FX and Gold: Price action points to positive response to EU proposal

The Euro 

Price action suggests the market likes the EU proposal so far, though there’s an odd divergence to what’s being discussed on most FX desks. Not only is it a long way from a signing summit in June, and not all countries are necessarily on board, but more specifically the proposal is not significantly different from expectations. 

But there were sufficient dueling tailwinds to support the Euro. The EC package was a positive surprise with the EUR250 bn of loans on top of the EUR500 bn grants, plus firm shares for countries with more than EUR80 bn for Italy. The market reacted accordingly, but even more robust than most had expected. This was likely due in no small matter to a large dollar sell signal into month end due to portfolio rebalancing after US stock indexes surged again in May. If US stocks are higher at the end of the month, foreign owners need to sell the USD to reduce their FX hedges.

The market is reacting positively to coronavirus lockdowns being eased across the globe. Equities have enjoyed a firm rally in the past few days and the Franco-German recovery fund proposal. Overall, this is a good setup for the Euro to remain firm over the short term.

 

Australian Dollar 

Bad news on the China-Australia trade war front as China is expected to impose restrictions on coal imports, starting with shipments from Australia, according to press reports. That news could be behind the jump in USDCNH above 7.19 overnight. 

Still, the Aussie dollar is holding up due to its high beta to US stock indexes, suggesting that in the reopening environment the A$ strong beta wins out all day long when the US and China compete on the board game of Axis and Allies. 

But you rarely see such a considerable divergence between CNH and AUD. They’re not always joined at the hip, but they do tend to trend in the same direction. And right now, they’re diverging. Still, the Aussie dollar market remains trade headline nervous.

If you think back to the Trade War days, there was a cycle where stocks would sell off on lousy trade news then regain their footing and trend back to the all-time highs again. Once stocks were looking good, President Trump would have the confidence to drop another Twitter bomb via new tariffs. I wonder if he will similarly use this equity rally to drop sanctions or some similar penalty on China in the next few days? I’m not saying this will happen but it would fit his prior modus operandi.

 

The Yuan

The markets appeared to have been caught off guard by the latest move higher in USDCNH as traders were likely lulled into complacency due to the risk-on environment and the weaker US dollar in the past few days.

The PBoC is signaling a more hands-off stance amid the potential escalation of US-China tensions regarding Hong Kong. Traders are looking for the easiest and cleanest hedge to cover the rise in US-China tensions and, ultimately, trade war risk. Staying short, the bellwether CNH fits that need to a tee.

 

The Malaysian Ringgit

Oil remains one of the weaker links for the Ringgit as Brent remains below $40 per barrel. Still, there are nascent signs investors are back on the hunt for yield expecting economies around the world to recover. This has triggered a reduction in long USD dollar hedges across EM, while investors are buying yield with more purpose, benefiting the MYR on the edges. The Ringgit is not considered a high yielder per se. Still, with BNM expected to cut interest rates, another 50 bp MGS bonds are garnering some interest from foreign buyers despite the poor optics of a weaker Yuan effect that’s sullying the regional currency landscape.

 

Gold Markets 

Gold reversed early losses despite risk-on sentiment. This may be a positive sign to the overall narrative and prices could gain traction after the recent fall.

Gold's ability to stem losses in the face of further increases in "risk-on" sentiment and, in particular, gains in equities is good for the bullion market. This reinforces the view that gold is mapping to reflationary components within the stock market rise, so the bounce above SPX 3000 is not particularly worrisome at this stage as both gold and stock markets are benefiting from swelling central bank balance sheets.

The weaker USD has been less positively impactful for gold than one might have expected. Both bullion and the USD have moved directionally much of this year, competing for safe-haven flows. This is not unprecedented as the same correlation happened after the GFC before gold’s reflationary ticket was eventually punched higher post-GFC.  

As most gold traders will be quick to point out, normal relationships seem to have broken down. In the current climate, gold may rally even if the USD goes up and could also be firm if the equity market is strong. But what is still positive for gold is geopolitical and trade risk. 

I remain very bullish as some of my first-level reflationary targets have been met or exceeded, it’s now a matter of putting some headroom above those numbers. 

 

Here’s my reflationary breakout checklist

• EURUSD 200-day 1.1016 At.

• AUDUSD 200-day 0.6663 Below.

• e-minis 200-day 2997 Above.

• WTI $40 Below.

Still, from a gold and commodity trader perspective, it’s always hard to predict the return of GDP growth and inflation. The unprecedented shock (Corona shock) that hit both demand and supply left the situation more complicated. Nevertheless, this shock is a deflationary event first as loss of aggregate demand through unemployment will be larger than that of total supply, and unemployment could linger for some time. 

 

Gold near term price influence is the EFP

When the coronavirus panic first arose, one knock-on effect was that gold could not be transported to different locations, nor did the bars get refined as refiners were operating well below capacity. Since the Comex is considered the most liquid exchange, most investors turned to futures to buy gold, which in turn drove the price to an $80 premium over spot. Usually the EFP would stay in line with the OTC market, preventing arbitrage. In its simplest terms, you would sell the elevated EFP, take the bars held in London, refine them into 100oz Comex bars, ship them into New York and capture the arb. 

But now, given that refiners are ramping up capacity and transportation is more readily available, there’s been a massive inflow of gold into New York, taking the gold inventory up from roughly 9 mio ozs at the end March to over 26 mio ozs. This has drastically reduced the EFP with June contract trading at -8, meaning Comex's front-month is now at a discount as no one wants to take delivery as there’s little demand for physical.

This consistent downward pressure on EFP will likely force some investors out of their outright gold futures positions. Spot gold may, therefore, go lower, back towards 1650. These are technical and deliverable interplays real gold traders focus on. While this probably doesn’t change the bullish outlook for gold in the medium to longer-term, it may be an essential dynamic to monitor in the short term.