Conditions improving for EURUSD rally

While sterling volatility remains high and dominates the focus, there is no further visibility from UK prime minister Theresa May surviving the No Confidence vote yesterday. If this vote was meant to give her a stronger mandate, it has somewhat failed, with more than a third of her own party wanting her to step down in the 200-117 result.

Sterling positions could remain expensive to hold in both options time decay terms and on the risk of spiky movements on the next headlines. It is doubtful that May can wring any notable concessions from EU leaders as all of the action in the Brexit denouement is likely to remain on the home front from here.

US-China developments have driven a modest revival in risk appetite and weaker US dollar, as China is apparently moving on car tariffs, has put in bids for huge shipments of US soybeans, and is even said to be easing off its Made in China 2025 programme. On the other hand, the case of the Huawei CFO arrest and requested extradition weighs, as does the risk that the US is set to go full throttle on accusing China of cyber- and economic espionage. 

The noise on Brexit and US-China trade talks has drowned out key developments in Europe, including a strong dip in Italy’s two-year BTP yield as budget negotiations with the EU are taking on a conciliatory tone. The EU summit today and tomorrow may put the issue behind us for now. The latest offer from Italy’s finance minister Tria is 2.05% of GDP, and the recent Yellow Vests protest in France is a game-changer as fiscal expansion announced by Macron will take France’s budget next year beyond the EU’s 3.0% growth and stability pact threshold.

As well, the new German CDU leader is a far more pro-European figure than the alternative and the pattern of populist revolt across Europe may finally be spreading to the EU’s capitals, even if the threat from the populists has not sufficiently penetrated the thick skulls on the EU commission. We are increasingly open-minded on positive euro developments, if not fully on board.

Building a EURUSD rally scenario

Probabilities still seem somewhat balanced, but in light of the last couple of days of developments, we are increasingly open to the idea that a combination of the following circumstances could lead to reasonable rally in EURUSD toward 1.2000, or at least into the 1.1700-1.1800 range in the coming weeks to couple of months, with the first four being the most important:

• Stable or lower Italian BTP yields (the large drop is an already underappreciated factor).
• Deepening sense of a US-China trade ceasefire/stable USDCNY, even if the longer-term relationship remains rocky.
• A dovish hike from the Fed or (much more forcefully) no hike at all at next week’s FOMC meeting.
• A strong risk response to the Fed’s ongoing shift to a more neutral outlook.
• US government shutdown over Trump’s insistence on border wall funding.
• Brexit process pointing to a delay or an eventual second referendum.

Chart: EURUSD

Something has to give here as we’ve traded in a very tight range for over a month and spent the overwhelming majority of the last seven months in the 1.1300-1.1800 range. An upside break likely requires a combination of the factors listed above, while a downside break might require the opposite: an ugly turn in US-China negotiations, higher EU existential risks and an ugly deterioration in risk appetite.