Barring some kind of geopolitical catastrophe, it seems unlikely we’re going to get anything on Thursday that’s “bigly” enough to overshadow Trump’s comments to the Wall Street Journal (published Wednesday) when it comes to reshaping how the market feels about the reflation narrative.
Yes, we got bank earnings and claims, but when it comes to trading USD and/or Treasurys, there’s nothing like a Trump bomb (or five) to throw everyone for a loop – especially when the yen and the 10Y were already looking for any excuse whatsoever to rally following the “dovish” Fed hike, the health care bill failure, and recent geopolitical tension.
Meanwhile, the euro is just waiting (rather impatiently if you look at vol) on the French elections, which will determine one way or another whether we see parity or not.
Make no mistake, these considerations are really all you should be concerned about. Or at least that’s how we see it. Because while equities are the sacred cow for now, there’s only so long stocks trading at record high multiples are going to be able to withstand an incessant grind lower in 10Y yields and USDJPY.
Here with more on this is SocGen’s Kit Juckes…
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President Trump doesn’t like a strong dollar, does like low interest rates, may yet offer Janet Yellen a second term, recognises that China isn’t a currency manipulator, and is struggling to enact policies that will boost US growth. Looked at in that light, perhaps it’s only to be expected that the dollar is drifting lower. The medium-term case for the euro to usurp it as strongest of the major currencies grows steadily even if European political uncertainty holds it back in the short term.
10-year Treasury yields are now 22bp lower than they were at the start of 2017. The failure of the healthcare bill and mixed economic data have done most of the damage, though geopolitical uncertainty has played a part and the weight of positioning was a major factor too. With JGB yields down just 4bp and Bund yields down only 1bp, relative yields have been a major driver of dollar weakness against the yen, and a reason for it to fail to make gains against the politically-anchored euro. Even more importantly, lower US yields have provided support for emerging and higher-yielding currencies, despite a series of political risks shaking several EM currencies. The Mexican peso is 2017’s strongest currency and the dollar is only up against a handful of stragglers.
Looking ahead, it’s tempting but probably unwise to write off the dollar’s prospects completely. The Fed isn’t done tightening yet, the economy isn’t done growing and we don’t think we’ve seen the highs for yields yet. At this point, market expectations of a third Fed hike this year has faded significantly, and by too much. For all that though, further dollar strength is going to be muted because by and large, economic prospects elsewhere are improving too.
At the top of the list of frustrating currency pairs is USD/JPY, which continues to track yield differentials faithfully. The inability of JGB yields to decouple from US ones is the Achilles Heel of the BOJ’s yield-anchoring policy, and we’re in the vicious cycle where a stronger yen weighs on inflation expectations, magnifying the relative real yield move. But, for all that, if we believe US yields are set to recover, and that episodes of risk aversion are going to come and go like rain showers and not stick around like the monsoon, USD/JPY is a buy once US yields find a base. The BOJ will keep easy monetary policy in place for longer than US yields can go on falling.
The euro is more like a coiled spring than anything else. We will know the result of the first round of the French presidential vote in a week and a half, and we’ll know the eventual winner in two and a half weeks. A Marine Le Pen win would be bad for the euro, of course, and probably drag EUR/USD below parity in short order. But any other result is likely to support it. A rally would be slower than a Le Pen-inspired plunge, but 1.10 is likely quite quickly and we don’t rule out a very sharp spike higher later this year. On current market odds, a 27% chance of a sharp fall, and a 73% chance of a slower rally makes for a difficult bet, but in the longer run there is more upside potential than downside.
One question we’ve pondered is whether the best post-election trade is in bond-land or FX. The correlation between yield and FX trades is very high, and the respective moves are rewarded by a proportional volatility over that period, but unless you have the bond trade unhedged in FX terms, it doesn’t make much sense, yet. Meanwhile, in terms of absolute return (but also probably in terms of sleepless nights) EUR/JPY still looks like the biggest potential mover of all. The elephant in the room for trading EUR/USD is still, however, when to go long. Before the first round vote? Between the two votes? Or only when all is said and done?