FX Weekly Preview: Not Getting Carried Away With This "Tightening Cycle"

By Rajan Dhall MSTA and Shant Movsesian

Dominating the financial news has been the upset in global equity markets in the last week or so, and not so much on the prospect of QE unwind and retraction, as we all now know that central banks are ready to roll out the carpet once again if sentiment turns aggressively sour - and continues. 

For now, Fed speakers - and indeed, central bankers worldwide - are not too concerned by the corrective moves led by Wall Street, so for now, we can expect the 3 rate hike scenario to stand, beginning with a widely expected hike in March.  Doubts over new chairman Powell's ability to pull the trigger are perhaps the only real obstacle standing in the way of this perception, and that would naturally cause another sell off in the USD which is recovering gingerly as it is. 

Key data out of the US this week focuses on the very anathema plaguing all major economies at the present time, and that is inflation, and we get the latest data alongside (US) retail sales to see whether there is a true impact on consumption, and that shifts our focus to the core rate which is expected to hold at 1.8% at the very least.  Oil prices are now starting to head lower again, so all the more reason to focus our attentions away from the headline numbers, which should also be inflated by the weaker USD we have seen in recent months.  

So this brings us to the ultimate question which is feeding through the markets, popping it's head up from economy to economy when we look at the individual data readings from one country to another - is the global economy ready to embark on a tightening cycle as the common narrative suggests.  No - well we don't think so, and there are signs that the market is starting to call the central banks out on this one.  

Case in point was the BoE announcement last week, when governor Carney and the rest of the MPC decided to ramp up the rhetoric on interest rate levels, looking to prep the market for rate hikes a little sooner than anticipated and a little more than previously communication for the forecast period.  After a brief rally when the algos had their fun, we saw GBP turn tail and head back lower, not least of all because of the high dependency on a successful transition deal for the UK, but also because the economy is not ready for it.  Reading through some of the predictions, we are still amazed by some of the bullish calls on rates, with some now expecting 2 hikes this year and outliers looking for 3!  Yes real wages are moving in the right direction, but for how long?  What is the true impact of Brexit in the economy? Have we seen it yet?  All presumptuous stuff on which to base one's case for effectively lifting borrowing costs when one could justifiably argue that here in the UK, growth is not exactly on fire with the current base rate at 0.50%!  

Friday's press conference by the EU's chief negotiator also gave little cause for optimism over a transitional deal, let alone a longer standing trade deal, and I would suggest that if there is any optimism to be had, it is that if the UK walks away from the talks, there is enough resilience in the economy, as well as willingness in Europe to maintain some form of trade relationship so that neither side loses out.  Until then, we still expect GBP to underperform in the weeks and month's ahead, with Cable have broken some notable support levels on the way down.   1.3500-1.3600 is still the major level we are looking out for here, and this will be heavily dependant on how EUR/GBP performs into 0.8900 and 0.9000 over coming weeks also.  

Back to 'tightening', and in signalling and end to QE later this year, the ECB will be communicating the inevitable, which they are working on painfully with the fear that this will set off another buying spree in EUR/USD which has now scalped 1.2500 on the way up.  Even the more hawkish members of the ECB (if we can call them that) insist that rates will remain low (where they are presumably) well past the end date, but the underlying belief is that the ECB are falling behind the curve.  Maybe they are, but the governing council has to direct policy for all 27 member states, so even if Germany is powering ahead, what would this mean for the rest of Europe.  Italian banks are forever in the spotlight given their hefty exposure to 'non performing loans', and with Greece still in 'bailout' mode, there is plenty of reason to exercise caution on the bullish EUR trade - which is suddenly not so bullish when you look at some of the crosses.

Last year we suggested the strong gains in EUR/CHF was off the back of dormant cash moving into investment in the Eurozone.  Well this pair is now looking a little heavy all of a sudden, and not least of all due to the flight back into the CHF on the back of lost risk appetite. All this feeds into the premise that risk exposure is ripe for further profit taking, and when looking at some of the Commitment of Traders data, we still see EUR longs vulnerable to liquidation risk near term.  Add in jitters over the Italian elections coming up, and we feel it reasonable to believe that EUR/USD especially could drop back to 1.2000 or lower over coming weeks.

German and Euro area GDP numbers for Q4 are due midweek to keep EUR proponents happy in the meantime, but positive results - as consensus expects - will likely have a limited positive impact given much or all of this is now priced in.  

Switching to the Antipodeans, both the RBA and RBNZ were expected to join the policy tightening cycle this year, but with data mixed to say the least, the inflation profiles in both Australia and NZ to not lend themselves to this development just yet.  Given both economies are heavily dependant on global growth, any upset in the equity markets will naturally have a dampening impact on the respective currencies, but if the real economy can tick along with steady demand for raw materials (the basics), then we can expect to see the AUD (less so NZD) start to outperform across the currency spectrum.  Australian rates at 1.5% look stable enough and the RBA will be happy to remain neutral until the domestic data picks up significantly.  In the meantime, concerns over household debt should be enough to anchor rates where they are - a lesson the BoE may learn the hard way despite their assertion the private debt is not a problem in the UK. 

We may see a little more downside in AUD/USD as a function of USD retracement which could play out across the board to varying degrees, the crosses are something we are watching from here, with AUD/NZD stand out given the arbitrary hit lower which now threatens a return towards the key 1.0500-1.0600 area.  There looks to be no discernible reason for NZD resilience in the near term, and those suggesting it is down to broader risk sentiment, don't really have a leg to stand on any more!  

NZ Business PMIs will show if industry is warming to the new coalition government this week, so is worth noting as a release next week.  In Australia, the RBA meeting minutes are preceded by the Jan employment report, which is expected to show another rise again but at a more modest pace - a 15k gains forecast.  

We have already had the equivalent jobs data out of Canada, which saw a heavy drop in part time jobs, offset partially by a gain in full time positions, but it was the rise in wage growth which turned the tide of CAD selling on the headline, with earnings now rising at an annualised rate of 3.3% vs 2.7% previously.   On the face of it, there seems to be little material reason to deviate too far from the 1.2500 area at the present time, but pressure from a potential breakdown in the NAFTA talks will now be added to by the broader pull back in Oil prices.  Pipeline pressures continue to see Canadian Oil prices trading at widening discount to the US benchmarks, and while some of the closed pipelines in Dec have been reopened, they are still running at reduced pressure and this is further exacerbating the build up in inventory.  CAD longs here are vulnerable as a result, but we are back to watching Oil prices here again.  

Ending with the JPY, price action in all pairs should be comforting for the BoJ, who (along with the rest of us) would have expected a little more volatility on the downside based on what has happened in the equity markets recently.  This may yet materialise, so we can expect little change from BoJ policy, which is set to maintain powerful easing until their inflation target is close by.  That said, the market is already looking buy up any material weakness in the JPY as part of an eventual shift towards normalisation, with impatient entries into this developing them coming at the mid 110.00's vs the USD, but signs are that some of the crosses are proving more attractive at current levels - not least of all EUR/JPY and GBP/JPY.