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Parity, Powell, and the Persistence of USD Strength - Global Exchanges

FICC Podcasts August 23, 2022
FICC Podcasts August 23, 2022

 

In this week's episode, we discuss recent developments in the FX market and a few key upcoming events.


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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 49 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 the recent developments in FX Markets and a few key upcoming events. The title of this episode is: Parity, Powell, and the Persistence of US Dollar Strength.

Stephen Gallo:

Hi, I'm Steven 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 Steven'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 the 23rd of August, 2022. Thanks for listening to Global Exchanges, again. Greg, we should kick things off, I think, by talking about the volatility that we're seeing in these FX Markets, the notable volatility I might add, even when we consider the fact that it's August and you do at times, in summer markets, get low liquidity extremes and currency pairs.

Stephen Gallo:

But cable and euro dollar are now both trading at, or just above, new cycle lows. And I think, Greg, we can't pin all these moves down to thin markets in the major European currency pairs. Don't you think that's the case?

Greg Anderson:

Well, the 2% dollar rally from last week was pretty broad based, so no, I wouldn't say that we could pin it all on euro and sterling. However, I would say this. Last week's dollar rally was the sixth wave of US dollar strength in the last eight months, and in five of the six previous waves, dollar yen has led the way in terms of USD strength.

Greg Anderson:

But in this latest wave, we've seen dollar yen stop about 1% below its July high, while Euro and Sterling have extended to new levels of weakness. So, I'm going to say that while this latest blast of volatility is still a broad US dollar move, it's got a European angle in there too.

Greg Anderson:

Stephen, we did a podcast back in July where we postponed the parity party, because parity and euro dollar turned out to only last for a few hours. But how about now? Does this move to parity appear a bit more permanent?

Stephen Gallo:

Yeah, Greg. There are a number of fascinating things that I think are going on here for the European currencies, but more to your point, we talked about a potential return to parity in euro dollar in prior podcasts, and of course, in written commentary. And as we head towards a critical autumn and winter, we've got various risks that are building, it does appear like this move to parity has a bit more staying power.

Stephen Gallo:

So maybe to use another P word, we're going to pause around par while we wait for developments, or I should probably say, at the very least, we're going to pause around parity.

Greg Anderson:

Steven, on our first pass at parity, back in mid July, we immediately got hawkish tones from the ECB, and then they hiked about 50 basis points about a week later ... which helped at that stage to prop up the euro. So my question back to you, can the ECB go back to that well again? Or, might we have now turned a page to where ECB rate hikes don't help the euro, and in fact might actually make it fall further as the FX market prices in recession risks?

Stephen Gallo:

You know what, Greg, this is a perfect point to raise at this part of the podcast. See what I did there? A P word overload. But, on a serious note, I'm taking a look at euro dollar swap rate differentials, and starting to draw some conclusions. And I'm also starting to see that this is something I might lose sleep over if it gets worse, especially if I were a policy maker.

Stephen Gallo:

So in a nutshell, a number of euro dollar swap rate differentials, like the two year, the five year, like the 10 year, they're actually moving in favor of the euro right now, but the euro has been under downward pressure. And so I'm sort of thinking, whoa, wait a minute. Maybe I need to take a step back and look at a few other factors.

Stephen Gallo:

Now, first off, as we said many times together, Greg, rate differentials don't always drive currency pairs, and they're certainly not driving euro dollar in this current environment. But, Greg, just because rate differentials are not driving Euro dollar and cable, that doesn't mean they have zero importance.

Stephen Gallo:

Because if I had to isolate a few fundamental catalysts, which I think have driven the weakness in euro dollar and cable we've been speaking about, those catalysts would be one, the fact that European natural gas and power prices have gone almost parabolic again in recent weeks. The fact that German producer prices rose by 5%, that's a month over month rate in a single month, during July ... and three, the fact that UK CPI inflation is already at double digits, along with some evidence that second round effects from wage pressures are building, and signs that price rises are being passed on to the domestic UK market by manufacturers.

Stephen Gallo:

Now, in that context, I think the fact that European rates are backing up, has to be interpreted in two ways. Firstly, that high inflation in Europe could be a bigger problem than we already thought might be the case, leaving central banks with little choice but to try even harder to get it out of the system. And two, investors don't really want to own many European assets until this process is finished, or at least until we start to see firm indications that inflation pressures are cresting, or that the war in Eastern Europe is in a phase of deescalation.

Stephen Gallo:

Greg, if I'm putting the pieces of the puzzle together correctly here, that might explain why European currencies are falling even though rates are rising. And as I said a number of times in podcasts, it's not my job to try and predict the European bond market, but maybe we are even seeing signs here that the bond market, along with the FX market, is factoring in a larger risk premium.

Stephen Gallo:

Because as we know, persistently high inflation, or a hard economic lending has all sorts of fiscal risks, it has all sorts of currency risks as well. Maybe it would be a good point for me to pass it over to you, Greg. Can you step in maybe and talk about your experience and your understanding of the Fed, and how it relates to the ECB and other European central banks?

Greg Anderson:

So, if I could draw a Fed versus ECB contrast, or a US dollar versus a euro contrast ... going back to Q2 and also into July. The biggest worry in financial markets was that the Fed would not be able to engineer a soft landing. And because of the US dollar's safe Haven properties, fear of the Fed over tightening was US dollar positive. And I'll argue that yes, that fear is still there, but I think markets have relaxed slightly after Powell's partial pivot, and then the soft CPI print.

Greg Anderson:

So now I think the epicenter of worry about central bank over tightening and that leading to a hard landing, that has shifted to Europe. And where the euro is less of a safe haven currency than the dollar or the yen, hard landing fears cause euro to fall, not to rally. So with that observation, Steven, what about Sterling in the middle of all of this? I gather there are hard landing fears in the UK, but how does that impact the pound?

Stephen Gallo:

Yep, Greg. Europe is definitely the epicenter of economic hard landing risks, and that's a suitable way of putting things. Greg, I don't want to be guilty of hyperbole, but when you throw in the balance of payments issues we've been seeing in the data into the equation, I think we're starting to get faint signals of some European currencies behaving like vulnerable EMs. We're not completely there yet, and I'm not making that call fully, but just something to keep in the back of our minds. So we'll save that discussion topic for another time.

Stephen Gallo:

But regarding your question about sterling, it's basically just along for the same ride that the euro is on now, Greg. Yes, the UK is less directly exposed to Russian energy than Germany is, for example, but sterling now has its own economic overheating, competitiveness issues, and elevated inflation backdrop to cope with. And large parts of Britain are still technically in drought conditions from this very dry summer we've been having here in the UK.

Stephen Gallo:

Now based on price action alone in cable, I get the impression, Greg, that some investors have been sniffing around in the 120 area, or just below, and picking up a few pounds along the way with a 12 to 18 month horizon in mind. And I think that's probably the right way of going about things, but I also think with cable having traded beneath its previous cycle low of 117.60 from mid-July, it did that today ... some of that buying interest may start to dissipate, unless something related to the picture I described a moment or so ago changes.

Stephen Gallo:

For Q3 to date, I see roughly a two percentage point gap between the spot return on cable and the spot return on euro dollar. In other words, the pound has outperformed euro. But I still see a risk of that gap closing, particularly if we get one or two more higher than expected UK inflation readings. This is as they say, Greg, the real deal, and investors haven't traded inflation readings this way in a long time, particularly during the era of super low inflation.

Greg Anderson:

Thanks Steven. So now that we've explored in detail, why European currencies are leading the way toward weakness in this latest US dollar up wave, I do want to come back to the dollar side of it, and verbalize on the podcast a point that I made in our FX daily that was published on Monday, August 22nd.

Greg Anderson:

What I wrote in that piece is that IMM leveraged funds have actually been trimming their net long US dollar positions over the past few weeks. So the net US dollar long against the IMM basket, that includes Ozzie, CAD swiss, frank, euro, sterling, yen, kiwi ... that dollar long has fallen substantially over the past few weeks, and as of last week, it was worth just 1.4 billion, which is the smallest in 13 months. And to me, this is a really interesting phenomenon.

Greg Anderson:

Here we've got the US dollar offering positive carry against the basket. It's rallying, and yet speculators are backing away from their longs. Now, if these speculators are geniuses, then they're telling us that the US dollar is near its peak, and I'll admit that that certainly is a possibility. However, I can also make a flip argument, and I'm actually starting to buy into that flip argument more and more.

Greg Anderson:

The flip argument is that if the US dollars rallying, even as speculators are trimming their longs, then there must be, underneath all this noise of the day to day speculative flows, some really powerful US dollar positive capital flows. And if that's true, then the dollar rally probably has more room to run, because these capital flows tend to have staying power. And just to cite an example from earlier this year of how sometimes speculators can be too hasty ... Back in February, March, April, IMM leverage funds built up very large yen shorts, and they were right. The peak yen short occurring on April 12th, when dollar yen was at about 125.

Greg Anderson:

Then they really started backing off in a big way after the pair hit 130. And unfortunately for the herd, they bailed out too soon and they missed the remainder of the move from 130 to 139 in dollar yen. At any rate, I think there's a risk that that happens again, just with the whole broad dollar. And with that thought on the potential for these deeper capital flows to be underneath everything, I'm going to say that I'm still reluctant to argue that we've reached peak US dollar, even though I still think that we've reached peak pricing in of Fed rate hikes.

Stephen Gallo:

And know what Greg, we may even be starting to see some signs of that flow in the Asian FDI data we track. We updated our Chinese [inaudible 00:14:15] Outlook earlier today, but we'll park that for now. We'll leave it for another time.

Stephen Gallo:

Given what you've said about Fed rate hikes, Greg, it's triggered something in my head, which is Powell, this Friday, Jackson Hole. Give us your thoughts.

Greg Anderson:

So regarding Powell and Jackson Hole, let me just start by saying, we've seen some really interesting slash confusing cross signals over the past month. So first, Powell said in his July press conference that the Fed was at neutral with a corridor ceiling at two and a half. Then a bunch of hawks came out over the next two weeks, and did their best to walk back Powell's pivot. Then the minutes came out last week, and they were more in line with Powell's less hawkish tone in the press conference. Talk about consistent messaging ... not.

Greg Anderson:

I guess I personally think that Powell's presser in the minutes, more accurately reflect the center of gravity for the whole FOMC. So I'm still of the view that the next move is a deceleration in the pace of rate hikes to 50 basis points. Yes, I'll add the caveat that it's data dependent, but we sort of know that at least the CPI data will be soft, and probably the employment data will soften too, in the weeks prior to that September decision.

Greg Anderson:

So for this Friday, and Powell's remarks at Jackson Hole. The market is presently pricing in 64 basis points worth of tightening on September 21st, and I don't think Powell wants to move that. I think he likes it priced with roughly 50-50 odds of 50 versus 75. However, if he does end up moving the price by more than five basis points in either direction, I think that the balance of risks are that he moves it toward the 50 basis point camp.

Greg Anderson:

With that Fed view, I guess I see the risk of a bit of a US dollar pullback on Friday, but if that's the way it turns out, I'd be inclined to trade my deeper capital flow story and buy the dip in the broad US dollar. And at this juncture, with euro and sterling having led, as we've talked about, I like long dollar yen in particular, and also with crude on the rebound, I also really like long CAD yen here.

Greg Anderson:

So Steven, as we wind down the podcast, are there any exchange rates where you see a really noteworthy tilt in the balance of risks?

Stephen Gallo:

You know what Greg, I'll give you two currency pairs, one where there's been a tilt in the balance of risks, and one where there's considerable momentum, which I think is going to persist for a bit longer. The first is dollar China. So China's domestic problems have not really changed. The backdrop domestically is still very poor. We always knew this, but what may be changing, is that the balance of risks facing Chinese export growth is tilting worse, or worse than expected, particularly if Europe has a really hard economic landing.

Stephen Gallo:

I think in that case, dollar China could at least test the seven level, but it might even trade above that level. So that's number one. The second pair I'll throw in there regarding momentum, and one I think where there's momentum that has staying power, is euro Norway, or euro NOK, as it's called. Yes, it's true that an economic hard landing for the European Union, for economies in the EU that are dependent on Norway, that will dent commodity demand somewhat, but in the current environment, prices may not stay at low levels for long. It's just simply that way.

Stephen Gallo:

So I think euro NOK has still got room to run on the downside, and I would be looking to the low 960s as the first stop, so to speak, Greg.

Greg Anderson:

Great comment, Steven. Hey, should we wrap it up here?

Stephen Gallo:

Yeah, Greg. Let's wrap up Parody, Powell, and the Persistence of Dollar Strength, to get even more Ps into the recording. Thanks for listening, 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.

Announcer:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's 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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