Author — Nick Korzhenevsky, senior analyst with AMarkets Company. The anchorman of a TV program "Economics. Day rates".
- Fed policy tightening is now back on table. The June FOMC statement is to indicate a rate hike in July or September.
- EURUSD upward corrective move has run its course. The downtrend has already resumed.
- Oil is getting overpriced, and is now the only commodity holding onto its year’s highs. Most likely this won’t last.
So here comes the hawkish side of Janet Yellen. Of course, it is the tepid hawkishness that is so typical for modern-day monetary policy, and yet the Fed is not giving up on hikes. Speaking at the Harvard university last month, the chairwoman put it quite bluntly. She openly pronounced that a rate hike seemed appropriate sometime in the coming months, which implies June, July or September the latest. We remain committed to a scenario of two hikes this year.
Tactically, the Fed is now probably ready to include the sacred “risks are broadly balanced” rhetoric in its June meeting statement. This is a traditional signal of a move planned for the next meeting. The committee might act as early as July. However, it would take a few things to make that happen. First, payrolls data for both May and June have to come out quite solid. Second, Chinese slow-motion devaluation ought to remain contained. And last but by far not the least, the Brexit vote must be a “remain”, meaning that the U.K. stays in the EU. The consequences of a “leave”, or an exit as the outcome will be discussed later in this report (extended discussion in the GBPUSD section below). But they are likely to lead to a general risk-off mood with a spike in volatility. That would be what the Fed calls “global financial risks” that make policy tightening unacceptable, as it amplifies general instability.
The second rate hike in this cycle should lead to a less-pronounced, but a lasting reaction in the market. A less-pronounced one because further tightening has been partially discounted. July federal funds futures imply a 60% probability of a move, and it shouldn’t rise much even after the June 15th meeting. Therefore, much of it is already in the price of the USD. However, December contracts still allow a 20% probability of no rate hikes this year at all, and the further part of the curve is still trading way too high (in terms of prices, or too low in terms of rates). A persistent pressure is likely to emerge that will keep all yields on a 2-year segment elevated. This, in turn, is a major factor to trigger sustained dollar buying. And that is why we expect the reaction to last.
Then, there is another rate hike to expect later in the year. It is too early to run any extensive analysis on that one, but we are gaining confidence that the political cycle might affect monetary policy. The presidential race in the U.S. is shaping up quite ugly. Most importantly, the probability that Trump wins is now outright high. Of course, professional political analysts strongly believe that Hillary Clinton is to be elected in November. But this group of forecasters was dead wrong just a few months ago when writing Trump off.
Furthermore, there is still no guarantee that the Democratic party convention proceeds smoothly and Hillary becomes the party’s candidate. However, we tend to believe that Clinton is nominated. What is truly unclear is what happens in November. The final electoral procedure is much alike the intra-party one, and each state gives all its votes to a single candidate (with two minor exceptions). Given Clinton’s skyrocketing anti-rating and Trump’s exceptionally clever campaign, we do not rule out a win for the Republicans. This would dramatically change economic landscape and create enormous short- and mid-term uncertainty. The Fed might find itself unable to act, and forced to postpone the next rate hike until the dust settles.
Meanwhile, on the other side of the Atlantic, the ECB is starting to buy commercial debt. June is the first month of this new exercise. The size of the program remains undisclosed, but we know that the ECB aims to boost its monthly purchases from 60 bln to 80 bln euros. According to our estimates, the central bank’s demand will amount to EUR5-10 bln., and that is a significant number. Actually, it is a competitor big enough to “crowd out” private sector investments. This is likely to lead to further worsening on the balance of payments, and more EUR weakness. We also note that this move is not necessarily positive for the European stocks. Strategic investors are fleeing the Eurozone, and the speculative money will be mostly attracted to bonds, now both government and corporate. The flow of euros out of the union will help keep global volatility subdued, counterbalancing Fed hikes.
EURUSD: sticking with the base-case scenario.
The main unit has precisely followed the path described in our May’s report. EURUSD tested 1.16-1.17 area, failed to break any meaningful levels, and promptly reverted to 1.11-1.12 range. That is where it is trading as of this moment. We still believe the euro will end the year notably lower, and eventually test the parity. Alas, there is not enough momentum for that due to the Fed’s cautious approach to rate hikes.
Reach of the parity would deem plausible had the FOMC delivered four rate hikes this year. We previously laid out economic ground for that, but the committee’s reaction function proved to be milder than envisaged. Because it is now only two hikes against four expected originally, the damage to EURUSD, and general dollar strength, is admittedly less pronounced. However, 1.05 should still be tested in the second half of the year. Clear technical signs indicate that the downtrend has resumed, and positioning now favors a lower EURUSD. There is a sense that Janet Yellen is now rushing to complete at least two hikes in 2016, and this is absolutely plausible. There is also a stronger flow of fresh EUR supply leaving the gates of the ECB, adding to downside pressure.
We view any upward move in the EURUSD as an opportunity to sell, originally targeting 1.08.
GBPUSD: in the driving seat for June.
The Brexit is easily the most important event of the month, overshadowing even the Fed’s meeting. The latter comes on June 15th, while the former is scheduled for the 23rd. The run between the two dates will not be an easy one for markets. The FOMC is apparently willing to prepare investors for an upcoming rate hike, which nearly guarantees there will be a language change in the next statement (see the introductory part of the current report). This means that for six full trading sessions markets will need to operate in a mode where, on the one hand, the Fed is tightening, and on the other hand, the EU is about to shrink, losing its true financial center.
So how does one trade sterling ahead of and after the event? We still believe that the GBP is to fall under mild pressure in the days prior to the referendum, and markets generally should trade in a risk-off mode (absent other catalysts for risk-buying). But the fun part starts once the outcome of the vote is in.
GBPUSD options currently trade at 32/34 IV, which means that the market is pricing in a 2% move in a single day. Our own estimate is even more brutal, as our models produce extremely fat-tailed price process distribution when allowing for heightened volatility. It is also clear that the current GBP exchange rate discounts a 50/50 outcome for the referendum. Taken together, these considerations mean that a very strong move is highly likely to follow, be that a move up or down. We think that the Brexit premium/discount stands at around 4 big figures in the GBPUSD, 0.038 of the price quote, to be precise. And that is still a conservative estimate (or, rather, an estimate for an immediate intraday reaction). Should the brits choose to leave the EU, the pound will probably trade through all the recent minima, and the GBPUSD is very likely to retest 1.38. Otherwise it is very probable the 1.5 is taken out on the GBPUSD, and EURGBP will get even heavier, as the next step for speculators will be to start trading on the Bank of England first policy tightening.
USDJPY: time to fight the yen strength.
The yen has been one of the most interesting stories this year. The Bank of Japan surprised with the introduction of negative interest rates, and the yen surged in response. That caught much of the market by surprise as this move deemed counter-intuitive. We believe that the reaction was greatly magnified by general positioning, which was extremely short the yen. Technical issues regarding the implementation of the monetary policy also played a role, and large seasonal repatriation flows were evident.
However, all of that is now mostly in the past. And the future is likely bringing us two things. First, the Bank of Japan is likely to ease again, and keep doing so until it gets what it wants: namely a much weaker currency. Second, the government has now switched to looser fiscal policy, trying to boost economic growth with less taxation and more spending. The decision to postpone a VAT increase by two-and-a-half years is just the latest sign of the general direction, and there will be more to come.
From a fundamental point of view, Japan has long been a country with a fundamentally flawed economy and exceptionally large fiscal imbalances. At this point the yen should suffer once outflows accelerate in response to higher U.S. rates. As we can now speak of two rate hikes as the most likely scenario for the Fed this year, USDJPY should be expected above 115 in H2 2016. We note, however, that the Japanese currency has been arduous to trade from a tactical viewpoint, and extremely strict money-management should be applied.
USDCAD: switching out of USDCAD into crosses.
Canadian dollar has been trading on the back foot. USDCAD has completed the expected corrective move to 1.285 and stretched further up to above 1.3. There seems to be excessive weakness in the loonie, but we would refrain from establishing positions via selling the USD. The preferred way of getting long CAD exposure is offering the crosses.
There are two alternative types of trades to consider. The first higher-risk option is selling GBPCAD. The main source of risk here is, of course, the british pound. Should the Brexit referendum conclude with a “remain” vote, significant upside potential for sterling is to emerge immediately. However, momentum strategies signal that the GBP is strongly overbought, and should decline against a basket of currencies in the short-term. We view GBPCAD as an extremely speculative, yet appealing trade that needs to be squared prior to the referendum day.
TThe second option is a regular relative-value trade, and here shorting AUDCAD and NZDCAD is the most sensible approach. Industrial metals had a horrible May and are now in a bear-market. Price action is extremely volatile and susceptible to any selling. The terms of trade for the Australian dollar are worsening by the day, whereas Canadian dollar remains supported by expensive oil. We believe that crude should trade sideways through the summer, and that would put additional pressure onto AUDCAD. The story for NZDCAD is quite similar, except we are talking a different set of commodities. It is also worth noting that AUD and NZD are much more exposed to a slowdown in China, and are more vulnerable in the face of Fed hikes.
We are selling GBPCAD targeting 1.818 and AUDCAD targeting 0.916/0.865.
VIX index (VOLX): adding to longs.
This is a reminder of our previously recommended trade. VIX, the S&P500 implied volatility index, has once again dropped to levels deemed unsustainable. Both Fed’s policy and current macroeconomic environment argue for the index to average 18-20. As we’re clearly dealing with a mean-reverting process here, these levels should be tested sooner rather than later. We expect the VIX to rise to at least 16.5 prior to the June Fed meeting, and also find support as the Brexit referendum approaches. Should the index drop even lower, we would adding to the position and consider leveraged bets. Historically, the VIX has never stayed below 10 for any meaningful amount of time.
USDCNY: holding onto longs, approaching the target.
The yuan is now on a firm downward path against the PBoC basket as well as the USD alone. It closes May at the lowest level in 5 years. Apparently, the central bank has decided it is too expensive to create artificial volatility in the FX market, as it is the sole buyer on the days of a stronger CNY. In an attempt to stem capital flight the authorities have already burned through USD 1 trillion of foreign-exchange reserves. Additional cost is probably viewed as highly undesirable. Furthermore, the PBoC is often comfortable with weaker yuan when a Fed rate hike is approaching. Recent developments in the Chinese FX are another sign that the FOMC is ready to tighten again.
OIL, Brent: overpriced, but too risky to sell just yet.
Oil is now surprising investors as the most resilient commodity, refusing to go down with the rest of the block. At $50/bbl both Brent and WTI look overpriced to us. We arrive at that conclusion regardless of the analysis method applied. Supply/demand balance, forward curves and volatility structures all suggest there is significant downside potential. The only factor preventing prices from going lower might be positioning. The market is afraid of going long as it remembers the last “great collapse”. Oil traded under $30 just about three months ago, and that is still fresh in the memory. But as speculative longs build there will be more potential for a leg down. We believe that $36.6-$38 area is to be re-tested in H2 2016, but at this point an outright short position is too risky. Option structures are preferred.
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