From the FXWW Chatroom: US equity markets remained in recovery mode last week through Friday though they did give back some gains into the close. S&P was up 4.3% on the week and the VIX closed below 20%. It is a US holiday today and with China still out until Thursday, a quiet start to the week is expected. Meanwhile, US bonds continued their sell off last week, though like stocks, we did see a bit of a reversal into the long weekend.
-The DXY index lost 1.5% last week and we did hit a fresh 3yr plus low at 88.25. As last week, I see this story continuing near term. Markets have been caught out by the sudden shift from fiscal austerity to an apparent stance that ‘deficits don’t matter’. The trade deficit is set to widen both as a result of the ‘J’ curve whereby imports become more expensive and as fiscal policy changes encourage tax and investment dollars to flow out the country. This will drive the current account deficit wider as the savings/ investment shock weigh. This takes a toll on the currency until bond yields rise enough to attract the increased flow required to reach an equilibrium. Let’s see how this story unfolds this week.
-The DXY index lost 1.5% last week and we did hit a fresh 3yr plus low at 88.25. As last week, I see this story continuing near term. Markets have been caught out by the sudden shift from fiscal austerity to an apparent stance that ‘deficits don’t matter’. The trade deficit is set to widen both as a result of the ‘J’ curve whereby imports become more expensive and as fiscal policy changes encourage tax and investment dollars to flow out the country. This will drive the current account deficit wider as the savings/ investment shock weigh. This takes a toll on the currency until bond yields rise enough to attract the increased flow required to reach an equilibrium. Let’s see how this story unfolds this week.
-Crude led commodity markets higher, though the run of news from a supply perspective has been far from positive. We have now had two weeks with US crude production above 10mbpd and the EIA up its production forecasts for this year and next with risks they have to continue this process. On top of this, money managers remain super long though we did have one piece of good news Friday with rig counts unchanged on the week. Bottom line, I am suspicious about the gains we saw in crude last week and tend to put much of the move down to the weaker US$.
– What does all the above mean for the A$? A weak US$, rising commodity prices and abating risk aversion all argue for a higher A$ near term. It’s important here though to differentiate between the A$ against the US$ and versus other currencies. AUD/JPY for instance is testing below 84 – an 8 month low – while AUD/NZD hit 6 month lows below 1.07 Friday. I am of the view that ¥ strength can continue though markets may be nervous as we approach 105. AUD/NZD is arguably reflecting some concerns about Australian politics given events in Canberra last week and over the weekend. So while the falling US dollar is lifting all currencies including the A$, it’s a different story on crosses.
– Friday’s UST performance was more likely a function of short covering / profit taking ahead of the US long weekend than any sign of a reversal of sentiment or a significant shift in momentum. While there is a lot of bearish news for Treasuries already in the price (higher inflation expectations, a surge in UST supply next fiscal year, ongoing balance sheet reduction, fiscal stimulus, 3 Fed hikes priced-in for 2018, etc.) there is little reason to expect a surge in demand anytime soon.
– Friday’s UST performance was more likely a function of short covering / profit taking ahead of the US long weekend than any sign of a reversal of sentiment or a significant shift in momentum. While there is a lot of bearish news for Treasuries already in the price (higher inflation expectations, a surge in UST supply next fiscal year, ongoing balance sheet reduction, fiscal stimulus, 3 Fed hikes priced-in for 2018, etc.) there is little reason to expect a surge in demand anytime soon.
– So our view is that we will likely see a 3-handle on 10yr US yields over coming weeks (assuming deficit and wage inflation concerns continue) and we would expect to see sellers into any rallies, especially if there are a few days of consolidation of current levels and a squeeze lower, toward 2.75%. Even so, as we have noted a couple of times recently, we are not particularly bearish on a medium term basis and would expect good demand for USTs around 3.1%. With Asia basically out for the Lunar New Year, that demand won’t be evident this week, however and we would expect price action to be very low volume. The major risk events will be around the Fed, with the FOMC Minutes and a raft of Fed speakers on the schedule. Obviously the market will assess the speeches for any shift in the consistent message of a gradual tightening cycle thesis. From a risk reward perspective, the shift of most market consequence would be a discernible increase in hawkish commentary, although that is not our expectation.
– In AU, the themes remain unchanged. The Board Minutes will once again reiterate “the on hold for the foreseeable future” base case and that will continue to support the front end of the curve on any US-led dips. That will also support the directionality of the broader 3-10yr curve, with the curve flattening on US-led rallies and steepening on sell-offs. We continue to hold the view that 80 is the next target, however a week of consolidation in the outright will test the resolve of those looking for quick gains. A steepener is a crowded trade at the moment, so there is scope for a “clean out” of positions before the upward trend resumes. We would expect those looking to reset or add more risk to steepeners to be targeting 70bp to do so.
– The AU-US 10yr spread begins the week ay +1bp. Our view has been that it will “do a lot of work” around the 0bp level and that is evident in recent price action. It is too early to expect the next re-pricing toward a sustainable inversion to occur this week, however we are very confident that any widening in the spread (likely on a rally in US bonds) should be faded.
– The AU-US 10yr spread begins the week ay +1bp. Our view has been that it will “do a lot of work” around the 0bp level and that is evident in recent price action. It is too early to expect the next re-pricing toward a sustainable inversion to occur this week, however we are very confident that any widening in the spread (likely on a rally in US bonds) should be faded.
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