The US Treasury market set the investment world on edge in early October when long US Treasury yields climbed to new multi-year highs – the US 10-year benchmark cleared 3.13% for the first time in more than seven years, and the big 30-year T-bond yield passed the massive 3.25% yield for the first time since early 2014, a level it had approached on no less than four occasions since late 2016. Driving the move was a spate of strong US data and Federal Reserve chair Jerome Powell suggesting that the Fed funds rate is “nowhere near neutral” in offhand comments. The reactivity of the US dollar to developments in US yields has been an on-again, off-again affair, but a sharp rise in US yields in late Q3, after strong wage inflation data were reported for August, resulted in a weaker dollar for much of September.

From here, whether rising US yields continue to squeeze global USD liquidity and especially emerging markets could depend on China’s intentions for the renminbi. Regardless, if US rates and the USD both rise further, the first would quickly break the US markets and eventually the US economy, and both together would likely break the global economy, particularly the emerging markets that most indulged in USD-denominated borrowing via the Fed’s zero interest-rate policy years after the global financial crisis.

For its part, China has vowed that it will not pursue such a course. This makes eminent sense on multiple fronts. First, a strong and stable yuan would help to deepen interest in settling China-bound trade in yuan, a key component of China’s strategic One Belt, One Road policy mix. Second, China’s current account is almost balanced at zero now after years of large surpluses as the country’s consumption of imports – particularly energy – has grown more rapidly than its exports. A weaker currency would likely erode Chinese purchasing power of key imports faster than any growth in exports could offset it, particularly as Chinese exports move up the value chain, where the country isn’t competing on price anyway.

We’re entirely unsure how China will play its cards from here but lean towards China maintaining the value of its currency, which would be a key component in the USD turning lower sooner rather than later. Regardless, the rise in yields, most urgent now in the US, but showing signs of spreading to Europe and even Japan, is the dominant theme around the world, and a higher cost of capital will act as a strong headwind for global asset markets and eventually global growth via its effects on the credit cycle, with varying consequences for the currencies of developed and emerging markets.

Currency outlook briefs

Our main thesis is that the direction of the US dollar remains the key driver of the action as we go from the late US monetary policy cycle to potentially the end of that cycle in a more concentrated and immediate timeframe than the market or the Fed anticipates. The US dollar and US rates can only rise so far from here before something – or rather more things – break. In Q3, we saw much of EM bending under the weight of a stronger USD and higher US rates, and the Turkish lira and Argentine peso suffered outright breaks while other current account weaklings in EM like Indonesia and India were under severe pressure. If the USD does not weaken from here, we will move into a phase of default and USD-denominated debt repudiation that will mark first the end of the USD’s ‘Reign of Terror’, and second a more profound search for global currency alternatives that is already under way.

USD – Strength can’t last. US long yields have crossed the Rubicon in technical terms, and a further aggravated rise in yields cannot be excluded in Q4. But higher rates will eventually put the brakes on the US recovery, something that may be already happening as Q4 gets under way. Q4 may be the quarter in which the USD finds a local top, if it hasn’t already, and then is toppled into reverse as the market figures that the Fed has taken things too far. Timing is the chief risk as we must deal in probabilities and the risk that we are a quarter or more too early.

EUR – A rebound in order. The euro badly wants to rally from undervalued levels against the USD as the European Central Bank’s quantitative easing policy draws to a close, even if it is doing so as the eurozone economy is likely set to weaken. It’s doubly unfortunate for the eurozone to see global economic weakness as it is the single economic bloc with the largest current account surplus to the world, which makes it the most sensitive to the trajectory of global growth. But this does not necessarily mean that we will see a weak euro. After the populist surge of recent election cycles across Europe, and with the prospects of European Union parliamentary elections next May, it is rapidly time for EU politicians to counter the populist threat. In this case, to stand and fight would mean injecting fiscal stimulus, which Germany will inevitably open up for once its economy clearly comes under pressure. So rather than tight fiscal and easy monetary policy, we will see the EU moving toward tighter monetary policy and easier fiscal policy – a more currency-positive outcome. Yes, there is room for bumps along the way and another round or two of euro stress if Italy’s 2019 budget problem isn’t quickly settled in Q4, but once we get a core EU buy-in on easier fiscal policy, this could prove highly euro-positive.

JPY – Explosive two-way volatility potential.  The yen is at a critical inflection point due to the 10-year Japanese government bond yield, the long end of the Bank of Japan’s “controlled” yield curve, having reached its supposed BoJ control level at 15 basis points in early Q4. In theory, any further rises in global bond yields will not be absorbed by Japanese sovereign debt at 10 years and shorter maturities and have to be transmitted to the yen, as long as the BoJ defends the 10-year yield cap. But just how unmovable is the BoJ if yields continue to rise? In other words, where is the breaking point? Surely the BoJ knows that a breaking point is out there somewhere and such policy caps and floors and pegs are dangerous animals, as the Swiss National Bank’s franc ceiling in 2015 and sterling’s Exchange Rate Mechanism crisis in 1992 showed. The longer the BoJ commits to the cap and that cap is out of sync with rate rises elsewhere, the more violent the reaction will be when the BoJ finally caves on its commitment to this policy. With longer-dated JPY volatility so cheap as Q4 gets underway, we like the idea of buying long-dated JPY upside volatility.

GBP – Path to Brexit after all? Sterling is entering Q4 on a strong note as the market is taking a more optimistic stance on Brexit after the Tory party conference saw a solid show of solidarity and the EU suggested that a “Canada+++” is still on the table if the two sides can figure out a solution to the thorny Northern Ireland border issue. Either way, the path to a potent sterling rally is only straight if a deal appears on the way that both sufficiently preserves UK sovereignty (i.e., does not resemble Prime Minister Theresa May’s Chequers plan) and satisfies the minority government’s tiny supporter – the Northern Ireland Democratic Unionist Party – when the deal eventually moves to a parliamentary vote. A failure to agree a plan would lead to ugly domestic political consequences and more likely a long delay to the negotiations, a new election and possibly even a second referendum. This latter scenario is more likely than a so-called no-deal Brexit.

CHF – too strong. The Swiss franc has been too strong for too long, and Q4 could be the quarter in which this is realised, with policy beginning to normalise around the DM world and the CHF in a very different place versus long-term levels relative to the rather weak JPY. CHF could be in for a particular rout if we do in fact see a Brexit breakthrough in Q4, which could drive a GBPCHF upside theme in the coming quarter and more.

CAD, AUD, and NZD – diverging paths. The Aussie is the single currency most used as a DM proxy for concerns over the Chinese side of the US-China showdown, and it has suffered a considerable devaluation together with its smaller cousin, the kiwi. As Q4 wears on, and if China maintains a convincing floor or better for the renminbi, positioning alone could drive a significant squeeze higher for the AUD, even if the credit cycle turning sour in Australia is a longer-term concern. The CAD could piggyback USD strength as long as it lasts and then fade in relative terms against the other “G10 smalls” if and when the USD turns lower. We also like AUDNZD higher on a mean-reversion and relative central bank policy and interest-rate spread basis, unless China surprises with more CNY-negative outcomes.

NOK and SEK – Mean reversion to continue. The Scandie central banks are on the move before the ECB, with a hike in the bag from Norges Bank and one potentially coming in December from the Riksbank. While NOK and SEK rallied in Q3, they are still perhaps the cheapest currencies in Europe. Thematic trades on normalising CB policy could be CHFSEK and CHFNOK shorts as well as eventually USDSEK and USDNOK shorts and the more straightforward EURSEK and EURNOK shorts.

EM currencies – the ugly present versus the ugly future. While EM currencies as a group could find some relief once USD strength fades and US rates (we assume) eventually peak, the cost of capital has risen for good and globally, cheap USD and even euro and yen funding will increasingly be a thing of the past. In other words, there is plenty of room for an accident or two in leveraged EM economies, particularly in those that have already been under pressure with their weak balance sheets, heavy exposure to foreign-denominated loans, and weak current account fundamentals – think Turkey, South Africa, Argentina, et cetera. But beyond the risk of a credit crunch for the most leveraged EMs, eventually we could see that those countries that are most leveraged to global growth are the ones that come under increasing pressure. These are the big current account surplus countries, the big exporting economies like South Korea, Thailand, and Singapore, for example (arguably the first and the last of these are not really EMs). For these Asian exporting powers, some of the weakness could be partly offset by a stable renminbi policy if that is the path China pursues.

 

By John Hardy, Head of FX Strategy at Saxo Bank

 

Source: Action