FX Strategy Weekly

Talking Points

• US yields approach key level

• Dollar higher after NFP, speculators most bullish since 2016

• Italy, Brexit weigh on EUR, GBP

FX Macro

USD is firmly bid as the trading week commences albeit with some thinner liquidity due to the Columbus Day holiday in the US. A Japanese holiday also means we have a slightly unusual start to the trading week. The euro and sterling are both under pressure whilst emerging market currencies are also affected by the stronger dollar.

Three things seem to be driving demand for USD: selloff in China and Italian debt worries sparking renewed haven bid; as well as the pricing in of further interest rate hikes by the Federal Reserve as markets react to some fairly hawkish commentary and data last week.

The combination of rising yields, Chinese easing and Italian worries is proving plenty of excuses for equity investors to book profits and seek safety, and FX markets won’t be immune from this increased volatility in stocks and bonds.

Yields

As discussed in today’s morning note, US bond yields are on a tear with a rally that is starting to dent equity markets.

Traders are eyeing the 3.25% level as a key breakout point for the 10yr. Higher US yields seem to reflect market expectations for the Fed to raise rates more from here due to a strengthening US economy that has somewhat caught bond bulls off guard. The comments from Jerome Powell last week – the end is not in sight for hikes - suggest the neutral rate is further away than was previously expected. However, it does not seem to reflect soaring inflation expectations with real yields shooting up. Higher yielding US paper should keep the pressure on emerging market currencies and is providing the necessary support for the dollar to appreciate further. However, we note that the DXY chart shows a bearish crossover on the Slow Stochastics that could signal at least a pause in the dollar rally, if not an outright retracement of the September gains.

What’s becoming really evident is that the US economy and the Fed’s desire to tighten are way ahead of peers. It does look that in this environment, dips are presenting bulls with plenty of opportunity to go long but this is not a one-way trade. Speculators net long positions on the US dollar have reached the most since December 2016 – the moment the wheels really came off the long dollar trade. This is looking like a very crowded trade.

Italy

Meanwhile traders are eyeing a looming clash between the EU and Italy over the budget. The mood music is starting to sound ominous. The European Commission wrote to the Italian government this week voicing serious concerns about the budget.

Ten-year Italian BTPs are on the ropes again with the yield above 3.6%, reaching its highest since the start of 2014. The bund-BTP spread – a key measure of risk – has widened to more than 300bps, the most in over 5 years.

The euro is feeling the heat from Italy and a firming dollar on Fed rate expectations could see the euro slide more from this point although it remains at the mercy of the political machinations in Brussels and Rome.

It all likelihood the EC will reject the budget and its 2.4% deficit target; the only question is what next after that? Uncertainty should weigh further on Italian assets but ultimately it seems unlikely that we reach a genuine crisis point with some form of classic EU fudge likely. This means the euro could start to claw back some losses later in the year, although we note that speculative net positions are still fairly balanced, turning to -7.1k last week from +3.7k the prior week.

However, bond market positioning is not reflective of this and it does look like traders are pricing the prospect of even higher deficits and spending. Indeed, Deputy PM Matteo Salvini raised the stakes again on Monday by describing the EC as the ‘enemies of Europe’. Could get worse before it gets better.  There is a risk that we start to see chatter around ‘Italexit’ again before a compromise is found.

China

A selloff in Chinese stocks is also weighing on the broad market sentiment, supporting haven bid for USD. The PBOC slashed banks’ reserve requirement ratio by 100 basis points in an effort to boost liquidity and lending. The fourth RRR cut this year also hit the renminbi. Such easing looks like the PBOC is actively encouraging a weaker currency and this could prompt a response from Washington.

Brexit

The pound lost ground as Dominic Raab, the UK’s Brexit secretary, headed to Brussels for more talks. The Brexit summit for October 17th points to more volatility for sterling as traders make calls on how talks are seen going. Of note, on Monday Downing St has said the UK could walk away from paying the €39bn divorce bill if it does not get the exact trade deal it wants. No deal cuts both ways – we are very much getting to the crunch and investors are left waiting on the sidelines.

FX Chart Analysis

EURUSD: testing key support at 1.14620 the lows of Wednesday and Thursday last week. A move lower opens up a potential retracement to the 1.13 low of August. A bounce – three tests of this level could indicate that the market doesn’t want to head lower just yet - presents bulls with a move back to the 23% retracement of the swing low from the Feb high at 1.16.

GBPUSD: Cable is holding within a range between its 50-day and 100-day moving averages and is trading through the 23% of the move from its April peaks to the August low. Coming off the mid-August key reversal (similar to EURUSD), the broadening wedge formation looks bullish but also indicates increased volatility. A bullish crossover on the slow stochastics out of oversold territory points to upside momentum but GBP seems entirely at the mercy of Brexit talks.

USDJPY: On the candlestick chart, the dark cloud cover reversal pattern from Thursday points to an end of the recent upswing and potential consolidation if not an outright retracement of the dollar’s gains. The bearish slow stochastics crossover also suggests near term weakness for the pair. The July 19th high above 1.13 is now offering support on the daily chart but a breach lower on the close today could signal a move back to support at 110.50. Jitters around China and tariffs may support further haven bid, giving the yen a slight advantage over USD, but a weaker yuan tends to disrupt any positivity around the yen.

Cryptocurrencies

Bitcoin: Speculators’ net short position on bitcoin Cboe futures rose to 1,297 contracts last week. Although bitcoin has broken above the downward trend line, the lack of momentum to breakout decisively suggests the descending triangle – usually bearish – is very much the dominant force. Nevertheless, there is some rising trend support starting to come with higher lows now evident since Jun that could indicate this triangle is losing its importance a little. What is most evident though is just the lack of any direction to this trade – bitcoin price volatility has hit a 15-month low as it trades sideways against the dollar. The narrowing in the Bollinger Bands combined with the end of this triangle suggests a decisive move is imminent.