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FX Update: Market buying into transitory inflation narrative.
John Hardy
Head of FX Strategy
Summary: The market is buying into the transitory inflation narrative peddled by the Fed, or at least it is pulling back from its conviction in pricing in inflationary outcomes if we look at the current trajectory of forward inflation expectations and Fed policy expectations. The next week may tell us whether the entire summer risks being an inconclusive slog as we await the evolution of inflation data and how central banks react. BoC and ECB previews also in the update.
FX Trading focus: Market slowly towards Fed’s transitory inflation narrative
I have been putting together a few charts for the FX Market Update webinar I am hosting tomorrow (sign up here) and on the surface, it is very difficult to put together a compelling view on anything ahead of a summer that may mostly prove one long exercise in waiting for the autumn and whether the “transitory” nature of inflation begins finding confirmation or rejection over the next three or four months. Two of the first guideposts on how nervous the market is on the subject along the way are tomorrow’s CPI data, where inflation expectations and the Treasury market are showing no signs of fear, and next Wednesday’s FOMC meeting, where I suspect that the Fed may feel emboldened to talk more taper than is expected, though possibly with enough contingency in the language to avoid upsetting the market. If the Fed can pull that off and there is no reaction to a hot CPI print, the US dollar may find itself on the defensive again, although as we note in the chart below, the key real yields narrative as a driver of USD weakness has not been really supported the USD bears’ case for some time now.
Note that after a strong 3-year Treasury auction yesterday that saw a solid pick-up in foreign demand, a 10-year auction is up tonight and a 30-year T-bond auction tomorrow.
Chart: US real yields versus the US dollar
A chart showing that, while nominal US treasury yields are falling for the 10-year benchmark, the 10-year inflation expectations are falling faster in recent weeks, such that US real yields are actually rising slightly, which is making life a bit frustrating for USD bears, with much of the fundamental support for their argument based on US fiscal profligacy driving far more negative real yields than elsewhere. At the moment, there is little support in market pricing, but will be interesting to discover in coming weeks the degree to which US real yields might actually rise more sharply if the Fed transitions to flagging an eventual asset purchase taper and/or if the end of the US Treasury’s drawdown of its general account at the Fed (the drawdown adds to liquidity and is likely contributing to the suppression of bond yields), which as we mentioned on this morning’s Saxo Market Call has some $300 billion further to fall before stabilizing around the Treasury’s deadline for completing the process by August 1.
USDCAD over Bank of Canada meeting. The Bank of Canada meets this afternoon and may not make much of a splash after the tapering move in late April and the drastic upward revision of its forecasts also at the meeting engineered a steep rally in CAD. How stern the policy statement sounds on inflation will be a key factor, but Macklem and company may not want to signal too much now that the 1.2000 level in USDCAD has heaved into view – a break of that level might be more down to USD weakness as opposed to isolated CAD strength, though a break we may get either way, if crude oil is set for another major surge or if this BoC surprises with distinctly hawkish guidance on further tightening via a taper. USDCAD has been stuck in a very compressed range with 1.2150-ish as the approximate range top recently – impressive CAD strength given the scale and persistence of the USDCAD sell-off since the spring of last year.
ECB meeting tomorrow. – having a hard time ginning up any enthusiasm about the ECB meeting tomorrow, where it was always declared that purchases were to be “front loaded”, so does that mean you even need to announce a taper? As well, a six-time oversubscribed Italian 10-year BTP auction yesterday suggests little of fear of a taper and a strong demand for yield where it can be found. I don’t see the meeting as likely to produce a major upside catalyst and suspect we might see more volatility tomorrow around the US CPI release. The ECB will release its latest set of forecast, which could garner attention. But perhaps more interesting are ECB plans to hold a multi-day “retreat” on June 18-20 in Frankfurt (in lieu of the postponed Sintra conference normally held in June – Sintra has become the ECB version of the Fed Jackson Hole symposium.” So if ECB is set to communicate something new, it will most likely be after the late-September German election and the Sintra conference to follow November 10-12.
Table: FX Board of G-10+CNH trend evolution and strength
The trend strength readings are settling lower and lower and I have a hard time recalling such low readings across the board, with all of the G10 currencies and CNH below 2.0 in absolute values. Medium to longer term options are one way to have and maintain a position, with the risk that we have a long summer ahead of the June FOMC meeting fails to trigger any new inspiration for FX traders.
Table: FX Board Trend Scoreboard for individual pairs
AUDNZD flipped official back to positive yesterday after the recent downside breakout has found itself rejected and interesting to note that NZDJPY is the first G10 JPY cross to tilt over to the negative after the NZD surge there was similarly rejected.
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