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FX markets saw a subtle shift in drivers yesterday, where the energy shock switched into a broad deleveraging of risk as cross-market volatility spiked. These risk unwinds tend to be short, sharp affairs. Before re-entering trades, investors will need to see some good news, either in the form of lower energy prices or central banks being able to ease policy.
USD: Focus could switch to US prices and the Fed
We saw a subtle shift in the drivers of FX markets yesterday. If Monday was entirely about the impact of high energy prices on energy-importing/exporting currencies, Tuesday was the broad de-leveraging of open positions as cross-market volatility spiked. Here, equities were hit hard – led by financials. That banks led the sell-off was down to the large overweight positioning in that sector.
It feels like the story of redemptions in the private credit space is ephemeral to the overall sell-off (e.g. Blacktsone, Blue Owl headlines), but is a story that should be watched. Instead, the spike in volatility and rising Value-at-Risk metrics has prompted a broad reduction of position sizes, which in FX markets is another US dollar positive given that investors were short. We would also say that some of the amazing headlines overnight – e.g. South Korea's Kospi index falls 12% – follow a 50% run-up in this index year-to-date February.
Near term market drivers of risk will probably be both whether energy prices can reverse lower if the Straits of Hormuz can somehow reopen, and also whether central banks will be able to cut rates to support activity, or at least not tighten policy. On the former, risk assets received a brief lift last night after President Trump said that shipping in the Straits may receive naval convoy support and that US federal institutions stood to back the insurance of shipping fleets. Those were positive, targeted comments, but the market will want to see evidence of this happening. So far, energy markets are remaining bid.
As to central banks, we have been writing this week about how the inflationary risk of the energy shock is re-pricing the short-end of the curve. That trend briefly reversed yesterday after equity losses intensified. But unless we see another major equity sell-off today, the hawkish re-pricing of the short-end of the curve looks the dominant theme. That is a dollar positive.
We see a few inputs into this theme today. Assuming the monthly ADP release comes in near +50k, investors will assume that the Fed has been right to assume that downside risks to the labour market have abated. We will then be looking at the prices paid component of the ISM services index. A high reading there can support the dollar. And then tonight we'll see the Fed's Beige Book ahead of the 18 March FOMC meeting. Any signs that price pressures remain sticky could see the market further scaling back expectations for two Fed cuts this year. 45bp of easing is currently priced this year.
The dollar has had a very good week so far based on the factors described above. DXY traded as high as 99.68 yesterday. We doubt investors will want to chase it through the 100.00/100.35 highs seen over the last eight months. But equally, we will need to see some clear improvement in the energy story before investors are prepared to enter short dollar positions again.
EUR: 1.1500 may be the bottom of the range
Long euro positioning – especially in the asset management community – left EUR/USD vulnerable yesterday. 1.1530 was the low. So, EUR/USD is being hit on both the terms-of-trade story and the broad-based deleveraging story. The terms of trade story will be the far more important theme and the duration of this energy shock will determine whether EUR/USD needs to trade down to 1.10/12 or can find support near 1.15. Our base case is the latter, in which we would expect operational intensity to decrease over the next week and the Straits of Hormuz to slowly reopen.
Barring any major new headlines from the Gulf today, we suspect conditions could calm a little (equity futures look less bleak this morning) and EUR/USD could find support in the 1.1550/1575 area.