ECB Keeps Laying Groundwork For Policy Normalization

Key Themes At Play In Forex Market

• The Sterling found enough buying interest to revert some of its recent sizeable. The currency has transitioned from being the worst performer last Friday to accumulate the highest gains on Monday. A slew of more constructive Brexit headlines were sufficient for short-term flows to return back into the Sterling. German’s European affair said a Brexit deal is still possible by November, while UK’s Brexit secretary Raab sounded fairly optimistic that a deal is still within reach in the next 8 weeks. Be ready for the constant mix of headlines over Brexit to become the norm in coming weeks as politics rule the price.

• The selling pressure was felt in the US equities as the ongoing trade tensions and US political issues hogged the headlines. On the latter, reports indicate that US Deputy Attorney General Rosenstein will meet Trump on Thursday to present his resignation, with some arguing that it may have been behind the imbalance of supply seen in stocks. On the China trade war front, while the Asian giant appears to still be willing to sit down, they are not going to budge, and more signs keep emerging that they are prepared for a long-lasting fight if needed. For now, markets appear to have discounted enough into the price of assets.

• ECB’s President Draghi animated the market with some juicy commentary on inflation expectations. The policy-maker, in a speech on the state of the EU economy at the ECON Committee in Brussels, said that he sees “relatively vigorous pick up in underlying inflation”. The headline is further evidence that the ECB is slowly but surely moving towards the normalization of policies. While the Euro failed to hold onto its gains against the USD, it sent both the 2-year and 10-Year German bond yields into new trend highs at -0.51% and 0.51% respectively, as the yield curve keeps steepening to the highest levels since early August ‘18.

• A major risk event for the markets this week, aside from the FOMC and the BOC policy meetings, is the Italian budget conundrum, which is part of the reason the Euro couldn’t keep the Draghi-led gains. We saw a spike in the Italian 10-Year as a reflection of the growing concerns ahead of the budget plan going through the parliament this week. The fears orbit around the Italians overblowing EU’s budget deficit limits on the promise of a basic income, which if true, is rather unrealistic unless they resort to a larger deficit in violation of EU treaties. The range that appears to be the make or break for the market is 3%, with any deficit larger to translate into a higher Italian premium and a lower Euro. Even above 2% may see some jitters.

• Shifting focus to emerging markets, it’s hard to imagine that EM currencies are out of the woods in an environment where Central Bank around the world is gearing up for an era of normalization. The latest observations by ECB’s Draghi is another reminder that the Central Bank is laying the ground to join the likes of the Fed, BoC, BoE in the tightening of policies. The steepening of the US curve and higher ‘real’ US yields makes it a toxic combination that may see further outflows of capital away from EM back into the US. The major Central Banks left in limbo having to still deal with limited inflationary pressures are the Asian/Oceanic economies, the likes of the RBA, the RBNZ or the BoJ.

• There were little signs that the heightened trade tensions between the US and China are having any significant impact on German business confidence. The IFO business climate came at 103.7 vs 103.2 exp. On the grand scheme of things, the reality is that the economic projections have decelerated a notch with the economy expected to grow at an annual pace of 1.8-1.9% vs 2% earlier on the year. Sooner or later, the uncertainty emanating from US-led trade wars may feed into confidence.

• Our prop macro risk-weighted index remains above the 100 hourly moving average. As a rule of thumb, as long as the index is underpinned above the indicator, we should expect the overall market conditions to remain supportive in attracting ‘risk on’ flows. Last week, the index broke outside a pennant pattern on the weekly chart, reinforcing the view that it’s ‘game on’ to keep playing the reflationary trade as equities keep rising in combination with the steepening of the US yield curve and higher DM bond yields.

• The price of Oil saw a major breakout above the sticking resistance of $70.00 following news that OPEC and allies are not considering to boost output. The rise in Oil further anchors the notion of the reflationary environment in play amid higher energy prices. This has direct implications, especially for a region like the European Union, strengthening the case for inflationary pressures to stay relatively elevated.