDP expansion in China should help this trade. For the first time in five years China’s producer prices have reentered positive territory and due to base effects and higher commodity prices we expect China’s PPI to remain strong for now reaching probably 1.5% early next year. Oil prices have traded higher as the API reported a 3.8mln stockpile decline.

The better commodity outlook provides support for commodity producers. Here the NZD is a good example, benefiting from rising milk powder prices. Fronterra’s auction did see milk powder rising to $2,760 a metric ton from $2,681 at previous auction. However, rising commodity prices add to inflationary pressures and this will matter most for economies having closed output gaps. Add to this the debate over replacing monetary with fiscal stimulus and the Fed’s Rosengren, Dudley and Fischer advocating steeper yield curves in order to reduce capital misallocation pressure and the story turns unambiguously USDJPY bullish.

We have been very clear for a few months that long USDCAD isn’t the best way to play any expectations of BoC easing, instead we have been short CAD on the crosses vs NOK and RUB. Our CADNOK position is now running out of steam as the market has already gotten extremely long the NOK. The RUBCAD position is working based on the carry and RUB side. Today the BoC will meet but we don’t expect a change in rates because the only current issue seems to be inflation. Actually data has been good enough: non commodity exports have rebounded (though remain well below their peak), July GDP and the 3Q Business Outlook Survey were both better than expected and house prices continue to surge. With core inflation hitting a 2y low this is where the BoC will cite potential risks to the downside. A change in the inflation outlook could also be seen in their inflation projections and if they push the closing of the output gap further out in time.