April 1, 2017 10:39 am
Author — Nick Korzhenevsky, senior analyst with AMarkets Company. The anchorman of a TV program “Economics. Day rates”.
- President Trump suffered a major setback on Obamacare; the U.S. tax reform is now on hold. But long-term plans have not been altered.
- Markets got carried away with pricing in aggressive Fed tightening for 2017, and are now busy scaling back the expectations.
- ECB starts sending early hawkish signals. If French elections go smoothly, the EUR might post another leg up.
General market trends in March proved to be just what we expected – massive corrective moves across most currency pairs, and, on a broader scale, a number of asset classes. An important one is, certainly, the U.S. rates. Since last November, when Donald Trump assumed the office, it is precisely the American bond market that has been in the driving seat for all of the FX space. As the new presidential agenda was being priced in, fixed income prices fell and yields shot up. Now that political process has suddenly become unusually complicated, part of that initial enthusiasm is being priced out.
Each time I sit down to write this report, I tell myself that this edition will only include extensive economic analysis and little to no political mumbling. And yet again political issues come to the forefront and overtake the very first paragraphs. The one of an utmost importance is the failure to repeal Obamacare. Mr. Trump suffered a devastating defeat which is sure to weaken his negotiating capacity in general. However, we would suggest not to overestimate the long-term consequences.
The loss does make it complicated to proceed with other reforms. The inability to do away with Obamacare implies that the budget is to bear the costs of the program further. Various healthcare-related expenditures amount to nearly USD1 trillion for the fiscal year, and president Trump wanted to cut these costs. This, in turn, would then allow him to proceed with his tax reform. Now that budget layouts are set to remain at current levels of USD3.7 trillion, it is going to be much more challenging to start discussions on lowering corporate taxes.
However, the agenda for the presidential term has not been altered at all. It is the timing of major reforms that is now uncertain, and it is highly likely to take longer to move on to the fiscal debate. The big decisions are to be postponed until 2018, but this does not fundamentally change the general path of things. Mr. Trump is a good learner, and he is going to find a way to sell his plans to fellow Republicans. He is by far not the first president to suffer a setback. There’s an old saying in Washington: “The President proposes, Congress disposes”. It means that the President is the handmaiden of Congress and subject to its will, not the other way around. And we’ve just witnessed this happen.
The difficulty of proceeding with the reforms bears significant short-term consequences for the market. This has already triggered a repricing of the so-called Trump stimulus. Growth expectations have moved down slightly, and the bond market now doubts that the Fed will deliver more than three hikes this year, if that. The U.S. dollar is, in turn, suffering due to the fall of rates and narrowing rate differentials. USDJPY is an especially vivid example of this process.
It should be noted that prior to the Obamacare problem U.S. markets did reach an unstable point of pricing in too many hikes and too much stimulus. We stressed that fact in the previous edition of this publication, talking about a high probability of a reversal in major pairs. Shortly after the edition came out, markets moved on to fully discount three rate increases of 25 bps by the Fed in 2017, and some were even betting on four hikes. Interestingly, the dollar was hardly responding to this ultra-hawkish sentiment. And that was a clear sign that the greenback rally is over. For now.
The move in EURUSD has been exacerbated by the ECB rhetoric. Mario Draghi was very careful at his March press conference, but he did stress the fact that downside risks have diminished greatly. This was perceived as a hint that there was no more easing is in the pipeline, and under certain circumstances the council might end up tightening. The ECB president did try to highlight the weakness in underlying inflation trends as a good reason to keep policy loose, but suddenly investors realized that “loose” can be different.
Going into the meeting, there were no expectations of any discussions of downsizing the QE further. Certainly, it was absolutely impossible to think of any ECB rate hikes. But after Mario Draghi spoke, expectations started shifting. There is now speculation that the quantitative easing program might be reduced further by another EUR20 bln/mo to EUR 40 bln, as ECB runs out of paper and reasons to buy. A general consensus is now an increase of the deposit rate, and the option is suddenly deemed realistic.
And then at the end of the month there was a speech by Sabine Lautenschlaeger, a member of the ECB’s executive board. She openly floated the idea of tightening the policy soon, if the data warrant a move. Mrs. Lautenschlaeger mentioned June as the month when it’s appropriate to revisit the stance. This hawkishness is largely explained by the fact that we are hearing a representative of the Bundesbank speak. German monetary school is known to be the least tolerant to any inflation risks, and always advocating for preemptive tightening. But even allowing for extreme aversion, we still see a new development: the rhetoric has changed. There are now voices within the ECB that are calling for less expansionary policies. And if price pressures surprise to the upside, these voices will grow louder.
EUR has strengthened notably on the back of prospective ECB tightening, but is now likely to consolidate ahead of key political events. These are the two rounds of the French presidential elections, taking place on April 23rd and May 7th. Marine Le Pen is set to beat all of her rivals in the first round, but is forecast to lose to Emmanuel Macron in the run-off. However, in a 2016 déjà vu, the gap between the two candidates has been narrowing as the voting approaches.
What is different from 2016 is that the market has actually priced in a 40% probability of Mrs. Le Pen winning the presidency. Therefore, the euro is destined to post a sharp move in the last decade of April – first decade of May. Should Mrs. Le Pen win, the EUR is likely to depreciate by about 8-10% on a weighted basis. But if she loses, the common currency can post another leg higher appreciating by about 6-7%, as this 40% probability is voided.
While the euro is fairly priced in the face of upcoming political turbulence, the pound is not. Yet it does face even greater uncertainty stemming from the launch of Brexit. The process has been officially triggered by prime minister May, and the two-year period of negotiations with the E.U. has started. We believe the talks are going to be very slow, and hardly anything will be agreed on before the end of 2018.
One significant circumstance is Great Britain’s internal centrifugal forces. Scottish lawmakers backed another referendum on Scotland’s independence in a 69-to-59 vote. The timing is horrible, though, as the ballot might take place just around the end of the next year too. If by that time the U.K. does not secure favorable conditions of its departure from the E.U., sterling might fall under extreme pressure. While we believe that GBP is the currency where fundamental value can be found, it is still too early to jump in.
Taking this altogether, we still view near-term market conditions as generally favorable. Risk-seeking behavior is still encouraged as the ECB and the Bank of Japan are providing fresh liquidity. The Fed is not in a rush to hike as fiscal policy in the U.S. is not becoming expansionary anytime soon. The greatest risk to overall stability, though, is not the interest rate policy but the prospect of balance sheet reduction. This topic has also receded to the middle ground, as Trump’s reforms have stalled. We expect the general corrective moves to extend through April, with EUR having the largest upside potential, and the JPY being the weakest of liquid funders.
XAUUSD: A long-term test
We closely watch price action around 1264 level.
Gold is exhibiting some intriguing behavior. Throughout March, as U.S. yields retreated and the dollar weakened, the metal posted a solid rally. Prices went all the way up to the 1260 handle, and there they hit the multi-month downtrend. The resistance at 1261-1264 is currently being tested, and this is a critical level. The target of short-term corrective move up lies precisely there, coinciding with the upper bound of the long-term descending channel. The channel starts at the 2011 high of USD1920 per ounce, and has successfully held ever since.
While we do not have an immediate trade idea in gold, we suggest closely watching the developments here. Should the prices post a clean breach of the 1264 level, it might signal heightened risks for the general “reflation” trade theme. Opening further upside potential for gold implies lower dollar yields and a flattening treasury curve. This, in turn, would put at risk equilibria in many markets. For one, the USD could fall under greater selling pressure, and many risk-on trades could be unwound. Vice-versus, should 1264 hold, it would be a good indicator that corrective moves are getting exhausted, and broader trends should resurface shortly.
CHFJPY: An alternative to the USDJPY long
We buy CHFJPY at 111.5, targeting 118.2/123.1, stop-loss at 110.55.
The CHFJPY cross has traditionally had a much clearer technical set-up than other yen pairs, notably USDJPY. This is due to the fact that both currencies are funders, rate levels in the two bond markets are somewhat similar, and neither had a clear yield advantage for a long time. The moves in CHFJPY are, therefore, primarily driven by immediate capital flows, and exhibit stable seasonal patterns. The financial year in Japan has just concluded, which means that the capital flow out of the country is likely to intensify.
We expect the yen to weaken broadly. Technical picture in USDJPY, EURJPY and even GBPJPY is one of a textbook uptrend, temporarily on hold due to temporary factors. If general risk perception changes for some reason, this uptrend can, of course, vanish. In terms of price activity, a weekly close of USDJPY below 108.2 would indicate that the upside is unlikely to materialize. However, fundamental factors are strong enough to consistently drive the yen lower this year. We add to our long USDJPY as described in the previous edition, and open long CHFJPY position to get additional exposure to a weaker Japanese currency.
EURUSD: Corrective move looks complete, messy trading to follow
We close long EURAUD, EURRUB positions.
The euro seems to be going through a fundamental inflection point. However, it’s too early to call the currency out of the woods just yet. Despite the positive change in expectations described above, the technical set-up is still one of a long-term downtrend. The common currency has successfully completed a corrective move up, cleanly taking out 1.089 target. EUR crosses have also posted a nice rally, but the upside momentum is now fading.
The failure to trade a reversed head-and-shoulders pattern in EURUSD is worrying, and might be a sign of further weakness. This would logically go with gold being unable to break through 1264 and USDJPY bottoming out above 108.6. We, therefore, see a contradiction between the general analytical considerations and price activity. Situations like these normally result in very choppy trading, and create perfect conditions for stop-hunting. We close out all of our EUR positions and move onto the sidelines.
Analytical materials and comments reflect only personal views of their authors and can’t be considered as trading advices. AMarkets is not responsible for losses as the result of analytical materials usage.