FX daily: Snakes and ladders

After suffering heavy losses on Friday, risk assets start the week on a slightly firmer footing on the (yet unproven) assumption that Omicron may not lead to more severe illness and that vaccines may still prove effective. It will probably take a couple of weeks to better understand this variant and until then risk-sensitive FX probably stays fragile.

USD: Dollar correction could have been worse

Having continued in their steady ascent from their lows in March 2020, risk assets landed on the Omicron ladder late last week, and on Friday the MSCI World equity index suffered its largest correction since last October. Fears over its severity have been marginally allayed by reports that the symptoms associated with Omicron are mild, yet it seems that we will have to wait a couple of weeks before we hear more definitive news on whether the current range of vaccines is effective, and about Omicron's transmissibility and impact.

Until then - and since it has been a good year for risk assets in general - investors may be reluctant to jump back straight away into risk trades such as long equities and long commodities. This is because this week we will invariably hear more reports of Omicron's spread in the community and presumably policymakers, wanting to preserve hard-won gains, will be announcing what they feel are proportionate new restrictions.

The emergence of the new variant has naturally questioned whether central bankers can stick to planned goals for policy normalisation. Overnight, the Reserve Bank of New Zealand Chief Economist said that they would have still hiked last week even if the Omnicron news had emerged before the meeting. And US interest rate markets have already retraced about a third of Friday's adjustment. 

In terms of the US calendar this week, the highlight will be Friday's release of the November US jobs report, plus key congressional hearings from FOMC's Jerome Powell on Tuesday and Wednesday following his nomination for a second term. Expect US data to continue to back the case for an early Fed tightening, but it will probably take some more detailed assessment on the severity of Omicron before DXY can make it back to the highs of the year at 96.94.

EUR: Oversold bounce

After continuing losses through November, EUR/USD had been looking oversold last Thursday and Omicron proved the catalyst for an oversold bounce. The reversal of euro-funded carry trades (e.g. short EUR/RUB has been a popular trade) has no doubt played a role in the EUR/USD rally and the calming of global risk appetite will no doubt have a say in how long this period of EUR/USD consolidation lasts. For the time being, we would see EUR/USD tracing out a 1.1220-1.1320 range.

Into December we had felt that a slowdown/reversal of USD funding demand for year-end balance sheet purposes could see the dollar correct weaker and uncertainty about Omicron may now also slow some of the dollar buying on the Fed normalisation story. 

This week in the eurozone, away from Omicron, the focus will be on the flash release of November CPI readings across the region. These will push up to new cycle highs and maintain 16 December as a key meeting for the European Central Bank.

GBP: High beta problems

EUR/GBP is about 1% off its lows. GBP seems to be vulnerable to Covid-19 variant news because: i) UK proficiency with gene sequencing means that the UK is more likely to spot and report new outbreaks in the community; ii) FTSE equity benchmarks are heavily-weighted to the miners and gets hit with commodities on demand shocks and iii) Bank of England tightening had been providing support for GBP, and the 16 December BoE decision looks to be even more in the balance/swinging to no change now.

As above, it may take a couple of weeks before we know a lot more about Omicron and thus GBP may struggle to quickly recoup recent losses. We favour EUR/GBP to trace out a 0.8400-0.8500 range for the time being. 

NOK: Getting help from OPEC+

As a high-beta currency, the Norwegian krone has been one of the worst affected by the Omicron news. Yet EUR/NOK is now 6.6% off its low for the year and arguably NOK has a lot of bad news priced in. We had already highlighted NOK as one of the most undervalued currencies in our 2022 FX Outlook and we feel it could be one of the strongest to recover were any Omicron assessments to prove more benign than first thought.

Additionally, Thursday sees OPEC+ meet to discuss quotas. Should it decide to slow supply increases in response to both: i) strategic reserve releases and ii) Omicron demand threats, crude can continue to recover from last week's sell-off and both the krone and Russian ruble should be at the forefront of any recovery in risk-sensitive currencies. 

Read the original analysis: FX Daily: Snakes and Ladders