US midterms, FOMC loom large in FX

This week features hefty event risks for global markets, from the US midterm elections on Tuesday to a Federal Open Market Committee meeting on Thursday. Meanwhile, perhaps the biggest question of all remains China’s intentions for its currency and this could remain bottled up for another few weeks.

Friday’s equity trading session on Wall Street saw a development we are likely to see repeated many more time for this cycle: an attempt at a solid extension of the rally off the recent lows that turned badly later in the session – likely at least in part due to an aggressive sell-off in US Treasuries. The 30-year US T-bond yield closed the week at its highest daily and weekly level for the cycle, just five basis points shy of the 3.50% level.

In other words, until we reach a turn in the policy environment from here, the risk is that whenever risk appetite makes an attempt to signal the all-clear, rising bond yields will swoop in and cap the enthusiasm. The Fed’s policy tightening and the weight of US Treasury issuance provide a countervailing force, in other words.

In currencies, we saw Friday’s’ turn supporting the US dollar from its bout of weakness (which was inspired by China pulling the CNY off the floor rather aggressively on Thursday).

China is doubling down on signalling that it wants to be seen as the “adult in the room” in trade negotiations, as Chinese leader Xi Jinping spoke at the Shanghai Expo conference, criticizing protectionism and promising a cut to tariffs. No word on the country’s current policy of strict policy controls and its artificial support for its currency, however, and many downplayed the significance of the Chinese leader’s rhetoric

Italy’s yields have dropped to their lowest in weeks despite lack of any real progress on the budget showdown. The Five Star Movement’s Di Maio was out encouraging a change of attitude in the European Union on austerity over the weekend. The FSM is struggling for additional traction with the latest Ipsos poll suggests that support for Lega is at nearly 35%, while the FSM polls at a still respectable 28% – a combined result well above 60% versus only around 50% at election time. Given the Lega’s massive doubling of popularity since the election, there are concerns that the governing coalition is unstable.

The budget issue risks generating further headlines this week as Italian Finance Minister Tria is in Brussels defending Italy’s budget intentions after the EU rejected its initial budget submission.

Tomorrow’s US midterm election will dominate the headlines early this week and into the tallying of results into Wednesday. The strong consensus is that the Democrats will take a clear if still slim majority in the House and will not capture the Senate. But as we suggest in our recent special midterm election update, the surprise risk leans in favour of the Democrats, given reports of heavy early voting turnout by young and women voters relative to past cycles. The turnout factor, particularly among voters that have never voted before, is the wildcard that could prove decisive, just as Clinton’s inability to inspire turnout was a critical factor in her loss in the 2016 presidential election.

Chart: USDJPY

If US long yields continue to press higher and the Bank of Japan holds the line on its yield curve control policy, the yen may continue to absorb the pressure. Last week’s high above 113.30 was the 61.8% Fibonacci retracement of the sell-off from the top and provides a tactical pivot that could lead to a test and then some of the big overhead range resistance around 114.50. Thursday’s FOMC meeting is likely the deciding factor this week on USDJPY direction.