February 1, 2017 1:58 pm
Author — Nick Korzhenevsky, senior analyst with AMarkets Company. The anchorman of a TV program “Economics. Day rates”.
- USD has been stuck in broad ranges, EURUSD and the DXY are in the late stages of their respective trends, but another leg is due.
- The bond market remains weak and nervous in the face of the discussions on the Fed balance sheet wind down.
- Gold struggles to break any meaningful levels to the upside, while oil and copper remain firm and are likely to extend gains.
This past January was not a month distinguished for a major market or economic development. All eyes were and remain stuck on Donald Trump and his first days in the office, and these simply can not go unnoticed. The new president of the U.S. has been doing literally what he promised to the voters during his campaign. The decisions are set to shake the global political landscape, but so far they have been limited to healthcare and immigration spheres, not the economy or the fiscal policy. We do note, however, that the pace of changes is quite rapid, and most of the measures are very blunt and coarse. This is likely to increase global policy uncertainty even further, which makes the central banks’ job much more challenging.
In terms of market dynamics January was kind of dull. Most of currency pairs were either going sideways or correcting their prior moves. The fall of the euro stopped at around 1.036, and the common currency has managed to move back to 1.07 at the moment of writing. There is scope for further EURUSD upside, but it is quite limited. The general trend is, of course, down, and it should resume in second quarter of this year. USDJPY is also completing a classic corrective move that should run out of steam once the financial year in Japan is over. Of a note, the People’s Bank of China has finally succeeded in squeezing out yuan shorts. USDCNH has also started a solid retracement, not even having reached 7.1 which was our target.
But, as we already said, these fluctuations should be viewed as a multi-week correction to a broader trend of the strong dollar. One new chatter that’s making rounds in the markets is the prospective Fed’s balance sheet unwind. Below we shall discuss this in greater detail, as we believe most of USD moves in 2017-18 will be at least partially related to this issue. It is also extremely important that the discussion was triggered by the FOMC itself.
Over the past month Harker and Bullard, both currently serving as governors, floated the idea of using the balance as an alternative tool to control inflation expectations. It is percieved to be a better option than “agressive hiking”. So is it really? And does one formally define “aggressive hiking” anyway? To evaluate the consequences of such tightening for the dollar let us first have a look at the pure economics of this process.
The current academic take is that it is the stock, not the flow of the QE that is important for the markets. The FOMC quantitative policy is usually transmitted into prices via two channels: the portfolio effect and the expectations. The first is quite direct: the central bank removes a certain amount of duration supply, and therefore its price rises (and yields fall). As the Fed stops reinvestments, the supply of treasuries will return, with prices falling and yields going up.
Yet here is the important point: by not that much. Numerous research shows that the entire USD3.5 trln of QE has reduced 10-year yields by approximately 100-120 bp at the peak of its effect. Janet Yellen’s own estimate is that all of the quantitative easing undertaken in 2013 had a net effect of a 13 bp decrease in 10-year rates. This means that any future investment reductions should not trigger a significant leap higher across the rate spectrum.
But these calculations are too mechanical and do not account for the signalling (or expectations) effect. However, this one is believed to be of a greater importance than the actual Fed purchases. The year 2013, mentioned above, is remembered for the so-called “taper tantrum”, where the Fed accounced it was going to phase out the QE program. This led to repricing of rate expectations, and the all the future rates moved sharply higher. It was later clarified that the FOMC was not going to tighten all too quickly, but the move was a great example of how sensitive the market is.
There is a way to avoid undesirable volatility though. First, the Fed should not rush and be absolutely confident it wants to wind down the balance sheet before it launches the process. Their own research shows that once started, reversing it will be very risky. It is also crucial that that the market is well-prepared for the policy tightening, so there would be no adverse reaction.
Second, from the academic view point, it would be highly desirable to set a target for the size of the balance sheet. This would remove a great deal of uncertainty, and, again, help reduce any negative impact on the markets. We believe that the assets in the SOMA account are never going back to the pre-crisis levels. The demand for physical money has grown and it alone now stands at around USD1.5 trillion. It is difficult to challenge the fact that the central bank will not go below this level. USD2 trillion would be a good estimate of the lower-bound to the balance sheet under current economic conditions.
But there is still an enormous gap between the current USD4 trln and the above-mentioned USD2 trln. Furthermore, launching this process in the 2017 – or under president Trump generally – would bear clear additional risks. It comes at the time when the federal government is planning to substantially increase the budget deficit. That implies signficantly higher borrowing, on the magnitude of up to USD500 bln a year, and lasting for the next decade. The Fed balance sheet would add to that in terms of market supply, meaning that the Treasury would need to refinance any amount that the FRBs release off of their balance sheets. Assuming that 2 trillion of assets are allowed to mature with no reinvestment over the same time horizon, it adds roughly USD200 bln to incremental supply. This is impossible to digest without exerting pressure on bond prices (and, therefore, upside pressure on yields). Given the current state of fixed income markets, an exercise of that sort might send the whole segment into a tailspin.
On the other hand, the wind down is surprisingly easy to perform in the short run. There is a notable deficit of short-term paper in the market, and increased Treasury borrowing here by defintion carries relatively little duration risk for the system. Should the Fed decide that inflation expectations have gone too far (say, due to overly expansive fiscal policy), it might as well slow down reinvestments, as there are no immediate operational challenges in the way. But again, that’s the story for the short-term.
And, certainly, no matter how it is carried out, reducing the Fed’s balance sheet would be a clear dollar positive. But the degree of currency strength heavily depends on when the process is launched, and how well the market is prepared for it. We should recall the fact that there is a registered dollar shortage in some regional markets, and less liquidity within the U.S. banking system would absolutely tighten access to USD funding globally. Cross-currency basis swaps are a good indicator of where QE unwind will have the most impace. It is worth remembering that the euro-dollar swaps moved to abnormal levels in H2 2016.
It should be noted, however, that for broader financial stability any policy mistake at this time would be catatrophic. The Fed might be operating in a bearish bond market, which means the reaction of other assets risks proving very sharp. FOMC members will surely watch every word they say on the issue of the balance sheet. But the discussion has been already launched, and questions on this matter are inevitable. The market will be closely watching each piece of responce that it gets from the governors. Given rising general uncertainty, which is due to Donald Trump’s general decisions, the Fed can not afford to misstep.
EURUSD: the final leg down is just not there yet.
We re-enter EURUSD shorts at 1.075, will take profits at 1.037, stop-loss at 1.083.
The euro downtrend has not been broken and will not be broken in the foreseeable future. That has long been our opinion, and we still stick to it. As it was described above, further tightening of the Fed’s policy will likely decrease global dollar supply and make the currency more expensive to borrow. This will absolutely spill into the exchange rate, as the market prices in future developments.
The ECB, on the other hand, is likely to stand pat. Mario Draghi and his team are bound by political developments, and can hardly consider any policy tightening. The migration debate is heating up just before major European elections. The news on the economic front are not overly encouraging either, and there is no sense of urgency to tighten. And some financial developments are somewhat worrying, as the Italian bond market keeps on selling off all by itself.
From the technical viewpoint, EURUSD is due for another leg lower. It is difficult to pick the timing, as the pair is in the late stage of its first long-term wave down. But it is quite obvious that current levels offer good entry points. Both targets with highest probabilities lie on the downside, at 1.036 and 1.016. A move into that area should be seen as a completion of the down move that started in September 2016, and an extended corrective move should follow.
GBPUSD: still expensive enough to go short, but gaining long-term value.
We will re-enter GBPUSD shorts at 1.266, take profits at 1.206, stop-loss at 1.282.
It is difficult to trade the pound, given its endogenous volatility. We should admit that our risk management has systemically underestimated the corrective potential of GBPUSD (just like our take-profit orders were too conservative, for the same reason). However, we remain convinced that the sterling will go lower before it can move to long-term rehabilitation.
From the technical viewpoint, GBPUSD should follow general USD trends in the first place (and, again, we believe that the dollar is going up at least one more time in H1 2017). The unit has not fully completely its move down, and should revisit the 1.18 area in the coming weeks. There is also a distant target of 1.02 that we deem realistic. In order to consider a move that far, though, a clear understanding of the Brexit conditions is required.
Fundamentally, we should note, a move like that could offer an excellent long-term entry point for those who like U.K. assets. Interestingly enough, Britain was the best performer among developed economies with its GDP growing at the 2% rate. That’s faster than the rest of Europe, or even the United States. While it is too early to dig deep into those figures before we get all the Brexit details, it is clear that the a broad economic restructuring is underway. It is likely to be very beneficial for the United Kingdom in the long run.
USDJPY: the yen remains our favorite idea for 2017.
We add to USDJPY long position at 112.6 with a stop-loss order at 111.8, will regain long exposure at 110.65 and 108.7 with a stop-loss order at 108.2, take-profits at 123.3 and 128.9.
The yen is the weakest link of the most liquid currencies. After the bond sell-off of 2016, yield differentials have widened significantly, and flows out of yen have intensified. There is a possibility that the Japanese currency continues to consolidate in the short term, until the end of Q1 when the repatriation kicks in. However, the seasonality is mostly observed in the last two weeks of March, and a lot can happen before then. Furthermore, current bond flows are so massive that they may as well counter the fiscal year end effects.
Technical set-up in USDJPY is quite clear, and actually textbook-ish. The first leg of the wave up is now complete, and the unit has retraced precisely 38.2% from it’s mid-December highs. The correction might extend to 110.6 and even 108.7, but this is not a certainty. We do not want to miss a good entry point, and consider current levels quite attractive for getting long exposure. USDJPY should prove very sensitive to the debate concerning the Fed’s balance sheet, and is highly likely to test levels above 120 as fedfunds futures are repriced.
XAUUSD (Gold): another sign that the dollar strength has not yet gone away.
We short XAUUSD at 1207.00, will take profits at 1027, stop-loss at 1232.
The price activity in gold has been a lot less messier than in the currency markets, and the technical set-up here remains quite clear. The metal reached a local maximum of 1220, but failed to close above any meaningful level on a daily or weekly basis. The corrective move is now demonstrating signs of exhaustion, and a return to the downtrend is highly probable.
The targets on the downside remain unchanged, with levels around $1000 being the strongest attractors. We note that gold has demonstrated stable correlation with the DXY, and currently serves as an anti-USD tool. Considering the developments surrounding future U.S. monetary policy, it makes perfect sense to reestablish shorts in gold. Previous metals also historically do not fare well when dollar yields rise, which is the main trend of the past several month, and the story for at least a few more months.
Brent: a bet on Trump policies and OPEC compliance.
We buy front-month Brent futures at 53.2, will take profits at 59.8 and then 66.6, stop-loss at 51.8.
Industrial commodities remain one of the strongest asset classes, with oil and copper posting very solid performance. While Brent got stuck in a range of roughly $53-56 a barrell, it looks firm in the face of negative newsflow that was present earlier in January. Most recent headlines are actually supportive of higher oil prices, and the move up should follow.
Currently the main fundamental story is the OPEC compliance with its agreement to decrease production. Latest data show that the cartel reduced supply by 900k b/d in January, which is ahead of schedule and is already 75% of the total commitment. Sources also confirm that non-OPEC countries, mainly Russia, are also on track to deliver their share of cuts.
Probably the only significant negative for the oil that we currently observe is the speculative component. The market is holding a large long position (yet not the largest net long position yet). This implies that there are few buyers left, and going much higher might be problematic. However, our estimates show that there is still enough short sellers to take Brent at least to the $60, especially if fundamental background supports higher prices. If oil gets to the extended target of $68, we are to reverse to short positions from there. Importantly, that the dollar and oil have been positively correlated since mid-2016. It means that a leap higher in Brent should be coincident with a move down to 1.036 in EURUSD.
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.