FX Update: Eyeing the post-Covid-19 dawn even as resurgence weighs

Today’s FX Trading focus:

Waiting and watching the USD, US rates and Georgia on my mind
The price action in FX has settled again, with implied options volatilies in key pairs staying low after dropping like a rock on the day after US Election day last week. The 3-month EURUSD implied volatility is back in the low 6% area that has been the low of the range since the Covid-19 spike in the spring, and the 1-year is in the same area and almost at a new low since then (the record low was posted in Jan-Feb of this year just below 5%). In other words, this seems a decent level to express a longer term view in either direction, although there is the risk that we head lower still until the US political situation clears up early next year.

On that note, Georgia is the last-ditch chance for the 2020 US Election to spring another surprise, as both Senate seats there are set for a run-off election on January 5. Both sides will engage in an epic fight to get out the vote and the stakes are national in scope, given that the Democrats taking both seats will completely alter the potential scale and focus of fiscal priorities as the 50-50 split of seats would allow Vice President Harris to cast the deciding vote. The market will have to hold its breath for this result, upon which the USD outlook also hinges, as we see larger fiscal stimulus as USD bearish on the relative inflationary risk and as it would aggravate US external deficits.

US yields are still at the top of the agenda if they rise back toward the 1.00% level and beyond for the 10-year US treasury benchmark, although the yield there did back off sharply yesterday and now stands at around 86 basis points. The shorter-term and longer-term outlooks are dissonant: right now we have the uncertainty of a terrible Covid-19 spike in the US requiring restrictions on activity (more likely self-imposed on public advisories rather than any risk of a France-style lockdown, for which Americans don’t have the appetite), but longer term, we trust that science prevails and delivers an effective vaccine.

In the meantime, the Fed and/or the US government can juice the economy with additional stimulus in reacting to this latest ugly Covid-19 risks before a vaccine starts to mitigate the damage sometime next year. When the light at the end of post-Covid-19 tunnel is properly becoming a new dawn sometime next year, a full US re-opening could release a considerable amount of pent-up demand (and pent-up savings from the US stimulus splash this year, much of which was saved) and drive US longer yields much higher – with the added response here over the winter piling on the inflationary potential. That would tend to be US dollar positive if yields are allowed to rush higher at the long end of the curve, although that story could change if the Fed signals a “Twist” operation or that it is mulling yield caps to tamp down longer yields, declaring that it simply will not allow financial conditions to tighten as long as unemployment is above, say, 5%. That would then likely turbo-chart the USD bearish argument on the risk of highly negative real US yields that have been the chief driver already in repricing the US dollar lower.

Chart: USDJPY
USDJPY tends to follow the direction of longer US yields, but investors ought to also consider real yields (the nominal yield less inflation), with Japan’s real yields slightly positive, while US yields are still negative, if rising for longer term treasuries. Incoming US inflation numbers and whether the Fed signals the intent to cap yields at the longer end of the US yield curve will be critical for whether an extension higher in US yields would continue to support USDJPY upside. For now, the technical bullish reversal after the attempt below 104.00 looks decisive until proven otherwise, but the tricky bit is that no rally has found legs in the pair in recent history and is unlikely to unless real – and not just nominal US yields rise from here. The Fed won’t want be willing to allow real yields to rise unless the US economy is suffering a proper over-heating, the last concern on the Fed’s list of concerns at the moment.