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Breaking News in FX - Global Exchanges

FICC Podcasts Podcasts October 13, 2022
FICC Podcasts Podcasts October 13, 2022

 

In this week's episode, we discuss recent developments in the US dollar, British pound, Japanese yen, and some of the G10 commodity currencies. In particular, we analyze whether the FX market is 'breaking'.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Greg Anderson:

Hi. Welcome to episode 53 of Global Exchanges, a podcast about foreign exchange markets and related issues. In this week's episode, my co-host Stephen Gallo and I discuss recent developments in the US dollar, British pound, Japanese yen, and some of the G10 commodity currencies. In particular, we analyze whether the FX market is breaking. The title for this episode is Breaking News in FX.

 

Stephen Gallo:

Hi, I'm Stephen Gallo, a London based FX strategist. Welcome to Global Exchanges, presented by BMO Capital Markets.

 

Greg Anderson:

Hi, I'm Greg Anderson, a New York based FX strategist. I'm Stephen's co-host.

 

Stephen Gallo:

In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets like commodities.

 

Greg Anderson:

We strive to make this show as interactive as possible, so don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us.

 

Stephen Gallo:

Okay, it's October 13th, 2022. We are well into the fourth quarter. Thanks for tuning into Global Exchanges. I've got a decent amount of deja vu today, Greg, to be honest with you. We just received yet another extraordinary elevated inflation reading out of the United States. Two back to back 0.6 month over month core inflation prints for September and August. The FX market's reaction function is mostly as you'd expect. The British pound is often a world of its own trading up on the day.

We'll get to that in a short while. But apart from that, the broad dollar is now about 0.2% higher since yesterday's close. Maybe more importantly, the knee-jerk response to the hot September inflation print was a rally of just under 1% in the dollar. Greg, please weigh in on the detail regarding this response and the dollar for me and our listeners.

 

Greg Anderson:

Early in the year, we talked a great deal about the correlation between the US dollar and the FFZ2 futures contract. And just a reminder, FFZ2 is the Fed funds futures contract based on the Fed funds rate in December of this year. Today's hot CPI reading caused FFZ2 to price in eight additional basis points of rate hikes this year. In the grand scheme of things, that's not worthy, but it's not a huge move. The reason that I think it didn't move more is that Fed speakers have been fairly consistent in signaling another 75 basis points and rate hikes on the second of November. If the Fed didn't go by a hundred in September, then they almost certainly won't in November.

Just a reminder hot reading, but CPI year over year did drop by a 10th. At any rate, the Fed funds futures curve did add about 10 basis points worth of hikes for the 14th of December, now taking it up to about 66 basis points priced in or let's call it just slightly higher than 50-50, odds of the move being another 75 instead of a downshift to 50 as was baked into the dot plot from the September FOMC. How much should 10 basis points more for the December meeting impact FX? Well, the 0.9% knee-jerk response in BBDXY that you mentioned, Stephen, it seemed a bit big. I'm not surprised that we gave about half of it back over the past hour or so.

But here's the thing I want to highlight. All year long, dollar-yen has been the exchange rate with the tightest correlation and greatest sensitivity to US rate moves. But on today's US rate move, the yen only weakened about 0.7% while Aussie and Kiwi both dumped by about 1.5%. And in fact, the loony dumped by 1.3%. These are huge moves based only on US CPI being a 10th hotter than expected. With that, I'm going to say that illiquidity in the FX market is becoming a noteworthy issue. Of course, New Zealand and Australian markets were closed when the data was released, so I can kind of understand low liquidity exacerbating things a bit for those two.

But Canadian markets were open and still we saw this huge response in dollar Canada relative to the FFZ2 move. With that, I'm just going to point out that the FX spot market in the less liquid G10 currencies is beginning to show signs of real distress. I wouldn't call it broken just yet, but we may be in the beginning stages of it breaking.

 

Stephen Gallo:

Yeah, Greg, I totally agree with your comments on the lack of liquidity in spot FX. Sterling in late Q3 and at the very start of October I think was a prime example of this. To be honest, I don't think this brewing liquidity issue is confined only to FX, particularly in the European scene. As for the fundamental story for this illiquidity in the FX market, one thing I'd like to point out is what I think is related to an important issue for the global currency space, that being that we still have the Fed hiking. Even though they're being very clear about where they want to get to, we still have the Fed proceeding with hikes and quantitative tightening taking place in the background.

We think we can see the end of Fed rate hikes in sight with a terminal rate of four and a half to 5%, but today's CPI print does make you wonder, particularly on the core. Let me just pose a question. Will various central banks have to hike their rates above the Feds just to stabilize their currencies? And will that process cause various things to break in the global economy rather than it being just the impact of the Fed? We can leave that question out there for pondering. It doesn't have to be answered in this podcast.

But I mean, what I would just add to the debate or to the story is that I think eventually many currencies having a higher base rate than the dollar should contribute to the peak in the dollar we've been talking about, you and I, Greg. But it's the process of getting to that point where non-dollar rates are higher than the Feds, which concerns me. UK is a prime example. Not so much the base rate, but what we've seen taking place in the gilt market. I mean, if there are things keeping central bankers up at night, this has to be one of the factors on the list that the financial distress and the liquidity events caused by them trying to keep up with the Fed, it could cause a lot of distress for the global FX market.

 

Greg Anderson:

Stephen, I'll support your thesis by pointing out that the G20 currencies that have fared the best against the dollar this year, and specifically I'm talking about Brazil and Mex, these are the currencies where the central banks have been more aggressive than the Fed. Brazil's now at a 1375 base rate while Mexico's at 925 and rising. But can the RBNZ or the Riksbank, to give a couple examples, can they do that in order to stabilize their currencies? Should they and would it even work?

Stephen, I heard you say a few times this year that rate hikes might end up being bad for currencies like euro and sterling, because they might put the economies into recession or better put, deeper recession and that just makes things worse. I tend to think that trying to out hike the Fed, that's not the answer. To me, the answer is that the Fed has to stop tightening, which it is unwilling to signal just yet. I guess we're likely to see more chaos. And on that note, Stephen, we've seen lots of chaos in your neck of the woods since our last podcast. First the move to 10350 in cable, then the 11% rebound in cable in the span of a week, and then the chaos in the gilt market that has led to BOE intervention there.

Stephen, my questions to you are these. First, have we seen the bottom in GBPUSD? And then second, is the channel change where distress moved from the FX market to the rates market permanent, or could we channel change right back to where FX is, where the chaos is?

 

Stephen Gallo:

Yeah, okay, Greg, this is what we said back in late September regarding 10350 in cable probably being the low for the cycle. I would say so far price action in cable sort of confirms this, although I do think there will be opportunities, Greg, to buy sterling below 110, the figure that is in cable, within one to three months, which leads me to your question on volatility. To paraphrase what you're asking, will volatility migrate from being extremely elevated in gilts to being extremely elevated in both cable in implied vault terms and gilts simultaneously?

I would say yeah, that is still a very high risk over the next one to three months unless the Fed blinks or something or underlying inflation pressures completely roll over. Here's why I'd make that overall argument, Greg. First of all, it looks to me like gilts and sterling have both lost their safe haven status. I hadn't seen anyone really talk about this yet, but gilt yields higher is now a risk off move just as gilt yields lower is now associated with risk gone. For sterling, that dynamic in the bond market simply compounds the currency's risk sensitivity, which is already high due to the UK's chronic current account deficit.

Higher interest rate risk and higher credit risk means a lower sterling. Second feature in my argument, Greg, would be binary risks feeding into the volatility situation. Why are they going to get prolonged sticky inflation in the UK or not? Why are they going to get a brutal winter or just an average one in terms of temperatures? There yet may be even more pressure on the government to provide support or there may not be. The other binary risks are Bank of England related and also political. Will the BOE have to step in and buy gilts again if it suspends the program at the end of this week? Well, that depends on a number of factors, many of which I mentioned just a few seconds ago.

But it also depends on what the government does. Today, Greg, we found out that, I think I'm sure you saw, we found out that the government is apparently taking steps to roll back more of its unfunded tax cut pledges. Now, if you had asked me yesterday, I would've never told you that this would happen this week. But could the government do a U-turn on its U-turn? That's not impossible. What I've been saying for a long time now is as the clock ticks down to the next election, you'd think that a government in this position with its poll numbers crashing will attempt to keep the fiscal taps turned on.

The third and final point in my argument, Greg, I'm not sure the adjustment in UK real and nominal yields is completely done yet, unless inflation comes in surprisingly weak. But here's an example for you. The UK basically has double digit inflation. It's got a war on its doorstep. It's in an energy crisis. The coldest months of the year are probably ahead of us. It's got a chronic current account deficit. Even if the government ditches more of its unfunded tax cuts, the UK's fiscal position isn't in the greatest of shape, and sterling is no longer the world's top reserve currency.

I had a look today and based on where 10 year breakeven rates were at the time, the UK's 10 year real rate of interest was less than 1%, while the US' equivalent was closer to 1.5%, 1.6%, something like that. Now, I'm not sure that's completely appropriate, unless there is a notable shift in the UK's fundamentals. But to me, right now it doesn't look appropriate. If that adjustment that I've been mentioning does come at some point, and that's a big if, I don't think it's likely to drive cable to new lows as I mentioned already, but it could drive it to the 105 to 107 range before this cycle is over.

And that would probably be the point, Greg, which we'd get volatility and gilts spreading to fx, causing volatility in FX possibly to exceed volatility in the bond market. That's me finished with sterling. I think I've made my points pretty loud and clear. I want to switch back to you and get your thoughts on another battered currency, the Japanese yen, Greg.As you've mentioned in prior publications, we've seen dollar-yen trade through the September intervention high, which was close to 146. Should we prep for more intervention from the MOF and, dare I say it, do we need to prep for a change in policy from the BOJ?

 

Greg Anderson:

The intervention you referenced occurred on Thursday, September 22nd, and we now know that it was worth about 20 billion USD. It knocked down yen from we'll call it 145.90 down to let's say 140.35 in the span of less than an hour. But by the end of the following Monday the 26th, we were back above 144 in dollar-yen and pretty much stayed there for two weeks. Look, there are two ways of looking at the effectiveness of the intervention. If your expectation was that the intervention should market top in dollar-yen and not get permanently lower by punishing foreign speculators, then the intervention was a big belly flop compared to that benchmark.

But look, I would argue that we are not in the swashbuckling era of FX speculation like we were at the start of my career. That expectation, it's misguided. This is not the dollar-yen of the 1990s. That was an exchange rate that still had Japan running a current account surplus underneath it. Not anymore. As I noted in our FX quarterly and also in an FX daily written earlier this week, Japan now runs a core flows deficit. Lots of countries, admittedly most of them are emerging market, but lots of countries have been in situations where their currencies face core flows deficits and the price action in the FX market is so out of control that the central bank feels compelled to intervene.

But in those situations, the benchmark for success, it's completely different. Slowing down the move and keeping the market functioning with two-way liquidity means that the intervention did its job in that type of a situation. That's what I'll say about this one. The intervention thus far has kind of done its job. Look, the fact that the yen fell by less than the loony on the CPI knee-jerk response that we talked about earlier, that means that the intervention somewhat worked. But I will say, the physical overhang of the 20 billion USD provided to the market, as well as the psychological overhang of the intervention, those things wear off over time.

I think the MOF will end up needing to intervene again. I would point to somewhere on the 148 handle, maybe around 148.50 is where I think they'll do it again. I think if they do, it'll probably hold the market in check for a few more weeks again. But your comment about the BOJ is right, to really stave off 150 let's say on a horizon by the end of this calendar year. To do that, the BOJ may need to scrap the yield curve control mechanism. Doing that, I think, would allow the chaos to shift from the FX market over to the bond market for a season, and then that buys some time for the Fed to signal that it's nearing the end of its rate hiking phase.

But let's get real about even what that BOJ move could do. It could hold dollar-yen in check for a season, but the BOJ scrapping yield curve control will not fix Japan's core flows deficit. Wow! I'm worked up here, and Stephen, there's still so much more to talk about, but I think maybe we've said enough until our next episode, which is just a few days out.

 

Stephen Gallo:

Yeah, I think you're right, Greg. There's a lot more to talk about here. But for the time that we have used, we've covered a number of substantial topics. We'll be back in a few days, as you said. Thanks again for joining us, those of you who stuck with us till the end. Until next time, bye for now.

 

Greg Anderson:

Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts at bmocm.com/globalexchanges.

 

Stephen Gallo:

We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

 

Greg Anderson:

This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's Marketing Team. This show is produced and edited by Puddle Creative.

 

Disclosure:

The views expressed here are those of the participants and not those of BMO Capital Markets, its affiliates or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

 

Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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