Falling US rates drive down the greenback
(by Arnaud Masset)
In late March/early April, the US Dollar made a recovery attempt, with the Dollar index rising 2.50% from 98.86 to 101.34, against the backdrop of mounting nervousness about the upcoming French election and Brexit jitters. Those sharp gains were mostly due to a massive debasement of the Euro, which fell more than 3% to 1.0574, while the Japanese Yen was treading water between 110 and 112.
Over that period, investors were less focus on developments in the US and particularly the failure of Donald Trump’s reform agenda. Investors took their time to send the Dollar back to where it came from as the Dollar capitalised on its status as a safe haven in a troubled environment.
Nevertheless, in the last week of March the wind began to rotate as investors started to call into question the viability of the Trump reflation trade. The equity rally paused as the S&P 500 eased slightly above 2,320 points - down from 2,400 in early March - as traders switched from equity to bonds, sending US 10-year Treasury yields back to 2.20%, compared to 2.62% a month earlier.
On the short-end of the curve, the debasement was more acute, with two-year Treasury yields sliding 20bps to 1.17%, as the market slowly realised that the Fed won’t deliver three rate hikes this year.
More importantly, the Trump trade, which sent inflation expectation to the moon six months ago, has also started to unwind. Inflation expectation fell substantially since mid-March and dragged down US yields. The USD inflation forward rate 1y5y (for 1 year in 5 years) slid to 0.19% recently, while on the longer-term, the inflation expectation remained stable, so far at least. We think it is just a matter of time before it starts to adjust to the downside as well. Inflation expectation 5y5y is still slightly below 2%, compared to 1.50% in November last year.
All in all, we believe that is just the beginning and that this basic movement will continue, if not accelerate over the next few months. This re-pricing of inflation expectations will weigh substantially on the USD. In the short-term, we would avoid playing this re-pricing against the Euro and the Pound as the political risk is quite substantial. However, once the French elections are over, the Euro will be set free. In the higher-yielding currency complex, we would long NZD position as speculators will continue to unwind their short positions.
French Elections: Pause in risk appetite
(by Peter Rosenstreich)
FX markets have shifted into a risk consolidation mode ahead of the French elections on Sunday. The French polls remain tight making outcome forecasting extremely complex. We believe there is high probability of a Euro negative scenario of Le Pen / Melechon winning +25% and +20% respectively and a Euro positive with a similar outcome between Macron / Fillon.
We suspect that the sudden demand in Euro has less to do with the markets’ confidence in a market-friendly outcome or ECB speaker suggesting less downside risk in the economy but rather the liquidations of short Euro positions (although short-term implied vols have declined from the highs).
Barring the event risk built into Sunday, we believe conditions are good for further risk-taking. Emerging Markets fundamentals are stronger while the Fed rate path remains subdued and uncertain in our view. Oil's rapid fall yesterday hurt some exporting EM nations such as MXN, yet in the broader term the fall in crude should be net positive for EM.
JPY fuel carry trades remain high on our list of favorites, as rising Japanese inflations expectations are overdone. A market neutral result on Sunday should lead to a renewed zeal for risk assets.