This week the FX cross-currency basis has seen the biggest moves in several months with the 3m EUR currency widening by ~10bp, the highest since March. It's worth recalling that the widening in the basis at the height of the funding stress earlier this year reversed thanks to the provision of liquidity via central bank dollar swap lines, and conditions remained calm as the use of swaps lines wound down over the summer.
One plausible explanation for the current increase in funding stress over the year-end is that demand for dollars is coming again via the rolling of short USD positions in the futures market.
However, FX traders should be paying attention to the funding conditions because at the very least a wider cross-currency basis increases the cost of shorting USD via forwards. That said, calendar funding tightness happens every year and routinely accounted for by central banks in their open market operations, so any impact on FX spot markets tends to be short-lived.
China Disinflation Could Delay PBoC Plan
China November CPI -0.5% y/y vs. 0.0% consensus, the first decline since October 2009. This disinflation could delay the PBoC's policy tightening/normalization plan making 1-2Y NDIRS receivers or steepeners a good carry trade for the winter.
China’s November CPI data marked the first negative inflation rate since October 2009. This need not signal weaker CNY management going forward, nor looser monetary policy, although NDIRS receivers could outperform on the headline surprise. The headline number was very much driven by food price deflation (-2.0% y/y) on the back of a recovery in pork supply following the African swine fever outbreak. Note that the PPI was a touch higher than expected at -1.5% y/y vs. -1.8% consensus and -2.1% last.
But China's disinflationary impact certainly won't play out well for broader markets over the short term given the lofty levels we are at.
FOREX Turn Selling Panic Offshore
Onshore USD funding remains stable, with overnight repo rate, SOFR, FF fix, and 3m LIB pretty much unchanged. Z0 IMM is slightly wider but looks unable to stretch to 17bp. For the year-end, the market is pricing in repo rate turn at 0.17% mid vs the recent neutral of 0.11%. This has been unchanged for the past few weeks.
Offshore USD had the second consecutive day of turn selling panic. Intraday, Dec/Jan turns traded to a session low of 125bp wider before retracing about 25bp higher in New York. QE globally may have been a driver of excess cash, e.g. AUD, with 1m yield cheapening 37bp vs 25bp in JPY since Monday morning. I expect IMM flows to weigh on CCYs for another two days.
Stimulus And Popeye Spinach Effect, Brexit + ECB Preview; Soggy Oil After API Inventory
US equities nudged higher Tuesday, with the S&P up 0.3% heading into the close, enough to secure a fresh record high. Tech stocks led the gains, recovering from losses early in the session. US 10Y yields slipped 1bp to 0.91%.
The sentiment was helped by reports suggesting US Republican Senate leader McConnell had offered the Democrats a compromise. Also supportive of Main Street concerns, White House officials asked Senate Republicans to include a $ 600-holiday stocking stuffer check for households as part of any stimulus package.
With the markets starting to exhibit some year-end fatigue, any stimulus holiday stocking stuffer will come at a most welcome time and ensure that well-subscribed equity markets will cross the year-end finishing line on a positive note. Indeed another week, another record print on US stocks.
But who cares for negative news or confirmation for economic fundamentals anymore? The narrative is one of 'looking through it' and expecting yet more of the warm fuzzy feeling that comes with policy accommodation; 'bad news is good news' remains embedded in investor sentiment, and momentum could not be stronger. The bulls remain very much in the driving seat; every time the word stimulus gets a mention, investors immediately start feeling like Popeye after sucking down a can of spinach.
The great news on the healthcare front is that the UK began its vaccine roll out Tuesday, which is a critical first step to reopening the economy and de-clogging the hospitals to better deal with more severe COVID cases and broader other health care issues.
In the case of "things can only get better," from this point forward, Germany's ZEW investor expectations index lifted to 55 in December, a better than expected rise, no doubt reflecting better financial market conditions. On the other hand, a miss on US small business optimism, NFIB index down 2.6pts. Japan household spending and earnings for October missed as well.
Stimulus and the Popeye effect
Of course, the stock market is making new highs even though poor employment numbers irate the street's fundamental side. If ever, I seldom look back at data that has been well in flight, and I have mostly focused on Europe this week. Still, it is difficult to shake the payroll heebie-jeebies even if the miss does scream to congress, "Main Street needs more stimulus."
But who cares for negative news or confirmation for economic fundamentals anymore? The narrative is one of 'looking through it' and expecting yet more of the warm fuzzy feeling that comes with policy accommodation; 'bad news is good news' remains embedded in investor sentiment, and momentum couldn't be stronger. The bulls remain very much in the driving seat; every time the word stimulus gets a mention, investors immediately start feeling like Popeye after a can of spinach.
As we alluded yesterday, an obvious tell among everyone that trades and analyzes stocks, The Put-Call ratio has plunged to near-decade lows suggesting investors haven't stocked up on protection for Christmas. Frankly, with so much disorder in the markets, printing new highs into year-end does not make a whole lot of sense.
And while endless columns on nonsense get written debating the world of Bitcoin, I'm surprised stocks haven't been painted with the same brushstroke. The potency of the stock market signal is hitting new lows when it comes to providing a macro tell for investors, beyond one of liquidity, leverage, and momentum, in addition to the heavyweights of tech in some instances.
One can only conclude stocks are 80% sentiment and 20% signal, while the bond market is the reverse. Indeed, this is the macro tell of all tells, a frothy sentiment-driven stock market rally perched on precarious easy money house of cards, so tread carefully.
And any Keynesian knows markets can remain irrational longer than one can remain solvent, and it is a fool's game to fight such momentum. But spend a little of those profits on year-end protection. It might be the cheapest and most effective insurance policy of the year.
Oil markets
Oil prices slipped a touch after The American Petroleum Institute (API) reported on Tuesday a build in crude oil inventories of 1.141 million barrels for the week ending December 4 versus a predicted draw of 1.514 penciled in by analysts.
Oil followed equities lower overnight but was unable to replicate the equity move higher later in the day. And I do not think the API print will help bullish matters today either. I would say this is surprising given that stocks are pushing higher on the stimulus effect, which should be positive for oil, but clearly, COVID concerns continue to sully the landscape. Oil is simply one of those assets that can’t look through the real-life COVID lens and ignore the fact the gnarly flu is currently ravaging the population on the ground.
The severity of the ongoing COVID surge (particularly in the US, where daily deaths have surpassed the level seen in April this year) is tempering some of the optimism that followed last week's OPEC+ meeting.
And while the compromise achieved by OPEC+ has limited the downside in oil price, action will struggle to push higher even with good news on the COVID -19 vaccine front. The UK approving Pfizer (NYSE:PFE)'s version's rapid deployment suggests there is a clearer path towards a normal oil demand level. Still, uncertainty on the global vaccine distribution speed; hence, the demand recovery pace means the near-term upside is also limited. The vaccine is of itself will not help the economic recovery, but vaccinations will.
Even though worst-case scenarios for oil have all but evaporated, the main driver for oil markets within an increasingly tighter range between now and a wider distribution of the vaccine rollout will be the vaccine rollout speed versus the relentless surge of COVID-19 during the current winter months.
Still, the outlook reads inoculated bright of the oil market. As more folks in the general population get vaccinated, mobility will increase substantially. And if the oil price is to be measured by mobility from point a to b, we might have to add t to the equation as travel demand will most certainly see more planes in the sky post-global immunization.
Forex
Despite the US stimulus fires getting stoked, the FX market remains unmoved, perhaps as the year-end turn spreads move worryingly wider and may prove to be an early warning signal and call to action to pare FX risks.
AUD implied yields had a massive move overnight, with wider turns following global sentiment. Indeed, this being the first year with proper excess cash in the system, the market struggles with excess AUD and USD availability fears. Over the week, AUD year-end turn slipped 160bp and 1m implied about 25bp lower, dragging the rest along. As a result, 3m cross currency is stripping around -20bp and 1y around -6/-7.
FX markets are drifting sideways as traders await the next steps in the Brexit negotiation and if the ECB will deliver any currency actionable policy pivot.
Brexit headline bluster
GBP lifted overnight on the UK's news to withdraw clauses 44, 45, and 47 of the internal market bills. These were the contentious ones concerning Northern Ireland, so their withdrawal raises some hope that common ground between the UK and the EU can be found.
Only to be dealt yet another headline harsh reality after Sky News EU reporter Adam Parsons (NYSE:PSN) tweets that the EU's negotiator, Michel Barnier, earlier Tuesday told EU ministers that the chances of a deal now look very slim. He said the EU was close to the moment when urgent measures would be needed to counter the effects of 'no deal.'
The pound held shy 1.3400 handles as the relatively resilient GBP close to its highs for the year will need more meat on the Brexit bone for FX traders to even think about firing above 1.3500 again.
Still, Brexit negotiations will drag on. The UK will not be allowed to participate in the EU summit this week formally, but that should not preclude UK PM Johnson from chatting to French President Macron and German Chancellor Merkel personally on the sidelines. So he might travel to Brussels tomorrow, or he might wait until Friday.
There could then be two possible outcomes: 1) there's a big deal by the end of the EU summit on Friday night or early Saturday, or 2) the two sides agree to keep talking via the negotiators. Number 2 seems more likely to me, which means yet another week of negotiations.
But when it comes to Brexit, deadlines have come and gone, and it appears the market will be tolerant of more slippage on the deal's timeline, even into 2021. the latest sharp bounce back in GBP shows this attitude will likely sustain a "buy on the dip" approach.
Pre ECB
Short Euro Into ECB Decision?
The European Central Bank might expand the PEPP by as much as EUR650 bn and extend it as far out as mid-2022. A larger headline number is possible given the ECB can say it will only be used if necessary. Pushing PEPP out beyond end-2021, however, seems very unlikely. The ECB may emphasize the exchange rate more prominently in the introductory statement. The Brexit overhang weighing on the Euro makes sense to stay short in the ECB decision.
The EUR's latest rise is likely to be problematic for the ECB. As both the currency's strength and the pace of the appreciation seen during the post-US election pivot is expected to be giving the central bank a migraine headache as a stronger currency tightens financial conditions, which is incredibly unhelpful for an economy facing persistent disinflationary pressures. And the challenges are only getting larger as the latest rise in the EUR has been, if anything, more aggressive than in the summer and has pushed EURUSD to its highest levels in nearly three years.
Still, things will get a bit complicated for my short euro position into the meeting as the market is starting to factor in a big or go home ECB response and are now looking for EUR500bn more in bond purchases extended out into 2022. So, it will become even more challenging for the ECB to deliver a surprise that could knock the EUR off its pedestal. The diminishing marginal power of QE to generate an FX market impact as viewed through the RBA's latest policy lens could be exacerbated by the lofty expectations already in place. Merely delivering what the market is expecting is unlikely to be enough to shock the EUR lower.
There is also a danger for EUR shorts that financial markets interpret QE as being bullish for eurozone assets, as opposed to bearish for the currency. We saw a similar reaction function via other central banks' QE lavishing. Right now, there is minimal perceived credit risk in the European periphery given recent yield movements. But the ECB has not been that active in driving a message of broader inflation risks and the disinflationary impact of a strong currency, suggesting this lack of pushback for Legarde could facilitate a more positive market reaction to QE in European asset price and spur on greater equity market rotations.
Much of the EUR's rally appears to reflect broader risk appetite and a USD blemish rather than pure bullishness about the eurozone's prospects. So The ECB may find it hard to stem the move right now and may opt for verbal intervention.