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Shock Therapy

by Karl Schamotta | October 4, 2021

With consumer prices climbing and political fortunes shifting, policymakers will continue to signal a gradual winding-down in stimulus levels this week, leaving markets on edge. But three major forces are likely to act on currencies in the days ahead:

Red pill, Merck pill: The consequences of Friday’s confirmation that an experimental antiviral pill developed by Merck & Co. could slash the chances of being hospitalized or dying of COVID-19 are likely to play out in currency markets over time as investors downgrade the probability of additional coronavirus outbreaks in the world’s biggest economies. By reducing the potential burden on the healthcare system and limiting the likelihood of additional lockdowns in 2022, the announcement could put sustained upward pressure on global yields.

Debt ceiling drama: As emphasized last week, an outright default remains extremely improbable – but with the government poised to run out of money on October 18, supply and demand dynamics in the market for the world’s safest assets – US Treasury bills – are becoming increasingly volatile. The Federal Reserve is doing its best to keep liquidity flowing, but the odds on a systemic plumbing problem in one of the most complex markets on the planet are ratcheting higher by the day.

Energy shock: Overall energy intensity has fallen precipitously since the seventies, but today’s sharp increase in energy costs is not landing on economies in an evenly-distributed manner. In China, Japan, Europe, and the United Kingdom, shortages threaten to take a negative toll on growth rates. In the United States, where energy exports – petroleum, natural gas, coal, and electricity – are now more valuable than imports, rising prices are pushing yields and the dollar upward. Today’s OPEC+ decision could provide further fuel for this divergence.

Note: We switched from the previous calendar-driven format to something more currency specific this week – would love to hear your feedback on how to improve:


Friday’s non-farm payrolls report could prove surprising: High-frequency indicators collected during the month of September have provided little evidence of a sustained rebound in the hospitality sector, but other industry segments may have done the heavy lifting. A range between 250,000 and 850,000 – around the market’s current 450,000-job expectation – is entirely possible.

Reaction could be anticlimactic: With the most dovish member of the Federal Open Market Committee – Neel Kashkari – now on board with tapering asset purchases, markets believe that only a devastatingly-bad jobs number could derail a move in November or December. As Jerome Powell put it, the central bank’s “substantial further progress” test had been ““all but met” in August, making a “knockout, great, super strong employment” number in September somewhat unnecessary.

Safe-haven flows remain important: An ongoing implosion in China’s property sector and the onrushing debt ceiling deadline are both likely to weigh on global risk appetite in the coming days, keeping demand for highly liquid dollar-denominated assets well supported.

At the same time, US growth opportunities look remarkably attractive: The household sector is still sitting on enormous amounts of dry powder in the form of savings and relatively low leverage levels. Corporate profit margins remain incredibly healthy. And a shale gas investment boom could be in the offing.

This “barbell” dynamic – in which the greenback gains during both risk-on and risk-off conditions – is likely to keep the trade-weighted dollar aloft for now: Long dollar positioning is beginning to look overcrowded, but the warning lights aren’t yet flashing red.


Q4: 91.9 | Q1: 92.0 | Q2: 93.0


Friday’s Labour Force Survey isn’t likely to dictate the Canadian dollar’s direction: Analysts are looking for a 60,000-position gain in September after August’s 90,000-job jump, but with overall employment levels nearing pre-pandemic trend levels, a modest disappointment shouldn’t derail the Bank of Canada’s stimulus withdrawal plans. Most observers expect the central bank to respond to higher-than-desired inflation levels by announcing a further half-billion dollar reduction in weekly asset purchases at its October 27 meeting.

Instead, today’s OPEC+ meeting could play a pivotal role: With American shale output lagging soaring prices, major importers are hoping the cartel will remove production restrictions at a faster pace – China has reportedly told its biggest companies to secure more supply at “all costs” and the Biden administration appears to be putting pressure on Saudi Arabia through back channels as the global economy suffers an energy price shock. If cartel members accede to these demands and move to maintain market share by agreeing to pump more oil, the Canadian dollar – which has exhibited a growing relationship with West Texas Intermediate prices – could see Friday’s gains wiped out.

Ranges remain resilient: Non-commercial traders were sitting on a net 17,000 short positions against the Canadian dollar as of last Tuesday, but there are few obvious catalysts for a breakout beyond the 1.26 – 1.29 range that has held since global interest rate expectations were reset at the Federal Reserve’s June meeting. For now, changes in global risk appetite look likely to overshadow domestic developments in driving price action.


Q4: 1.2400 | Q1: 1.2300 | Q2: 1.2500


Mexican inflation continues to run hot: Economists expect year-over-year price growth to break the 6% threshold when September’s data is released on Thursday – significantly outside the Banxico’s comfort zone. Under current market assumptions, the central bank will hike rates by another 25 basis points at each meeting in November and December, with another 150 points coming by the end of 2022.

Peso volatility is also heating up: The exchange rate has fallen 1.8 percent from the September open, and one-month implied volatility has climbed off mid-month lows as debt ceiling-related plumbing issues roil the US Treasury market. Speculators are rebuilding short positions on the currency.

But moves in the dollar will dictate market direction in the coming days: With the June low at 20.75 offering some resistance and carry yields looking increasingly attractive, an improvement in global risk appetite could power a rally toward the 20 threshold.


Q4: 20.00 | Q1: 20.06 | Q2: 20.28


Brazil’s monetary hawks remain dominant: The Banco do Brasil has been among the world’s most aggressive central banks this year, lifting the benchmark Selic rate 425 basis points in less than eight months, with another 100-basis point move on the cards for October 27.

Prices have not been responsive: With food prices and drought-related electricity costs skyrocketing higher, Thursday’s data is expected to show annualized inflation topping 10 percent in September, well above the central bank’s 3.75 percent target.

The real should remain under pressure this week: With carry trades violently reversing as inflation concerns rise in the United States, even Brazil’s real interest rates – currently the second highest in the emerging markets – aren’t enough to keep traders invested. Rallies up to the 200-day moving average at 5.3520 look likely to trigger reversals.

But intervention risks are growing: The central bank – seeking to stabilize the currency and mitigate inflationary shocks – stepped in on Thursday, selling $500 billion in swaps. More could come in the coming days as the central bank tries to reduce its reliance on blunt-force interest rate increases.


Q4: 5.24 | Q1: 5.20 | Q2: 5.28


Germany’s election came and went with little fanfare in currency markets: Coalition negotiations, now underway, could take months to reach a successful conclusion, and will mostly likely result in a heavily-diluted policy platform – one that has a limited and incremental impact on pan-European politics.

An energy price shock is stalking the Continent: Governments are rushing to provide relief to households and small businesses that have been most impacted by the rise in prices, and rescues are underway for suppliers who have suffered an inversion in operating margins. But growth is poised to slow.

Monetary policymakers continue to repeat the “transitory” mantra: Speeches this week from President Lagarde and Chief Economist Lane will be closely examined for any indication of a cracking in the European Central Bank’s dovish facade. Minutes from the bank’s September meeting, due on Thursday, could shed light on whether members were implementing a technical tweak or responding to higher-than-expected inflation when they turned slightly hawkish, reducing the pace of bond buying under the Pandemic Emergency Purchase Programme.

But markets understand Europe will remain several steps behind the Fed: Underlying growth levels in the common currency area are far weaker, giving the Federal Reserve more latitude to respond as prices rise to uncomfortable levels.

The euro continues to trade with a downside bias: With yield differentials under pressure, the euro-dollar pair looks more likely to test support at 1.1530 than to stage a rebound above 1.1700.


Q4: 1.1800 Q1: 1.1800 | Q2: 1.1800


The Great British Peso is back: Last week’s plunge in the pound had some calling it an “emerging market currency”. The sterling-dollar exchange rate tumbled more than three percent to an eight-month low as energy shortages, looming tax increases, and the end of several government support schemes brought memories of the stagflationary seventies to the surface.

But such comparisons are overblown: Currency traders are contemplating a classic emerging-markets dilemma – high inflation potentially forcing the central bank to raise rates too quickly for the underlying economy – but we think the Bank of England is less inclined to make this sort of policy mistake.

Markets may be conflating an attempt to preserve flexibility with a desire to raise rates: According to minutes taken during the last Monetary Policy Committee meeting, officials said they were willing to raise rates “even if that tightening became appropriate before the end of the existing UK government bond asset purchase programme” – but there is little to suggest that such a threshold will be met before the end of the year.

Last week’s selloff seems unlikely to find an echo in the days ahead: With dollar shorts now largely wiped out, our charts suggest that near-term support is emerging around 1.3415, with the risk/reward ratio slightly tilted toward upside gains – potentially opening up a break above the 1.3625 mark.


Q4: 1.3500 | Q1: 1.3500 | Q2: 1.3500


China’s on holiday: Mainland markets are closed through Friday morning (CST) for the Golden Week Holidays – meaning that the deluge of real estate development-related newsflow should slow to a torrent.

Trade tensions are returning: The Biden administration is widely expected to highlight China’s non-compliance with the “phase one” trade deal signed under the Trump Administration in talks later this week. But this shouldn’t shake the yuan – the currency proved largely unresponsive during the height of the (far more bellicose) trade war two years ago.

The onshore renminbi will flatline till Friday, but offshore markets are betting on modest appreciation. We’re not sure why: Authorities may be boosting the country’s purchasing power as a potentially-destabilizing rise in commodity prices looms. Last week’s crackdown on foreign exchange dealers might be creating mismatches on order books. Or traders could be front-running a move by the “national team” to stabilize the currency in the event of an Evergrande default.

But the People’s Bank of China will serve as judge, jury and executioner for traders caught offside: If CNH diverges too widely from the desired onshore fix this week, the Friday open could get bumpy.


Q4: 6.45 | Q1: 6.42 | Q2: 6.43


Japan’s political status quo remains intact: The ruling Liberal Democratic Party chose to install Fumio Kishida as Prime Minister last week, electing a candidate with centrist, if slightly right-leaning views. Markets expect more stimulus spending, including direct payments to individuals, to come later in the year, but currency traders understand that a lower house election in November could play havoc with the new administration’s plans.

Lockdowns have lifted: With per-capita vaccination rates moving well ahead of the US, the government ended a state of emergency and canceled a number of prevention measures last week, putting the conditions in place for a fourth-quarter rebound.

But the yen remains the worst-performing G10 currency this year: With Japanese monetary policy on autopilot, and the US Treasury market acting as global shock absorber, the currency has fallen more than 7 percent against the dollar.

Tuesday’s inflation data won’t reverse the tide: Consensus estimates suggest that consumer prices rose for the first time in 14 months in September, up 0.2 percent year-over-year – but with mostly-imported energy prices providing the propellant, the monetary policy implications are null and void.

All is calm, until it’s not: The yen has settled into one of the tightest trading ranges against the dollar in recent memory, spending the bulk of the last four months between the 109 and 111 marks. Heavy resistance has emerged around the 112 threshold, with challenges quickly rebuffed, while the 100-day moving average at 110.10 offers solid support. Changes in domestic conditions are unlikely to trigger a breakout – instead, a volatility shock in the form of a global market selloff looks like the most probable catalyst for a rally.


Q4: 111.00 | Q1: 111.00 | Q2: 112.00


The Reserve Bank of Australia is overwhelmingly favoured to stay on hold this week: In September, the Bank said it would not review its bond buying program again until February. Monetary policy settings are already set to extremely accommodative levels, and officials have made it clear that fiscal intervention would pay greater dividends at this juncture.

Policymakers might acknowledge upside risks: A faster-than-expected vaccination campaign and an accelerated removal of zero-tolerance lockdowns should convince central bankers to take a more positive view on the future – even if this sense of optimism is not shared by market participants.

But policy divergence should keep a lid on the exchange rate: With yields rising elsewhere as the central bank sits on the front end of the curve, interest rate differentials are working against the currency – eliminating the carry trade flows that helped stabilize the currency during prior global tightening cycles.

And developments in China could have mixed effects: A slowing property sector and Xi Jinping’s crackdown on excesses in the steel industry have depressed iron ore prices, but the approaching winter is lifting other demand for major Australian energy exports – liquid natural gas and coal.

The 71.70 cent level – near the mid-August low – could offer support in the near term, while the 73.15 50-day moving average proves stubborn in the face of any bullish run.


Q4: 0.74 | Q1: 0.75 | Q2: 0.75

Notes: Consensus estimates derived from rounded average of median Bloomberg and Reuters forecasts.


Courtesy of our London-based lead technical analyst, Trevor Charsley:

Notes: A support level is an exchange rate at which demand is thought strong enough to stop the currency pair from falling any further. The rationale is that as the exchange rate falls and approaches support, buyers (demand) become more inclined to buy and sellers (supply) become less willing to sell. A resistance level is the opposite – a rate at which supply is thought strong enough to stop the currency pair from rising higher. As the exchange rate rises and approaches resistance, sellers (supply) become more inclined to sell and buyers (demand) become less willing to buy. When a resistance or support level is broken, its role can reverse. If the exchange rate falls below a support level, that level will become resistance. If the exchange rate rises above a resistance level, it will often become support.


Long reads to kill your Monday morning productivity levels:

“The cost of clunkers and dealership trade-ins has suddenly become market-moving information, with analysts, economists and traders fixating on an obscure indicator called the Manheim Used Vehicle Value Index.”

New York Times: Wall Street Scans the Lots as Used Cars Prod Inflation

“One looming risk is if political leaders mismanage things in the world’s largest and second-largest economies. Namely, in the United States, a standoff over raising the federal debt ceiling could bring the nation to the brink of default. And in China, the fallout from the property developer Evergrande’s financial problems is raising questions about the country’s debt-and-real-estate-fueled growth.”

The Upshot: The Economy Looks Solid. But These Are the Big Risks Ahead.

“If you live in a Developed Market it means that you are pretty likely to be well-off individually (when measured on a global scale). But it also means that you benefit from Developed Market Privilege: your government can run counter-cyclical monetary and fiscal policy.”

Principlesandinterest: Developed Market Privilege

“It is vivid evidence that macroeconomics, despite the thousands of highly intelligent people over centuries who have tried to figure it out, remains, to an uncomfortable degree, a black box. The ways that millions of people bounce off one another — buying and selling, lending and borrowing, intersecting with governments and central banks and businesses and everything else around us — amount to a system so complex that no human fully comprehends it.”

The Upshot: Nobody Really Knows How the Economy Works. A Fed Paper Is the Latest Sign.

The dot-com bubble and the subprime mortgage crisis didn’t look like examples of markets calmly processing all available information. Meme-stock madness is adding to the doubts. Gabaix and Koijen’s work, “In Search of the Origins of Financial Fluctuations: The Inelastic Markets Hypothesis,” explains how the amount of money sloshing into markets can have an outsize and lasting impact on share prices regardless of fundamental factors such as earnings, revenue, or growth.

Bloomberg: Does New Cash Make Stocks Go Up?

“The prices of stocks, bonds and real estate, the three major asset classes in the United States, are all extremely high. In fact, the three have never been this overpriced simultaneously in modern history.”

New York Times: Stock, Bond and Real Estate Prices Are All Uncomfortably High

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