FX

Increasing market expectations for a Fed hike this year (42% probability) have supported a rise in US 2y yields from a low of 55bp on 5th July to 68bp today, however in bp terms this rise has been small relative to previous rates markets sell-offs, supporting why the USD hasn’t actually rallied that much on both the G10 based DXY index ( +0.9%) and the Fed’s Broad USD Index (+0.2%). Another reason for the lack of a USD rally has been the continued movement of funds into higher yielding currencies and assets. Flow research is showing surging flows into EM assets, with EM recording $6.4bn of inflows last week ($5bn of which was into equities), the largest weekly flow since December 2014. Other risk indicators are also pointing towards a period of calm, supporting risk sensitive currencies such as the IDR, MXN and even CAD within G10. We point investors towards the VIX index which is now at the lowest level since July 2015, and our global risk demand index which continues to head higher every day. The risk asset sell off normally associated with a rise in bond yields is also difficult to find.
Our previous observations showed that inflation expectations in the US tended to fall when USDCNY rose. Since the start of the month however there has been a divergence between these two indicators; the US 5y5y inflation swap has started to rise from 1.86% to 1.91% today at the same time as USDCNY which has also risen from 6.65 to 6.68.Today the PBoC has fixed USDCNY lower to 6.6946 from 6.6971.Somecommentators are discussing whether this is an indication that the PBoC is looking to control the outflows and stop market expectations for further currency weakness. We would suggest the focus is on USDCNH and wanting to keep the CNH-CNY spread fairly well contained. Expectations for a stable RMB over coming days should also add to lower volatility in markets, supporting higher yielding FX. This morning the front-page commentary in the official Economic Information Daily is suggesting that China will not have a debt crisis in the short term as economic growth is in a stable range and that China’s leveraging problem is not very severe, and debt risks for nonfinancial enterprises are manageable overall.
Market focus will be on Draghi’s first press conference after finding out about the Brexit vote. Forecasts are not expected to be updated at this meeting so markets will have to wait until September until any change in policy but the tone will be closely watched. Inflation expectations as measured by the 5y5y swap have bounced to 1.35% from the lows of 1.25% last week but are still not expecting inflation to reach 2% for more than a decade. The ECB should be focused on financial market and banking stability which is addressed via LTRO facilities. Note that yesterday’s release of th eECB Bank lending survey, while mostly done before the Brexit referendum, was quite upbeat about credit suggesting that LTROs had improved bank profitability. The equity markets may disagree, having fallen 17% since the March ECB meeting, but we do expect theECB to acknowledge relatively calm market post the Brexit vote. Draghi could acknowledge that there will be business uncertainty after the Brexit vote, which if translates into lower growth and inflation, would require further easing.
If Draghi reverses his statement from March , now saying that interest rates could be cut further then it would weaken EURUSD on the day but only lastingly weaken the currency if there are expectations of more than a 20bp cut. Suggestions of an extension of QE won’t beableto weaken the EUR as further corporate bond purchases would not be ableto bring down long term government bond yields sufficiently. Rates investors will be watching for any clues on how the ECB could tweak current government bond purchase programme rules to allow for any extension of QE without hitting bond availability limits, though this type of discussion could likely be left until the September meeting. Weare now forecasting EURUSD towards 1.18 by the end of this year and are still long EURGBP.
G10 investor attention has been on the next central banks to provide stimulus measures, I.e. the RBNZ and RBA, with good reason given that the RBNZ is expected to release a new set of forecasts tonight (10pm Ldn) and the RBA minutes point towards openness for further easing. However we like to focus on the oil currencies today, where USDCAD is forming a triangular structure with upside resistance at 1.3150 and downside support around 1.2900.Should the reduced crude supply data (-2.3 million barrels last week) as reported by the API yesterday be confirmed by the EIA today, the markets may provide support to oil related currencies. NZDCAD has fallen from its previous resistance level around 0.9560 should see further downside.

GFX