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Whiplash in Sterling and Yen - Global Exchanges

FICC Podcasts November 09, 2021
FICC Podcasts November 09, 2021

 

In this week's episode, we discuss two noteworthy recent momentum reversals in the FX market.


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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 24 of Global Exchanges, a podcast about foreign exchange markets and related issues. I'm Greg Anderson. In this week's episode, my co-host Stephen Gallo and I will be talking about two noteworthy recent momentum reversals in the FX market. We'll go through the causes of those reversals with thoughts on how things might play out for the rest of 2021. The title for this episode is Whiplash in Sterling and Yen.

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.

Disclosure:

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

Stephen Gallo:

Thanks as always for the intro, Greg. And for the record, it's November 9th, 2021. We're continuing at this low volatility environment in FX. It's pretty remarkable, so much so that I'm finding it tough to not get over excited by what are relatively small moves in the bigger picture. But in terms of interesting FX market developments over the past or so, I think dollar-yen and Euro-sterling stand out. How about we dig a bit deeper into these moves, Greg?

Greg Anderson:

Where you provide our primary coverage on the pound, let's put you to work first if that's okay. We started October at 86 the figure in Euro-sterling, and then dropped to as low as 84.03 late in the month, as markets build expectations of a Bank of England micro hike. As it turned out, the BOE didn't hike. Could you walk us through a postmortem on the Bank of England decision, it's FX implications, and where you think the BOE and the pound go from here through the rest of 2021?

Stephen Gallo:

Yeah, Greg. The BOE wrong-footed a lot of investors last week, myself included, and I had very mixed emotions about the central bank going into last week's policy announcement. And I still do now. It kind of felt like the bank was saying to the market last week, if we're uncomfortable with the tight rope we're walking, you should feel uncomfortable too. Now, I don't want to overstate things.

Stephen Gallo:

I don't think positioning in FX was massively skewed towards the long side in sterling going into the decision, but there was enough of a buildup in positions by leveraged funds. So that on the day, the pound depreciated 1.4% against the dollar and by 0.9% against the Euro. This is in the wake of the BOE rate decision. But the move in rates was far more violent and volatile. If you look at the two year swap rate, sterling denominated.

Stephen Gallo:

It has recovered a bit of lost ground this week, but it's still down 18 basis points or so since before the BOE rate decision. And that move at the two year sector to me says a lot. It tells me that central banks are in a very tight spot. They know they have to keep inflation expectations anchored. But at the same time, they're terrified of crushing demand. The volatility in the rates market reflects the uncertainty over how central banks engineer a smooth landing out of the environment we're currently in.

Stephen Gallo:

But even if you look at two year swap rate differentials, the moves there were equally impressive. The move in the sterling-US differential was nearly 20 basis points against the pound last week, and the move in the sterling-Euro differential was about the same. So if there are two questions on the minds of investors there probably, where do we go from here and will the BOE hike in December?

Stephen Gallo:

The OIS curve is about fully priced for a 15 basis point micro hike from the BOE in December and it's about 80% price for a follow-up 25 basis point hike in February. My angle is that since becoming operationally independent in 1997, Greg, the BOE has never hiked rates in December. I think the likelihood of the MPC going from just two votes for a hike in November to five or more votes for a hike in December is not zero, but still fairly low.

Stephen Gallo:

But look, I think one of the key takeaways from the November press conference from the BOE was that the next two releases of labor market data next week and again on December 14th are exceptionally important. Given how sensitive the bank is to the demand side of the economy, it's probably going to be a lot easier for them to get rates off the ground just before Christmas if the labor market is showing a combination of very strong employment growth, significant wage pressure, and still a very high vacancy rate.

Stephen Gallo:

We need to really watch the labor market data over the coming week, Greg.

Greg Anderson:

Steven, just to follow up on the FX angle, what do you think would happen to sterling and I guess both on Euro-sterling cross, as well as against the dollar, assuming that the Bank of England does not hike and then in the outlier case that they do?

Stephen Gallo:

Greg, I think that unless the economic data are so inflationary that the bank has little choice, but to hike, and that includes more strength in the labor market, sterling is going to struggle to sustain upward momentum between now and mid-December. Also, you have to remember, given the nature of the surprise in November, I just don't think investors are likely to get overly bold up in sterling.

Stephen Gallo:

I think the risk into mid-December is that a portion of the remaining long positions in cable and in sterling against the Euro simply bleed off. Now, if the bank does defy its historical tendency to not tighten policy in December and it ends up hiking in December, I can't imagine that the move won't be pre-telegraphed somehow by various MPC members. I would look for a moderate recovery in the pound long before the December rate decision if that turns out to be the case.

Stephen Gallo:

But the problem for cable, which price action in the second half of this year has shown, is that the act of central banks turning more hawkish has had limited impact on non-dollar currencies across the FX space. And until the uncertainty about inflation and central bank reaction functions clears up, this backdrop is going to be an important break on sterling appreciation versus the dollar in my view. And then Greg, if you want levels, I think 137, 138 in cable is becoming more formidable as an area of resistance.

Stephen Gallo:

I'd tell you that a sustained move below 85 in Euro-sterling is looking less and less likely before year end. I would describe the near term risks in Euro-sterling as pretty evenly balanced, Greg.

Greg Anderson:

One last follow up question on Euro-sterling, Stephen, without going down a rabbit hole, if you can somehow avoid it, there is another theme that seems to be at play in Euro-sterling, and that theme is trade frictions. With the recent row in Euro-sterling from let's call it 84 the figure to 85 and a half now, how much of that do you think comes from the trade frictions? And what are your thoughts on events related to this theme through year end?

Stephen Gallo:

That's a fair question, Greg. I think the issue related to the UK triggering Article 16 of the Northern Ireland Protocol has not been responsible for significant pound selling as much as it has been responsible for less pound buying. So look, without going into too much detail, the factor to watch after Article 16 is triggered, Greg, if that's what happens is the EU's response.

Stephen Gallo:

I would say there's a moderate to high risk that the EU's response is to give 12 month notice of its intention to walk away from the trading cooperation agreement as retaliation. But what that will most likely mean is a lengthy set of trade negotiations and posturing by both sides rather than a full blown trade war. For the time being, the Article 16 factor I think is likely to cap sterling appreciation rather than cause the pound to fall sharply.

Stephen Gallo:

Now, Greg, I've been doing a lot of the talking and that can get monotonous for everyone involved. It's time to put you in the hot seat and talk about the yen.

Greg Anderson:

Stephen, I've got sunlight streaming through my window on me on a surprisingly summerly November afternoon, so I'm already in a hot seat literally. We might as well complete it with a yen discussion. Fire away.

Stephen Gallo:

All right. Greg, the day before the September FOMC, in dollar-yen, we were looking at 109, then we rallied over the next few weeks to almost 115, and now we reversed about a third of that move. What's going on here in dollar-yen and should we be looking for more downside in that currency pair?

Greg Anderson:

Thanks for leading me into another long rant on dollar-yen. Let me just start by saying that dollar-yen has two noteworthy correlations. The first is with oil, due to Japan needing to import the majority of its energy. Oil higher means dollar-yen higher. And that move to nearly 115 in dollar-yen corresponded with a move in WTI from let's call it $71 a barrel to 84. Then oil ran out of steam, so to speak, and so did the upside in dollar-yen.

Stephen Gallo:

Wait a minute, Greg, so you're saying the move up in dollar-yen was all about oil? What about the impact of the Fed taper and rising US bond yields?

Greg Anderson:

I didn't mean to imply it was all about oil, but I wanted to lead with that so that it didn't get forgotten. You mentioned bond yields and that leads me to dollar-yen's second key correlation. Usually there's a fairly strong correlation between dollar-yen and US bond yields of some tenor or another. Sometimes like when the Fed is near an inflection point, the tenor of maximum correlation with dollar-yen is a three month. Sometimes it's the 10 year or the two year.

Greg Anderson:

This year, there has been a stunningly high correlation between dollar-yen and the five year Treasury yield for whatever reason. Now, during the window when dollar-yen rallied from 109 to let's just call it 115, the yield on the five year Treasury bond rose from roughly 85 basis points to 120. So that fundamental alongside oil seemingly justified a rally in dollar-yen. But what went up has now come down.

Greg Anderson:

The five year yield has backed off thus far in November, and it's now down to about call it 107 basis points today. So that reversal in the bond yield fundamental is exerting a downward pull on dollar-yen now, although I wouldn't say that oil is exerting a downward pull with its little recovery in the wake of the OPEC plus decision last week.

Stephen Gallo:

Now, Greg, for the benefit of our listeners, I have to say that I know you well enough to know that you're distrustful of this correlation between bond yields and dollar-yen. Can you tell our listeners why that is?

Greg Anderson:

Thanks, Stephen, for that cue. Foremost, I'm distrustful of correlations between dollar-yen and bond yields because I've seen several spectacular decoupling of interest rates in dollar-yen during my career. And I've witnessed several blowups in the books of people who rely too much on those correlations. Secondarily, I would just say, as I often do, that there is no string that connects the US five year yield this year to dollar-yen.

Greg Anderson:

It's not like Japanese fixed income investors suddenly rush in and buy a bunch more of US dollar denominated five year treasuries because the yield rose by 10 basis points, nor do they rush to sell their dollar denominated holdings because the five year yield dropped by 10 basis points. We know that because their flows are reported weekly and there is next to no relationship between the actual bond flows and yield.

Greg Anderson:

But what happens is that speculators seated on trading desks, hedge funds, dealers, et cetera, they have an internal belief that this correlation should hold, so they trade accordingly and their flows are enough to maintain the correlation. At least until something big changes in the environment, then the correlation fails. This year it hasn't failed yet. But thus far, the reversal lower in dollar-yen in November, it corresponds almost perfectly with the reversal lower in the five year yield and the positioning corresponds too.

Greg Anderson:

Leverage investors are short bonds, but they're probably trying to lighten up with years end approaching. Leverage investors are also short yen. And in fact, last week's CFTC survey suggest that net short yen was their biggest position in any single currency. At any rate, a lightening up of that position naturally moves dollar-yen lower, just like the lightening up of bond shorts moves yields lower.

Stephen Gallo:

Okay, Greg. If I follow you, a lightening up of positions is definitely a key driver here. Great points. How much further do you think this is going to go in dollar-yen?

Greg Anderson:

I suspect it would take a move all the way back down to 109 for leverage positions to really be fully squared up. I wouldn't rule out a move that big. With the mapping between dollar-yen and the five year yield, that is where dollar-yen should go if the five year yield were to fall back to 85 basis points or so. However, with oil finding renewed strength, we suddenly have some interesting cross traffic in the fundamentals for dollar-yen, so to speak.

Greg Anderson:

Five year yields are pulling it lower, while oil is pulling it higher. Given the cross traffic in my bullish sentiment on oil, I think the bottom in dollar-yen is probably more like 111 rather than 109. And at this moment, I guess I'd give you a point forecast of something like 111 and a half for December 31st.

Stephen Gallo:

I think that's great insight, Greg, especially concerning the cross traffic issue and how you moved into the picture a lot of different variables. Why don't we wrap up episode 24 here, Greg? Thanks for listening. Until next time.

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:

This podcast has been prepared with the assistance of employees of Bank of Montreal, BMO Nesbitt Burns Inc. and BMO Capital Markets Corp. (together, "BMO") who are involved in fixed income and foreign exchange sales and marketing efforts. Accordingly, it should be considered to be a product of the fixed income and foreign exchange businesses generally and not a research report that reflects the views of disinterested research analysts.

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

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