USDJPY may further gain although JPY is the dominant risk aversion trade
(by Peter Rosenstreich)
The EURJPY remains the currency to watch for the market view on the French Presidential elections. Recent polls suggesting market friendly Emmanuel Macron has a slight lead gave the Euro a boost. However, terrorist acts in Paris last night reintroduced uncertainty (Fillon and Le Pen have suspended campaigning).
Developments in Europe also support our short JPY call. We had anticipated a pullback in USD demand but that downwards correction in USDJPY has outpaced our expectations. We anticipate a recovery to resistance at 112.15.
The JPY has been supported less by growing inflation expectations but rather weakening in global risk environment. JPY remains the dominant risk aversion trade above gold, USD and CHF (however, we are not seeing significant JPY buying on fluctuations in French polls).
Clearly, rising geopolitical worries have caused investors to rotate out of risky assets and into JPY. We suspect tensions have reached a peak and suspect that the historically customary path of diplomacy will takeover.
IMM positioning indicates that the JPY is well overbought suggesting room for readjustments. This week’s BoJ meeting will bring no meaningful adjustment to the current strategy as policy board members are likely to shift focus on personal changes rather than monetary policy. Last week the BoJ nominated two very dovish members showing support for aggressive balance sheet expansion to its committee.
For now, the realization is that the BoJ ¥80trn annual balance sheet expansion is unstable, leading to a switch to yields curve control that will dictate strategy. While the ECB inches towards tapering and the Fed contemplates the next 25 bp hike, the BoJ policy continues to be the loosest. This strategy should remain supportive of USDJPY.
Yet, it is not the BoJ that will drive USDJPY higher but the reactions of the US economy and interest rate. The US economy seems to have slipped into a period of cyclical softness which should organically pick up in early summer. However, while investors have all but thrown the Trump-reflation trade away, there is still the probability that that the Trump administration gets a pro-growth win (tax reform remains the clearest).
IMM data indicates that USD is oversold indicating room for additional demand. In addition, implied yields on Fed Futures for 2017 are near the lowest they have been in 2017 and 2018 suggesting it would not take much for markets to quickly reprice the pace of Fed interest rates hikes, sending USDJPY higher.
EURUSD volatility to the ceiling indicating investors’ fears
(by Arnaud Masset)
The Asian session was extremely calm on Friday as traders adjusted their positions ahead of the first round of the French Presidential elections on Sunday. The single currency edged slightly higher against most of its peers with the exception (obviously) of the Swiss Franc. EUR/CHF was trading sideways at around 1.07.
On the surface, there is no evidence to suggest that the market is worried: the yellow metal is down 0.15%, the Japanese Yen edged down 0.05% against the EUR and equities are treading water.
However, in the option market it is a complete different story. The one-week implied volatility (ATM) on EUR/USD hit 18% overnight, compared to 6.37% a week ago. The one-week 25-delta risk reversal measure (the difference between the volatility of a call and a put) collapsed to -3.90%, indicating that investors rushed to buy insurance against further downside in EUR/USD.
The same phenomenon happened to USD/JPY as traders braced themselves for a massive flight to safe-haven in case the pro-business candidates get squeezed out. Indeed, if neither Emmanuel Macron or François Fillon make it to the second round, and assuming that Benoît Hammond is already out, the EUR will take a wild ride. The worst scenario for the Euro would be Le Pen and Mélenchon at the second round.
In EUR/USD, the key support stands at around 1.06-1.0630 (previous low and bottom of uptrend channel). Lower, a support can be found at 1.0341 (low from January 3rd).
Investors will react violently to a squeeze out of pro-business candidates and we won’t be surprised to see EUR/USD free-falling toward the 1.03 threshold. On the other hand, we’ll see a relief rally should Macron or Fillon make it to the second round (a Fillon/Macron second round would be a blessing for the EUR and French bonds).
In any case, be ready for some opening gap on Monday morning.
Geopolitical risks are back in investors’ calculations
(by Peter Rosenstreich)
After a long hiatus, geopolitical risk is back in investors’ calculations. Geopolitical tensions remained the market focus giving safe haven currencies JPY and CHF a boost.
It’s likely after the French election results are in, geopolitical risk will continue to drive risk-taking. The US missile strike on Syria on 6th April and the largest non-nuclear bomb ever used in combat on 13th April in Afghanistan highlights President Trump’s willingness to use military forces.
While in Asia, China has increased the rhetoric around North Korea’s nuclear weapon development, which in turn is stressing warming China/US relations. There is a current feeling that diplomatic responses may not be enough to lower the risk of further military actions. To emphases this, regarding dealing with North Korea, US Secretary of State Rex Tillerson stated: “Let me be very clear: the policy of strategic patience has ended.”
History indicates that unilateral missile strikes generally have an immediate negative effect on the markets but quickly recover nearly all loses within five days in most examples. Global stock market indices volatility generally remains elevated, while there is limited effect on gold, USD or bond yields.
In the case of a full blown regime change (executed by NATO in Iraq, Bosnia and Somalia), the stock markets response was mixed although on average there was a gain on the first day then further gains for the next week. Gold and oil prices generally fall after the first day.
In Syria, we don’t see escalations above localized missile strikes. The decision to strike a single target (this case an airbase) or Syrian surface to air missile sites indicates that the move was not in preparation for a larger campaign. Syrian President Bashar al-Assad was not targeted suggesting that the US was not intending to change the regime or risk provoking the Russians.
A military escalation on the Korean peninsulas would have deeper downside risk. First, N. Korea is military prepared for defensive retaliation (or even first strike). Any action against N. Korea should be considered a total regime change operation. Any action aimed at N. Korea will have profound negative repercussions on financial markets. Japan and South Korea economics account for around 8% of the global GDP (stock markets of South Korea, Japan and China would see negative shocks). The spillover of disruption economic activity into world growth will be real.
The path of least resistance generally defines the path of geopolitics. And despite the erratic behaviour of many of the individuals involved (Trump, Putin, Assad, Kim Jong-un). it’s likely that a diplomatic strategy will continue. Already actions (offering for a better trade deal with the US or larger US military presence in the region) by the US have forced China to take a strong stance on N. Korea including new sanctions. While regional military conflict generally has a negative market impact, the mid-term view is that the impact is negligible.
We understand the headlines are scary and force investors to contemplate the unimaginable. However, investors are better served to follow the historical market impact norms and not overreact to geopolitical developments. As we have sated at the start of 2017, fundamentals remain the core driver of asset prices and this will continue barring an extreme event.