18/11 Forex Market Commentary

John Hardy, Consulting FX Specialist, Saxo Bank

USD/risk divergence proves fleeting...
Yesterday's action saw a brief, if rather marked divergence in the USD direction relative to the direction of risk appetite, as the USD showed a rallying tendency (if still within the recent range) despite equities closing rather close to recent highs.

This drew considerable interest on our part, considering the degree to which the USD and risk have tended to move in complete negatively-correlated lockstep for months now. With the action in Asia and Europe so far today, however, it appears this was merely a fleeting development. Below we try to unravel the reasons behind the churning action in the USD.

Trying to make sense of the greenback
Technically speaking...or does the market speak that language at the moment?
Technically speaking, this market is a miserable mess as every attempt by the market to tip its hat in any direction proves fleeting and treacherous. The major USD crosses that had crossed to the strong USD side of their weekly pivots have now crossed back to the weak side of those pivots, eliminating what little upside momentum had developed for the greenback.

Since we seem to just be churning in a range here, the only thing we can do at present is glance over at coincident fundamental indicators: risk appetite and interest rate spreads. These two inputs reveal a conflicting story, perhaps a key reason why we're seeing an inability for the market to commit one way or another.

Risk appetite (high risk appetite supports USD carry trade): Risk appetite remains very high by some measures, with equities at highs for the cycle (both in the US and in emerging markets), junk bond spreads close to lows, and FX volatility also close to lows for the cycle.

Interesting to note, however, that the credit market is showing some signs of worry, with CDS prices (default insurance) having risen for a month now even as equities have rallied back from their recent sell-off. The credit market often led the broader market in risk in 2006-08.

Interest rate spreads: generally, the forward expectations for the major central banks have been falling over the last few weeks, and despite falling yields at the front end of the US yield curve, spreads have actually contracted slightly in favor of the USD for the likes of AUDUSD and USDCAD, while EUR vs. US spreads have remained relatively flat. This is acting as a brake for dramatic new lows for the USD, while risk appetite is trying to push the USD in the opposite direction.

Zooming out
So the only thing we can do here considering the above inputs is to zoom out a bit and look for the technical levels that indicate a bigger break of the range and try to identify any key event risk that could serve as a trigger for a bigger directional move. For EURUSD, the technical breakouts lie at 1.5063 and 1.4808 at the moment. On the event risk side of things, it's a bit of a tougher call. Nothing looks "big enough" for the remainder of this week and next week features the Thanksgiving holiday on Thursday and Friday.

Just ahead of the holiday we have the first revision of the first estimate of US GDP and we have the monthly Conference Board confidence number, either of which could receive a lot of focus if the market continues to show signs of indecisiveness. We should also never forget the "Thanksgiving surprise" of 2006, when EURUSD rocketed above 1.3000 for the first time in 18 months on Thanksgiving Day. Still, if coincident indicators continue to show the type of confusion we are seeing at present, the market action could remain muddled and treacherous, with false breakouts, etc.

MPC Confusion
The Bank of England was out with an odd, split decision in which the two dissenters were on opposite sides of the majority. The dovish dissenter, Miles, voted for £40 billion in QE (vs. the £25 billion agreed upon) and the hawkish dissenter, Dale, voted for no QE. The MPC discussed changing the interest rate on excess reserves, which would be considered dovish and therefore pound-bearish. The market responded by strongly bidding up the 3-month short sterling STIRs, as less tightening was priced into the forward curve.

On the more pound-supportive side of the equation, the MPC raised its inflation forecasts to a 2.7% annualized rate in Q1 of next year. This is only 0.3% from the level requiring the bank to write a letter to parliament and makes current policy look extraordinarily accommodative if inflation does tick up to those levels. All in all, this may prove a relatively pound-supportive development despite the initial reaction, which perhaps focused on the dovish dissenter and the excess reserves debate.

US Data
The US data today not especially supportive of risk, with CPI coming in slightly above expected and more interesting, the housing starts and building permits numbers diving well below expectations and close to the lows for the cycle. The US housing story is not over with, as millions of sub-prime-like mortgages (Alt-A and Option ARMs) face a reset in the coming 18 months or so. A very high percentage of these will end in defaults/foreclosures and serve as a large potential supply for extra housing on the market.

Looking ahead
Again, we twiddle our thumbs and wait (not so) patiently for the market to show its hand. The US 10-year yield benchmark is worth of our attention as it is trading close to the trendline support and the 200-day moving average just below 3.30% today. It's perhaps interesting to watch the oil market today. Crude prices have banged on the 80-dollar per barrel door for a month now, never really managing to break above it. We're at that price level going into today's US inventory data. Also, look out for the SNB's Hildebrand out speaking later - EURCHF has done absolutely zilch of late and could be ripe for a surprise.

Chart: US 10-year note yields
Again, we note that 10-year yields are trading up against important support after having traded in a very constricted range for months. No even risk suggests a dramatic move here, but certainly an interesting level to watch as an indicator on overall risk appetite if yields are able to drop through this level (suggests more worry than we are seeing in other asset markets at present). This is especially important, as always, for JPY crosses.