US/China Tensions Escalate

Risk appetite starts the week in poor form. The shock announcement of 5% tariffs on all Mexican exports (from June 10) to the US and an intensification of tensions with China, have fuelled growing expectations of a worsening in the global growth outlook. Safe haven assets such as JPY and CHF are likely to remain in demand while core bond yields are likely to continue to move lower, with markets continuing to raise bets on Fed rate cuts this year.  Indeed the 10y US Treasury yield has dropped by 1.1% since 8 November last year, with the fall in yields accelerating over recent weeks.

US/China tensions escalated over the weekend, with the deputy head of China’s negotiating team, Wang Shouwen, accusing the US of “resorting to intimidation and coercion”.  This coincides with the increase in US tariffs on $200bn of Chinese goods coming into effect over the weekend as Chinese shipments reached US shores, while earlier on Saturday Chinese tariffs on $60bn of US exports came into effect.  There is also growing speculation that China may curb exports of rare earth exports to the US.

Wang accused the US of abusing export controls and persisting with “exorbitant” demands and insisting on “mandatory requirements that infringe on China’s sovereign affairs”.   Meanwhile China’s defence minister Wei Fenghe, said that China will “fight to the end” on trade if needed.  China is also starting to investigate foreign companies who have violated Chinese law.  Soon after Chinese state media reported that the government was investigating FedEx for allegedly “undermining the legitimate rights and interest” of its Chinese clients.

Attention this week will be on several central bank decisions including the ECB (6th June), RBA (4th June) and RBI (6th June).  The market is fully priced in for an RBA rate cut to 1.25% this week.  The ECB is unlikely to surprise, with no change in policy likely.  Attention will be on terms of the TLTRO III while ECB President Draghi is likely to sound dovish in his press conference.  RBI is set to cut policy rates again, with Friday’s release of weaker than expected Q1 GDP adding to pressure on the Reserve Bank to boost growth amid low inflation.

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CHF under pressure

In sharp contrast to AUD but for the same rationale (improving risk appetite and low volatility) the CHF has succumbed to pressure. Comments this week by Swiss National Bank officials highlighting their resolve to enforce the CHF cap, their belief that the currency is still overvalued, and are prepared to take further steps, highlight that the Swiss authorities wish for a much deeper correction lower in the currency. This is unsurprising as the CHF real effective exchange rate has been on a strengthening path over recent months, much to the likely chagrin of the SNB.

The fact that Swiss CPI inflation dropped back into negative territory on a YoY basis in February reinforces the need to further weaken the currency. Steps such as negative deposit rates and/or FX intervention cannot be ruled out. In the meantime, USD/CHF looks set to test resistance around 0.8930 (26 Feb high).

EUR and GBP losing ground

Safe haven currencies including JPY and CHF will be the main FX beneficiaries of the current bout of risk aversion although the USD has also edged higher in part due to some slippage in the EUR and GBP. I had noted at the beggining of this week that EUR/USD will remain a buy on dips on any decline to 1.3775. However, after hitting a high around EUR/USD 1.3916 following the European Central Bank’s inaction at its policy meeting last week the currency pair distinctly looks like it has topped out this week. Technical and positioning indicators are also looking less positive for the currency, with the RSI (Relative Strength Index) at a stretched level and speculative positioning above its three month average.

Comments by ECB Vice President Constancio that the markets had not fully taken on the message from the ECB last week that policy will remain accommodative also helped to dampen sentiment for the EUR. Further slippage to technical support around 1.3778 looks likely in the near term.

GBP has lost ground overnight too. Softer data including yesterday’s January industrial production data as well as comments from the Bank of England have weighed on the currency. As noted last week GBP/USD was looking vulnerable above 1.6700 and will face some further short term pressure, with a test of support around 1.6538 looming.

CHF pressures

USD/CHF and EUR/CHF enjoyed a bounce as risk aversion eased but continued uncertainty over the situation in the Ukraine suggests that any upward momentum will be limited. The fact that the largest economic impact from any worsening in tensions with Russia will be felt in the Eurozone highlights that life may become difficult once again for the Swiss National Bank as renewed safe haven inflows move into the country. Indeed the EUR/CHF floor at 1.20 may be tested over coming weeks. Data tomorrow will likely give further reason for the SNB to oppose CHF strength, with the annual rate of CPI inflation set to remain very low.

US dollar restrained further

The USD will continue to be restrained by poor weather conditions and lower US Treasury yields (around 2.6%), especially against the JPY which has also been supported by higher risk aversion and consequent safe haven demand. The USD index is at threat from dropping to its October 2013 lows around 78.998 (currently 79.828)

A similar story applies to the CHF, with USD/CHF hitting its lowest level since late 2011 around 0.8783. This pattern will not change in the short term, especially given the potential escalation in tensions in the Ukraine, keeping the CHF under upward pressure as safe haven inflows increase. EUR/CHF has dropped sharply as a result, with the resolve of the Swiss National Bank to support its line in the sand at 1.20 set to be tested shortly.

Risk currencies in contrast will likely come under growing short term pressure including AUD, NZD and many emerging market currencies. AUD/USD will likely trade with a heavy tone even though the RBA is unlikely to cut policy rates at its meeting tomorrow.

EUR benefitted from the upside surprise for Eurozone inflation but has run into resistance around 1.3800 versus USD. Speculative EUR positioning has continued to rise but the fact that CFTC IMM positioning has risen to above its 3 month average suggests that further EUR gains will be more limited.

Indeed although the USD continues to be restrained by weaker data and lower US yields, the potential for a dovish surprise from the ECB will limit the ability of the EUR to capitalise on USD weakness this week. Strong technical resistance for EUR/USD will be found around 1.3894 (2013 high).

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Low volatility unsustainable

There seems to be a real disconnection between the problems / tensions in China, Ukraine, Turkey, Thailand etc and market sentiment.

Even in the US the market has happily swallowed Yellen’s speech that data weakness is all related to bad weather (US equities rose to record highs overnight while the VIX index has edged lower). Well once the weather improves the data had better improve too otherwise that theory will be shot to pieces and markets will be hit.

In particular there really does appear to be a surprisingly degree of complacency towards events in Ukraine (see earlier comments). On that note even if the Ukraine avoids default via money from US/Europe/IMF tensions with Russia remain a major issue.

In terms of FX reaction JPY and CHF could face more upward pressure while the EUR is looking increasingly exposed. High beta FX EM FX will look increasingly vulnerable against this background.

What is surprising is that both major FX and EM FX implied volatility indices (1m, 3m) are tracking below their historical vol indices. The low level of volatility in both FX and equity markets looks unsustainable.

Lower US yields undermine the US dollar

A drop in US yields has undermined the USD over recent days against major currencies although emerging market currencies remain under varying degrees of pressure. US 10 year Treasury yields have fallen by around a quarter of a percent since the end of last year, acting as a real drag on the USD.

A rise in risk aversion over recent days (the VIX fear gauge has risen by over 13% since its low on 10 January) appears to have resulted in increased demand for Treasuries and weaker equities, with markets ignoring generally firmer than anticipated US economic data this week including weekly jobless claims and existing home sales.

Emerging market currencies have come under strong pressure while the usual safe havens have strengthened most against the USD in particular CHF and JPY. The EUR has also made up some ground. Fortunately for the USD expectations of Fed tapering continue to fuel some buying of the currency, constraining any downside. Nonetheless, until US Treasury yields resume their upward movement the USD’s upside momentum will be limited.

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