Monday, 14 April 2014

April 14th - FX & FI strategy

G10 FX overview:

The EUR starting the week on the back foot  some headlines from Draghi from washington

A strengthening of the exchange rate requires further monetary stimulus. That is an important dimension for our price stability 

EURUSD opened a modest 0.4% lower after these words, but frankly it is nothing more than what we've heard before. We have been told that the EUR will lower inflation (10% in EUR = -0.5% in CPI etc) and it doesn't take much to have expected the ECB to consider the EUR in their forecasts. As such they don't particularly want a strong fx rate. It is clear that 1.40 will play a big part in this, much like 75 in USDJPY a few years ago, or 0.95 more recently in the AUDUSD, as such we need to tread carefully. The USDJPY held up incredibly well throughout the back end of last week at a time where the Nikkei (cash + futs) traded sub 14,000 and the US 10 year dropped into the low 2.6's. However from first glances this week, it seems to have found some support (and the DXY as well) and risks now present themselves to the upside. With a break of 102 being critical in the short term - 101.20 still defines the downside, where a break sees 100.

most important line in FX this week,  USDJPY daily

On the commodity $ bloc, the AUD, NZD look overextended for sure, but I will look into those in much more detail later. CAD has been choppy but I don't really see much direction, with 1.09 still being a key level to watch.

Rates / Equity overview:

Last week saw a significant move lower for yields across the world, with the US 10 year breaking lower from the chart I presented last week, yet no meaningful tick higher in volatility (volatility only going to rise, if rates rise?), and we saw the 5yr sector in particular trade much lower, down about 24bps

Us yield curve
Notably in the European debt markets we saw the German 10y bund trade at 1.5%, a level not seen in over 9 months, I would still say its on the ECB-is-going-to-act play driving yields and yield spreads lower and tighter.

On the equity markets, I posted a chart last week, and since looking at the VIX term structure inverting, we've seen a modest bounce today. Given we dropped for no reason, I don't see it out of question to rally for no reason. Business Insider's Matt Boesler did an article on it (Chart

Looking ahead this week, I'm rather neutral on the impact from the equity markets, but of course we need to remain vigilant as a dive towards 1800 on the SPX could lead to weakness in USDJPY potentially spilling into risk off in the FX/FI markets, but we'll cross that if/when we get there.

EURUSD and the ECB:

I've written quite a bit on my thoughts of what the ECB should do, and how the EURUSD is likely to react. Broadly speaking the TL;DR of my other notes is: EURUSD downside will be a USD story, and EURUSD upside will be a EUR story. But now I am going to focus on the implications of a EUR rate cut.

As discussed earlier, it is clear that the EUR is becoming a more important piece of the puzzle for the ECB. However, assuming we see a rate cut (negative depo or whatever else) the inital reaction is likely to be a sharp (50-100bps) drop in the EURUSD. But like last time we had a rate cut, I'd expect this drop to be short lived and not be a game changer for the EURUSD in the medium term.

Using these three charts as proxies (good ones) for some of the key determinants of the EURUSD, we can see why the EUR has been so supported, and why we'll likely see more support.

So we have relative equity performance proxied via bank share ratios, 3M EUR vol as a good proxy for FX market volatility in general, and then of course the Italian-German 5 year spread as an indicator for peripheral debt spreads and risk premium in the troubled EZ.

Considering these each in turn, a rate cut would almost certainly result in stronger EZ bank shares relative to US ones, not much needed explaining here.

Central banks love to kill vol, it's what they do best in the long run. While there may be a short term spike higher in volatility, a show that the ECB will act to prevent deflation and try to anchor expectations will undoubtedly calm medium term fears and as such, if volatility doesn't drop (as its already historical extremes) it would struggle to meaningfully rise. Given the true tendency for the USD to act as almost the ultimate safe-haven currency, and given its low short term rates (key that very short end is lower than EUR rates), this will mean the USD is used as a funding currency far more so than the EUR, and therefore with lower vol, comes a higher EURUSD.

On the last point, there is a cause and effect here. Firstly, the yield spread is lower as people have been buying BTPs, and this has caused larger FI inflows and help supported the EUR, but looking forward, we would expect to see futher tightening and further inflows into the EUR sov debt market further buoying the EUR even further.

Taken these three assets and building a composite indicator, we can see how closely it has followed the EURUSD before, and would lead me to believe that we could see a higher EURUSD on the back of a negative rate.

This was a quick look at what I believe a negative rate cut would do, and considering the likely consequence, I believe the ECB won't pursue this measure (or if they do, act in other ways to prevent EUR rising). However disinflation is a real concern, but as discussed before, leaving it alone is a really bullish EUR aspect (real rates idea discussed here)

AUD and the RBA

I feel I'm focusing too much on central bank rhetoric this week, but oh well, we have the RBA monetary policy meeting minutes coming up where I expect the RBA to have once again moaned about the AUD, which if we remember last time we rose to the 95 area vis a vis the USD they were pivotal in us turning lower. However, the idea isn't just strucutred on the minutes coming up, I feel the growing concern from China will likely weigh on the market, and there is a concern that if Us equity ticks lower risk could filter away from the market.

Positioning is also key, and according to Citi FX (one of the largest FX banks by volume) the AUD demand is starting to falter and given the market is quite overbought (up 9% in a few weeks) we could see a pullback as longs look to cover, citing the RBA as their "excuse" to take profits.

Extract from Citi

Clients positioned for growth and disinflation

Global Overview: Our flow signals do not change dramatically from last week. EUR remains the most oversold currency in the G10 – while AUD and CAD reach overbought levels. Client interest in selling EUR and buying AUD are both waning, leaving the currencies at risk for a correction. CAD demand remains strong into the BOC. 
Strongest Directional Signals: EURAUD selling at risk: An oversold EUR and waning demand to buy AUD is now the most “stretched” flow in the G10. The cross remains sensitive to any disappointing US and Chinese data. · 

They see EURAUD as being the most stretched in terms of positioning, and in fact I quite like buying in small amounts down here

From a technical outlook, we see Stochastics and RSI confirming the positional commentary from Citi, and given the AUD's outlook, I'm looking to buy around here (1.4665) for a move higher towards 1.49 (or so) 

Stops will be somewhere below the last low, but 1.46 is the area I'd be looking to cut at anyway.

German 10 Years - tactical shorts?

As mentioned earlier, Bunds traded at 1.5% on the 10Y, and I decided to short the futures at 144, the provides decent exposure to any possibility of a move lower in global FI, and also in case we start to see EZ data / inflation start to pick up. This trade won't perform well if the ECB does act, but that is a matter for June anyway.

10Y bund daily chart
Either way, I like being short bonds here on a tactical basis, as even though we've seen a large drop in yields recently, and sharp spikes in Eurodollar contracts, I think the actual fed path hasn't changed from 2 weeks ago, so I see bonds as structurally expensive here.

On other notes, been bearish SEK for what feels like too long, but its hopefully starting to pay-off with a lot of room above 6.60 vs the USD, and the Riksbank is sure to become more dovish after having a year of deflation.

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