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The Long and Bumpy Rounded Top - Global Exchanges

FICC Podcasts Podcasts November 08, 2022
FICC Podcasts Podcasts November 08, 2022

 

In this week's episode, we discuss the latest movements in the broad US dollar with particular focus on the euro, British pound, Chinese renminbi, and Japanese yen.


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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 56 of Global Exchanges, a podcast about foreign exchange markets and related issues. In this week's episode, my cohost Stephen Gallo and I discuss the latest movements in the broad US dollar with particular focus on the dollar's movement against the Euro, the British Pound, Chinese Renminbi, and Japanese Yen. The title for this episode is: The Long and Bumpy Rounded Top.

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 cohost.

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 8th, 2022. Thanks for tuning into Global Exchanges Episode 56, as noted by my colleague, Greg. Greg, I think it's best to start with the dollar at this point because you've referred to the rounded top in the dollar in the title, and I think we've been observing some interesting price action in the dollar over the last two or three trading days. In the BBDXY, it looks to me like we've broken through short-term support around 1,316, 1,317 or so on the dailies. What I find interesting is that the broad dollar is down about 2% since the release of Friday's US employment data, which wasn't all that bad and still suggests the labor market is reasonably tight in the US. My questions for you, Greg, are, one, is the price action in the broad dollar quite typical for what we would expect to see late in the cycle of a dollar up trend? That's number one. Number two, are there any assumptions we can make about how the dollar will respond to the second to last CPI reading for this calendar year for the month of October, which is due on Thursday?

Greg Anderson:

 

Okay. To set up my responses to those questions, let me just start by saying that the 2.2% FX response to the payroll's mixed bag number, so to speak, it seems a bit excessive. Look, the two year yield jump from 475 to 480 on the knee-jerk response to the data, and now it's down to about 467 with a long measured response. Not a big reaction. Based on this year's correlation parameters, I would say the US dollar response should only be about 1% lower, not 2.2% lower. It's a similar story with the equity market. It's up about 3% on the long measured response to the US employment situation report, and that should more correspond with something like a 1% dollar down move, not 2.2. I'll admit I'm a bit at a loss to explain why the FX reaction has been more forceful than the reactions in other markets.

I guess maybe it's a function of US dollar evaluation just being so stretched that FX investors are nervous, so they've taken this occasion to back away from US dollar longs. Now if they're largely done with that positioning adjustment, then we may not get a second overly dramatic reaction in FX if we have a soft CPI on Thursday. However, if we're not completely done with the position trimming, then I guess the second round of traumatic dollar downside might be the result of even an inline CPI print. Hopefully that answers your second question. Back to your first question about whether an overly emotional or volatile market is typical for a late cycle. My short answer is yes, but in addition to the cycle idea, I think it's also important just to point out size of recent moves or how stretched the market is. Look, typically the US dollar index doesn't move more than 5% in either direction over the span of 12 months, but over the span of the last 12 months, we've got about 15% of dollar upside, so three times more than normal.

Anytime you've had that much of a move, the natural expectation is okay, there should be a partial retracement at some point. The first hint of a counter trend move, and people get nervous and they start to back away from positions, and so you get this high intraday volatility or bumpiness. Let me turn the tables on you a bit now, Stephen. For any configuration of the US dollar index, the biggest element in the index is going to be the Euro. We were at 97.50, call it Friday morning prior to the US employment data, and today we're pushing towards 101. Is there any good news in Europe behind that? To follow up, from 101, if there were a five big figure move before years end, do you see more risks of that being to the downside, back down to 96 or to the upside to 106?

Stephen Gallo:

 

Good shout, Greg. No, I don't think there is much fundamental good news behind this move up in Euro dollar at the moment. Maybe at the margin, the underlying trade balance flows for Euro dollar have improved a bit in Q4 because on a quarter on quarter basis, if you look at the average for Brent crude oil, it's basically unchanged currently from where it was in Q3. Moreover, natural gas storage levels in Europe are about where they need to be for this time of year, maybe slightly above that level, and we haven't experienced any severe cold weather outbreaks just yet. Natural gas prices are relatively low and stable, but that's about where I would stop on the good news factor. It's probably not so much good news, which has driven the Euro dollar higher, but the lack of terrible new news which has forced FX investors to close out a portion of their Euro dollar short positions.

It looks to me like the net short position in Euro dollar held by leverage funds is in the process of being trimmed. Since the second week of October or so, it's been trimmed to the point where the net position is now roughly flat. Sure, as you point out, Greg, if we had some exceptionally good news such as a cease fire in the war in Ukraine, we would be out 106 in Euro dollar and probably beyond that in a heartbeat, but it doesn't seem that we're there just yet. The factors I would be worried about if I were thinking about getting long of Euro dollar above par are first the negative carry, which of course means you have to pay for being long Euro dollar. Second, when the Euro dollar shorts are finished trimming their position, what happens to Euro dollar without a more positive flows dynamic for the Euro? I think my answer to that question would be Euro dollar will start to drift lower again once Euro dollar shorts are done squaring up.

That leads me to the downside risk factors for the next one to two month period or so, which I think outweigh the upside risk factors. Firstly, there are still big unknowns regarding how winter weather conditions will play out and how also escalation risk in the war in Ukraine will play out before a possible cease fire can happen. Secondly, the Euro's negative core flows picture is still likely to be a downside factor for the Euro for at least the remainder of this year. Thirdly, sovereign debt and credit marker risk in the Euro area is still particularly high, I think, particularly if the hawks within the ECB force a move to balance sheet reduction late this year or early next year.

Greg Anderson:

 

Let me follow up with questions about Sterling. The Euro Sterling Cross is pretty much flat since the US employment report, so it seems like both Euro and Sterling are reacting similarly to whatever is underneath this US dollar downdraft. Is there anything extraordinary going on in the UK that FX investors should be mindful of as they stare at this rally in cable, the Sterling SD exchange rate, from 112 to 116 in the span of three trading days? I mean, is there good UK economic news that I missed?

Stephen Gallo:

 

Yeah, that's a good point, Greg. It looks like Sterling and the Euro are roughly on an equal footing in this dollar move, as you noted with the price action in Euro Sterling. There's nothing extraordinary going on in the UK right now, Greg, that's very positive. We're still in a relief period for the Pound following the crisis scenario moves during late Q3, early Q4, so at the margin that may be assisting Sterling a bit. Other than that, it's tough to pinpoint a fundamentally bullish factor for Sterling either, just like we were saying for the Euro, other than the fact that maybe the Pound's trade flow position like the Euros has improved a bit in Q4. I would finish with one key point though, Greg, which is that with the Bank of England having already turned quite a bit more dovish with its military policy outlook, I think the FX market will be a bit less terrified of bad UK economic data, and we get some tier one data from the UK on Friday, GDP in particular for Q3.

I think FX investors will probably recognize, even if that economic data is worse than expected, that the Bank of England doesn't intend to make the recession 20 times worse or whatever by hiking quite as aggressively as financial markets had been pricing in prior to last week's Bank of England policy announcement. I don't think that means we're going to 120 rapidly in cable unless the dollar really falls sharply for some reason, but I think it's another reason to argue that the low for the cycle in cable is probably in, which is what we've been saying for the last month or so.

Greg Anderson:

 

Okay. Thanks for your thoughts on Euro and Sterling.

Stephen Gallo:

 

All right, Greg, with Europe out of the way, let's move over to Asia now and stick with the G10 currencies. Let's start with a Yen. 145 to 150 in dollar Yen. Are you still sticking with that call through year end?

Greg Anderson:

 

Let me give one last bit on the employment report response before answering that. Just looking again at the moves since the US employment report, I mentioned at the outset dollar index down about 2.2%. The Euro and Sterling moves have both been up about 3%, so bigger. Interestingly, the move lower in dollar Yen has been about half of that, so let's call it 1.5% or smaller than the dollar index move. This is interesting in my view at least because for most of the year dollar Yen has been the major exchange rate that has been most reactive to US economic data and by far the most volatile. It's a funny time for it to go numb, so to speak. Okay, now back to your question, yes, I still think that we are likely to most likely stick in a 145 to 150 range in dollar Yen for the next six weeks. Although admittedly, maybe I should hedge slightly on the bottom of that range with a sitting on a 145 handle at the moment.

Look, the fact that we seem to be getting a profit taking correction on US dollar longs and the price response in dollar Yen is the smallest among G10 exchange rates. I think that should tell us something. To me, what it says is that there really aren't very many long dollar positions against the Yen that are out there and needing of being dreamt. That limit is in downside I think. Meanwhile, we have the ongoing MOF intervention threat anytime we get anywhere close to 150 on the upside, so limited on the downside, limited on the upside. I think that is where this year's number one move, the massive adjustment higher in dollar Yen, it's in the process of just dying off into a narrow range. If I'm right on that and all the tensions around dollar Yen fade over the next few weeks, I think that that should help all the rest of the regional currencies to stabilize too. Stephen, please tell me your latest thoughts on dollar RNB, which is what's really going to determine the movements in the whole rest of the ADXY index.

Stephen Gallo:

 

Latest thoughts on dollar RNB, Greg, I think you're basically correct. If the dollar Yen move is starting to die out and arrange the risk of dollar RNB reaching new highs for the cycle probably comes lower by at least a notch or two. That would be my thoughts there. That being said, Q3 balance of payments data reported last week by Safe made an interesting read. Long story short, it looks like PBOC actually had a reserve build during Q3, meaning that it likely bought foreign exchange to keep up the depreciation pressure on the RNB. Now, I think that would surprise many people to hear that because one of the assumptions an observer might make based on the price action in dollar RNB this year is that PBOC has been intervening aggressively to stop RNB depreciation, but China doesn't have an inflation problem really. It has a growth problem. The increase in the trade and current account balances helped by the weaker RNB is offsetting the hit to growth from a weak property sector and weak domestic demand.

Greg, to be clear, China has experienced net capital outflows this year partly as a result of investors pulling away from Chinese assets a bit, but those net capital outflows have been relatively small compared with the surpluses in the current account. It looks like PBOC has been pretty heavily involved in helping the depreciation in the RNB and it's combined monetary and exchange rate policies dancers are continuing to diverge from the Feds essentially. Given your views on dollar Yen, Greg, I guess the bottom line here is that I wouldn't be so bold as to say we're likely to see new highs and dollar RNB before the cycle completely turns, but I do think it's quite possible we'll see the 735 to 737 range retested first before we get a sharp move lower in dollar RNB. Basically we can still retest the highs in this pair, I think.

Greg Anderson:

 

Just a reminder, narrow ranges for all of us, dollar RNB traded between 630 and 640 for the entire four month period of December, January, February, March. I guess the open question is if we were to settle into a new tight range like that in the 730s, would that be enough of a depreciation?

Stephen Gallo:

 

I think it depends a lot, Greg, on the global growth picture and what other major currencies do over the next couple of months. If we see new lows in Euro dollar and new highs and dollar Yen over that period, and the global growth picture worsens even more, then I think dollar RNB will touch new cycle highs. On the other hand, if the dollar peak is already in, I think PBOC will be relatively happy with dollar RNB in the 725 to 735 range, which is considerably higher than the five year average in that pair. It's about 10% above the five year average, which is fairly large depreciation, I guess.

Greg Anderson:

 

Thanks. That's very helpful. I think we've gotten out most of what I wanted to say today. Do you have anything else you want to add or should we end it here?

Stephen Gallo:

 

Yeah, why don't we wrap up here, Greg, As always, I'll just make sure I thank our listeners for sticking with us and we'll be back next week. 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.

Speaker 3:

 

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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