An FX Cheat Sheet

A distillation of the macro backdrop and important price considerations for selected currencies.

US Dollar

• The market always has taken the Fed's forecast for three rate hikes next year with a large dose of skepticism. The fed funds futures strip implies growing expectations that the Fed pauses after a hike in December and Q1 '19.
• It is still unclear the direction of fiscal policy next year. It may be difficult for the Democrats to oppose making middle-class tax cuts permanent and an infrastructure initiative cannot be ruled out. Still, the most pressing fiscal issue is the possible partial closure of the government in early December, which the White House is threatening unless its proposed border wall with Mexico gets more funding.
• The Atlanta Fed sees Q4 growth tracking 2.8%, while the NY Fed's model sees it at nearly 2.6%. Although this would represent a slowdown from 3.5% and 4.2% in Q3 and Q2 respectively, it is still above what officials regard as the long-term non-inflationary trend.
• From a high level (and oversimplifying), if there is one price to use as an overall metric for the dollar, it may be 96.25 in the Dollar Index, which is where the uptrend connecting the September, October and November lows can be found at the end of this week.

Euro

• Two of the eurozone's three largest economies (Germany and Italy) unexpectedly contracted in Q3. The flash November PMIs that will be released at the end of the week are expected to confirm the lack of rebound in Q4.
• The ECB meets on December 13. It will confirm its intentions to cease net new asset purchases at the end of the year. There is some risk that the incoming data, including the dramatic drop in oil prices, will prompt the staff to shave growth and inflation projections for 2019.
• The EC has a process in place to address countries that are in violation of its fiscal rules. EC officials will likely seek to minimize the fodder it provides to the populist government. Investors have taken their pound of flesh. The 10-year yield is consolidating around 3.50% and the five-year peak in the premium over Germany was recorded a little more than a month ago (~3.27% vs. 3.10% now).
• Except for a few days last week, the euro has been confined to a $1.13-$1.16 trading range since the start of October. The rate differential with the US has stabilized (June 19 Euribor and Eurodollar spread bottomed near 338 bp on November 7 and is now a little more than 320 bp). Three-month implied vol. peaked near 8% last week. The lower end of the three-month range is slightly below 7%.

Sterling

• Political drama is running high. Although the agreement that was negotiated by the EC and two different UK negotiators, both who have resigned, is widely criticized, neither an alternative leader nor an alternative plan (besides, "renegotiate" or accept no agreement as the superior alternative) is in sight.
• Three-month implied volatility remains elevated. It was hovering around 7.5%-7.80% most of the summer and spiked to almost 13.2% last week. It is around 12.75% now. The uncertainty surrounding Brexit will likely keep the actual volatility high and demand for insurance strong.
• The economic data is mixed, but on balance, the weakness in retail sales and house prices is a yellow flag. The political uncertainty may weigh on investment.
• Sterling's low for the year was recorded in mid August near $1.2660. The October low was a little below $1.27 and the Brexit-inspired sell-off last week saw $1.2725. Sterling has been recording lower highs. Last week's high was a little above $1.3070.

Sterling

• Outside of occasional jabs by President Trump about Japan's trade surplus with the US, Prime Minister Abe has managed to keep Japan off the mercurial leader's radar screen. The 12-month moving average of Japan's trade surplus recently peaked in February 2017 near JPY343 bln a month. It now stands at a little more than JPY5 bln. Japan's current account surplus is driven by income from investment more than trade.
• While the BoJ has not and cannot declare victory in its efforts to boost consumer prices (excluding fresh food) to 2%, Kuroda has indicated that will not see a significant expansion of existing programs (qualitative and quantitative easing complemented by yield-curve control).
• The 10-year yield has eased after approaching the new 20 bp cap in early October and has returned to below the old 10 bp cap.
• The dollar recorded the high for the year near JPY114.50 in early October, as the 10-year yield was rising. The dollar pulled back as the yield and stocks moved lower. The lower end of the the dollar's recent range is around JPY111.60.

Canadian Dollar

• Recent data has been mixed. The labor market remains strong, for example, but wage growth slowed. Inflation is in the middle of the central bank's 1-3% range.
• Yet the expectations for monetary policy next year is in flux. The implied yield of the June BA futures has fallen to about 2.55% from nearly 2.70% (November 8).
• Oil prices in Canada typically sell at a deep discount to the US. The oil requires more refining and higher transportation cost. However, that discount has grown amidst concern that the lack of sufficient pipelines in Canada is creating a surfeit.
• Since late May, the US dollar has traded between CAD1.28 and CAD1.34. It has been tracking a trendline higher since the early October low a the lower end of the range. The trendline is now found near CAD1.3130.

Mexican Peso

• As expected, the central bank of Mexico hiked rates by 25 bp last week to 8.0%. The logic, especially the uncertainty over the new government's course, was particularly hawkish and another rate hike is expected next month. There is increasing talk among economists of a 50 bp move, if not in December, then early next year.
• Growth recovered in Q3 to 0.9% after a contraction of 0.15% in Q2. Quarterly growth is volatile but has averaged about 0.65% over the past 20 quarters. The weakness of the peso lifts inflation expectations.
• The US dollar has risen against the peso for the past seven weeks. It is the longest rally in a year. The dollar has tested the MXN20.50 area a few times this month, though it has not closed above it since last June. Uncertainty about AMLO's policies and the leveraged market's positioning (long local currency paper) warns that the cap is vulnerable. The year's high was in mid June near MXN20.95.

Australian Dollar

• A robust October employment report and talk that Chinese efforts to boost the domestic economy will have positive knock-on effects for Australia has helped the Australian dollar recover in recent weeks. It has risen against the US dollar for the past three weeks and five of the past six. It reached its best level since August, near $0.7340. It and the New Zealand dollar have been among the strongest currencies in the world over the past month.
• The Reserve Bank of Australia remains squarely on hold and we suspect the market may have gotten ahead of itself if Trump and Xi do not reach a handshake agreement (as Juncker and Trump did over the summer). The $0.7400 area may cap further gains.
• Australia's two-year yield consistently traded at a premium to the US since 2000. It fell to a discount earlier this year and has not seen a premium since February. The discount reached 91 bp earlier this month and is now a little less than 75 bp.

Original Post