FX Weekly Preview: Time To Start Pricing In The Risks Away From The USD

Submitted by Shant Movsesian and Rajan Dhall MSTA from fxdaily.co.uk

FX Weekly Preview - High time to start pricing in the risks away from the USD.

The headlines have been preoccupied with the level of weakness in the USD in recent months, and this could have been accentuated by some follow through in another sell off seen this week.  The DXY pierced below last months base in the mid 0.8800's, but as we saw through the European session on Friday, there was little or no interest to extend these levels.  

The moves have been dictated by heavy losses in USD/JPY, and as we saw in the TICS data last week, this aligned with heavy selling of US Treasuries out of Japan to the tune of $22.6bln through Dec.  Last month, erroneous reports that it was China looking to trim or halt Treasury sparked off significant USD selling, but this week's numbers also showed a further accumulation in US fixed income of a little over $8.2bln.  Looking at the USD/CNY price action, this has been reflected in contra USD moves with the pair pushing back above 6.3000 after hitting notable levels in and around the 6.2500 mark.  The Chinese trade figures suffered through Jan, and while we are reluctant to broach the topic of exchange rate management (a polite way of say manipulation), there is a case to be made for smoothing the pace of appreciation/depreciation in any currency over a set period of time.  The Japanese MoF have stated they are not considering intervention at these levels, but given their activity in the bond markets, it would make little or no sense to even think it!

Looking at some of the projections for end of year, USD/JPY consensus is now skewed towards 100.00 by end of year - a complete turnaround from those seen this time last year which touted 120.00 and 130.00 in some cases based on Trump policy reform!  Levels around 105.00-110.00 were where we saw prices justified a year ago, and but for timing (!), we are back at the lower end of this range at present, having tentatively based out in the broader USD price action seen at the end of last week.  Japanese data has been steadily improving over the year, but to nowhere near the levels which would inspire a pick up in inflation which would see the BoJ's target of 2.0% achieved any time soon.  Q4 GDP rose a mere 0.1%, but with Japanese stocks undervalued vs the US, prospective flow should weigh on the spot rate, and we see USD/JPY as a sell on rallies, but perhaps stepping back in at more comfortable levels closer to 110.00 if not above.  

Chinese markets are off for another 3 days observing the Lunar New year, but in the meantime, we have plenty of data out of Japan to consider (for the longer term), starting with the Jan trade figures on Sunday night, Feb manufacturing midweek and Jan inflation on Thursday.  

In the US, there is little top tier data of note, only the FOMC minutes on Wednesday night where the market will be looking for affirmation of a highly anticipated rate hike in March.  We expect little out of the blue in terms of the economy, with last week's inflation data not included in this meeting's considerations, but will have vindicated their outlook of an eventual pick up, which in part has been a function of a weaker USD.  That said, the core rate held steady at 1.8%, while the prospects for wage growth are also positive based on the recent labour report as well as tax incentives prompting some of the larger corporates voicing their intentions to pass this on.  None of this will have a major impact on the USD, but will be net supportive of a correction in the near term, which we continue to anticipate in a more substantial form.  

EUR/USD is where we could see the more significant moves in coming weeks, with 1.2500 now breached for a third time and again failing to hold.  At some point the narrative has to change, and given we are nearing one of the major political events this year in the Italian elections, the issue of populism and unity once again come to the fore.  German politics is already in limbo with the SPD yet to vote on an agreement on coalition with Merkel's CDU, and combined risk factors should start to weigh on the single unit which has clearly run out of steam on the topside - not only against the USD, but across the spectrum of major currencies including the risk-laden Pound.  

Added to this is the level of policy normalisation, where the market clearly knows the ECB has to end the asset purchasing program at some point.  Positioning for the eventual communication now offers limited value given outright levels, so we can assume this is, or close to being priced in and the market should, and will likely focus on the unanimous view in the governing council that interest rates will stay where they are for a considerable time beyond the end date of QE.  This would appease some of the member EU states not quite enjoying the economic expansion at the pace we are seeing in Germany. Once again, the 'one policy does not fit all' argument comes back into focus and more so when we get wholesale shift in (policy) direction, and this adds to the notion that the EUR has run its course on the upside on near term time-frame. 

Over the longer term horizon -1-2 years - the EUR is likely to exceed 1.3000 with accommodative ECB conditions fuelling robust growth, but the current pace of appreciation is unsustainable and we would not rule out a brief return to 1.2000 or lower over coming months.  For the week ahead, we look to 1.2100-50 as a potential target on the downside, with the longer term view making downside moves choppy at best.  

EUR/GBP is one pair which perhaps highlights over-exhaustion but perhaps offers better upside value, and against a currency which carries an abundance of uncertainty in the Brexit negotiations ahead.  We still do not buy into the notion that some form of Brexit deal is highly likely by the end of the year - calling that one is pure, baseless speculation.  Even if we do, it will require a significant degree of compromise from Theresa May's government and that points to internal (party and parliamentary) divisions fracturing further still.  Domestic data has been a saviour of the Pound in some part, and the BoE will no doubt take some credit given the rate cut initiated last year.  This has since not only been retracted, but we are now set on gradual path of rate normalisation, which we (and others) are clearly viewing with a high degree of scepticism.

Is this the right time to start sounding a hawkish tone?  Analysts suggest their intentions to hike - perhaps as early as May - will underpin GBP in the near term, but there was a time when the market would question policy intent rather than follow - or hang on - every word of the central bank.  We have seen the Fed dot plot largely ignored in the FX markets, and we sense it will be the BoE next.  Household debt seems to be less of a concern - until it actually is.  The explosive housing market has had a large part to play in that (equity/credit creation), feeding into high street spending over the years, but (house) prices are levelling now.  Spending looks tentatively weak if the start of the year is anything to go by with Jan retail sales rising a mere 0.1% vs a 0.5% redress expected, and it is reasonable to assume, consumption will be restrained from hereon out given uncertain times.

The jobs market is holding up well in the meantime, as is wage growth, which is just as well given the currency induced rise in inflation, and we get the Dec employment report on Wednesday to show us more on this.  Earnings are the focus once again with ex bonus expected to stick at 2.4%.  BoE members Carney, Broadbent, Haldane and Tenreyro all speak on the same day but can only impact negatively on GBP based on their assumptions made in the previous meeting.  On Thursday is the second reading of Q4 GDP, which is expected to remain at 1.5%, but any revision either way will get the algos excited despite the comparatively weak levels as they are. 

We see Cable has largely having topped out, with any any extension above the 1.4355 highs likely to prove limited in time and size.  EUR/GBP is a mixed back given what we have covered above, so we will stick to the view that we look set to remain inside 0.8650-0.9000 over the near term, with the skew over the longer term all dependant on how the Brexit talks play out this year.  

We also have a fair chunk of data coming out of Canada next week, and rather than ply the same old line over NAFTA uncertainty, which is taken as read, we will focus on the domestic data and also start concentrating on the direction of Oil price.  The latter has clearly hit a wall with WTI stalling through $66.00, with $70.0 already touted as a top as per comments from OPEC themselves.  They seem comfortable with price inside $50-70, and for Canada this is also a net positive given the 'adjustments' seen in domestic production.  However, Canadian Oil prices have been lagging the US benchmarks, with differentials widening once again.  While spreads are nowhere near the extremes seen in late 2013, they are moving towards levels seen in early 2016, so along with a further dip in WTI, we could be in for some CAD weakness if pipeline issues persist and Canadian inventory continues rising at a faster pace than US stock.  Fair to say, Oil price correlations are back, if only to explain away some of the more recent CAD under-performance which cannot be purely be put down to NAFTA - see MXN levels for that! 

Pre 1.2400 looks well supported against the USD, while pre 1.2700 saw good interest to sell again, and the crosses reflect the relative weakness seen in the market with AUD/CAD and NZD/CAD both on an upward trajectory at present.  On the broader economic front, we have Dec retail sales to look to this week, with CPI expected to drop from 1.9% when we get the release on Friday.   

NZ retail sales for Q4 on Thursday will shed some light on whether this current NZD out-performance in justified.  Few can put their finger on the resilience seen of late, which is pushing the AUD cross rate lower still, and threatening a push under 1.0700 again.  This is more than AUD weakness, given the RBNZ have also left the door open to a potential rate cut going forward, while the RBA are more inclined to sit on their hands given the headwinds to the economy, not least from sluggish wage growth on which we get the Q4 stats on Wednesday.  

Australian construction work done is also due, and is expected to show a sharp drop in Q4 of a little over 10%, but the AUD impact should be limited as the RBA minutes will likely mirror comments from governor Lowe last week.  Lowe remains pretty sanguine on the economy and the balance of risks and positive factors which keep the central bank on hold for now.  The fact that he still sees the next move as up, suggests they are ready to remain on hold for longer, but whether this is a reason to turn aggressively on the AUD at this stage is debatable, with underlying demand for commodities, globally rather than just China expected to stay healthy enough.  Based on this assumptions, we could see a more muted negative response (on AUD) if/when equity markets turn sour again, with money flowing 'back to basics' in both industrial and precious metals alike.  

A relatively quiet week for the Scandies, but for Swedish CPI numbers on Tuesday.  The Riksbank held rates unchanged at -0.50% again last week, and while they are in no rush to hike rates (BoE take note), the prospects of some normalisation here are not an unreasonable assumption given where rates currently are.  The Norges bank are also considering tightening at some stage at this year, despite sluggish inflation, but growth has been slipping and is also showing an annualised rate around 1.5% compared to 2.9% in Sweden.  That said, public finances in Norway are as strong, enjoying low debt to GDP and a strong trade surplus.  

Swiss trade data also out this week, and recent strength in the CHF could impact, but little rhetoric of note from the SNB after USD/CHF sank to fresh lows through 0.9200.  0.9070-75 a key area to watch here, but expect EUR/CHF to come under pressure if the upside traction in the USD continues from the end of last week.