Diverging rates are expected to benefit the dollar – a hawkish Fed will trump a dovish Draghi every time. This is the scenario that dollar ‘bulls’ have bought into, however, it’s currently not working for them this week – the release of the dovish FOMC minutes coupled with some economic slack comments from Yellen has the dollar ‘hawks’ on the run. Leading to many ‘long’ dollar positions being squeezed, as the market drastically prices out an early rate hikes by the Fed.
Economically the US is sound and much further ahead of Japan and Europe. According to the IMF, the UK is the EU’s outlier on the growth front, while China, with its questionable economic data, (this week it was weaker Chinese export data) is everyone’s problem. A dovish US and a disappointing China is allowing US treasuries to remain better bid, with US 10’s touching a four-week low yesterday (+2.65%), as traders dampen their enthusiasm and bets that US policy makers are moving towards raising interest rates any time sooner.
Any weaker Chinese data surprises will always boost the safer-haven demand of a number of other assets like bonds (specifically Bunds, Tsy’s and JGB’s) and currencies like the Yen. Traders’ wagers on the futures exchange yesterday put the likelihood that the Fed will start raising rates in July 2015 at +63%, for June the percentage actually fell to +41% compared with +54% projected last week. The fixed income market is basically re-pricing the curve, pushing out the “lower for longer.” theme.
Yesterday and this morning’s asset moves have confused many. Equities are falling and the treasury market is rallying – this is technically the norm, as investors shift cash flows from equities into a safer-haven asset class like bonds. But, the dollar also has come under pressure, printing a number of new quarter lows versus G7 counterparties. The recent sharp sell-off in equities provided a supportive climate for safe-haven securities but did not include the USD this time around. Dealers noted that currencies were currently diverging from traditional risk barometers.
Why? Forex volatility is at an historical low level courtesy of extremely “easy” monetary policies from the developed economies. The combination of low volatility, Fed QE and a weaker “net savings” position has the USD underperforming (a distinct long term competitive disadvantage to other G7 members). This has led to other CBanks like the RBA, BoC, Norges and even now the ECB to change their policy guidance to counter a tightening of their monetary conditions from stronger currencies versus the USD. All CBanker’s can hope for is that the US economy will recover enough for Fed guidance to be challenged and that the front end US Treasury yield curve to finally break higher – giving G7 CBanks some relief. Otherwise investors and dealers will be trading in the new “norm” of low forex volatility and contained intraday ranges.
The US Treasury curve has priced in +100bp of rate hikes for the next three-years, with the first-hike in 2015. According to the Fed and fixed income watchers, historical examples of Fed rate ‘normalization’ suggest the process can be significantly more aggressive. In the forex market volatility remains rather subdued, handcuffed mostly by the CBanks actions. Currently, FX vols are pricing sharply lower the price of more rapid Fed tightening. When there is a need to reprice anything differently, the short-term FX vols should be capable of rising from their current ultra low levels, moving both spot FX and cross positions for a brief period.
Any shocks from a re-pricing of the Fed reaction function are expected to be “fleeting” in the current environment – leaving longer dated maturities well anchored as policy makers focus on the short end. It’s up at the “front” where Ms. Yellen and company will be busy guiding and smoothing expectations helping to form FX trends. These trends will again smooth out volatility as investors buy on dips using FX to overshoot Fed-tightening expectations. Now all this market requires is a break in the “lower for longer” cycle. For any hardcore reaction the forex and fixed income market needs a tightening Fed otherwise its back to watching paint dry. Today’s low levels of FX and Equity vols are “historically a sign of extreme leverage and poor capital allocation.” A Fed on the move will break this – the more the Fed policy drains cheap USD liquidity the stronger the USD becomes. For now, the “lower for longer” argument is hurting the greenback at least until investors become fixated with something else that may grab their attention.
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