Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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FX Update: Risk off swoon sees twin USD and JPY wrecking balls swinging.
John J. Hardy
Chief Macro Strategist
Summary: The weak close in equity markets last week is turning into an outright rout to start this week as Asia and especially Europe hit the skids ahead of the US session. The purported driver of the weakness in risk sentiment is the resurgence of Covid, but an increasingly complacent market was always going to be poorly prepared for a spike in volatility, one that in FX is sending the usual twin wrecking balls of the USD and JPY swinging, with the risk of the fallout worsening further before the move exhausts itself.
FX Trading focus: Market complacency prior to this episode of risk-off aggravates the potential for an ugly acceleration before things improve
I remarked at the close of last week that the USD had put in a remarkably resilient week, given that 1) another hot CPI print from the US for June keeps real US yields by the far the most deeply negative among major currencies, and 2) that Fed Chair Powell continued to maintain that inflation would prove transitory and that the “substantial progress” needed for the Fed to shift its guidance was still “a ways off”. Fast forward to the pre-US open market today and what looked like a fairly run-of-the-mill consolidation into the close Friday for equities is turning into something a bit more ominous, with the usual reflexive action in currency markets: the USD and JPY are up against everything, and the latter more than the former.
This is the classic risk-off pattern of the markets of past cycles, with the JPY full flexing its muscles on the combination of steeply lower safe-haven bond yields, weak risk sentiment, and EM and credit coming under pressure. Adding to the risk that this situation could get far worse before it gets better, Market positioning in the US futures market has yet to see the persistent EURUSD long more fully unwound, although last Tuesday’s level is the smallest net speculative long since March of last year, in the teeth of the worst phase of the Covid crisis for markets. Elsewhere, the JPY short among speculative traders, still at nearly -56k contracts as of last Tuesday, was still quite large if not by historic standards. Recall that 109.00 is an important area for USDJPY. By the way, combining those two, we can see where some of the energy for this downside move in EURJPY has come from.
Elsewhere, note that EM is under pressure on the strong USD/risk off one-two and NZDUSD looks very much on the rocks as it becomes evident very quickly that shifts in EM- and smaller DM policy and policy guidance to the upside don’t amount to much when the risk-off USD and JPY wrecking balls get to swinging in full force. Stops could see quite an acceleration lower in NZDUSD on a break below 0.6900.
Chart: AUDJPY
The classic risk proxy among G7 currencies, AUDJPY, is flashing its historic correlation with global risk sentiment, tumbling through the 200-day moving average overnight as the market has rushed to take off reflation trade, unwinding commodity and commodity currency-longs and the currencies these were often traded against, notably the yen. The next area of note is perhaps the old resistance on the way up around 78.50 or the 61.8% retracement of the entire move up from the lows last October near 78.00, below which a full breakdown is a risk toward the low 73.00’s – a scenario only likely if we are set for a major rout in equity markets of full 10% “correction” magnitude or greater. It is also worth keeping an eye on AUDUSD, which has broken down through a key area around 0.7400, a development that could point toward 0.7000 in the weeks ahead.
I should point out that my timing last week in looking for ways to trade central bank policy normalization could have hardly been worse, as we have seen three of the four (longer term EURUSD and AUDUSD calls, selling EURNOK and selling EURGBP) moving sharply against the trade views. That’s because, as I noted, these trades would like prove correlated, but also because any ugly risk-off wave often coincides with lower anticipation of central bank tightening. Clearly, I was far too early here, although I will certainly revisit these ideas in the weeks ahead, especially as any add-on USD move will likely turn so destructive so quickly that this move will inevitably prove self-limiting (the clock ticks very loudly with a 10% correction in US equities and possibly well before then if USD or JPY volatility spikes badly.)
Table: FX Board of G10 and CNH trend evolution and strength
The USD and JPY rallies have accelerated steeply in recent days, particularly today, and note that all of the G10 “smalls” save for NZD (due to the tremendous surge in short NZ rates on a more hawkish RBNZ in recent weeks) are quite deeply in the red, while the DM currency “midpoint” here is the euro, and to some degree sterling. The CNH seems always to trade as a low beta USD.
Table: FX Board Trend Scoreboard for individual pairs
The JPY pairs are showing extreme readings, led by CADJPY and JPYNOK, with some USD pairs not far behind – note that USDCAD traded a full 8 figures off its lows today, while among recent developments, spot gold making a go at flipping back to the negative side is perhaps the highlight.
Upcoming Economic Calendar Highlights (all times GMT)
- 1400 – US Jul. NAHB Housing Market Index
- 2330 – Japan Jun. National CPI
- 0130 – China Rate Announcement
- 0130 – Australia RBA Minutes of July policy meeting
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