USD technicals and DXY strength, ECB and EUR
The USD has experienced a powerful rebound re-establishing post US election relationships between the performance of risk assets and US bond yields on the one hand and the USD on the other hand. Importantly, suggestions according to which US anti-trade rhetoric would increase US inflation but reduce US growth prospects have been dismissed by yesterday’s price action. A stagflation scenario would push nominal bond yields higher, the curve steeper and the USD lower, which was in line with price action witnessed earlier this week. However, stagflation would undermine shares too, but the share market rallied towards new highs, allowing us to express confidence in our bullish USD call by adding bullish positions to our strategic portfolio.
USD technicals have dramatically improved. The DXY has printed four marginally new lows earlier this week with Wednesday’s low not finding confirmation in the 9-day RSI and creating a ‘positive divergence’. More important has been the BoJ stepping into markets increasing its Rinban operation in the 5-10 year JGB sector from JPY410 to 450bln in line with our projection expressed here yesterday. This operation has steepened the JGB curve further with 40 year yields reachingnew cycle highs which should help banks and insurance companies to boost their profitability, but it does increase the chances too that the BoJ expands its operation into the long-end of the curve trying to reduce volatility. Keeping JGB volatility low must be one of the key BoJ policy objectives to allow commercial banks to shift their JGB holdings accounting for 17% of total assets from the negatively yielding part of the curve into positive yield territory without increasing the critical VAR.
Falling DM productivity rates in conjunction with demographics boosting savings relative to consumption and globalization has allowed DM real rates to decline over the past three decades. Lower real US rates were an important factor driving US financial and real sector investment abroad providing the fuel for the EM economic growth engine. This trend may terminate now with globalization slowing and the demographically related increase of savings relative to investment peaking. US productivity is the next factor to look at. Productivity has a structural and a cyclical component. Higher investment will boost cyclical productivity suggesting US capital demand and US real rates going up, both working in favour of the USD.
The EUR will not withstand these pressures either and we reiterate our view calling the EUR the ‘mini JPY’. Inner EMU sovereign bond spreads have widened with Italy, Portugal and Greece taking the lead, pouring cold water on the idea the ECB may head towards an early reduction of its monetary accommodation. Greece and its EU creditors continued to struggle on Thursday to reach agreement on a key review needed for Athens to unlock new loans and avoid a descent into renewed financial turbulence. Italy’s economy struggles with its real rates which are too high relative to its ailing investment outlook, leaving the ECB with little other choice but to create conditions under which Italian real rates can fall. Tightening its policy too early may come with too high costs putting Italy under even more stress. Hawkish comments from ECB members representing core countries (Mersch, Weidmannn, Lautenschlaeger) may be dismissed as the ECB directorate runs the show and here dovishness has prevailed. The EMU’s core may develop inflation while Italy may prevent the ECB from acting ahead of the curve, creating an ideal environment for EUR weakness.