Morning Commentary: Mind the Gap

Foreign Exchange - Morning Commentary
Mind the Gap
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
Normally, interest rate differentials play a key role in driving the foreign exchange markets.  But these are not normal times as FX markets have been driven largely by overall market risk sentiment with equities playing a large role in this.  

Since mid-March, equities have staged a massive rally and are up again today despite extremely soft economic data including both economic and sentiment-based measures.  Such is the dichotomy between equity markets and the real economy that the gap between these two measures have hit its widest level in 50 years. This is a concern because history shows that 90% of the time, this gap closes within 5 months.  The question becomes does the real economy improve to match what equities are pricing in or do equities fall back to where the real economy currently sits?

In my view, there is a greater chance for equities to converge with the real economy than vice versa.  Current equity levels imply that the US economy is in the late stage of its recession.  But given the large size of the COVID-driven economic shock and the elevated uncertainty around its long term effect, the risk remains for the recession to be longer, not shorter, than expected.  

Should the elevated uncertainty around the pandemic hinder the real economy’s recovery to longer than a quick recovery implied by equity prices, stocks will have to fall again.  This view is supported by history with equity prices in longer recessions having 2-3 troughs before a true inflection point higher.  Moreover, recent developments with US-China tensions only adds to the uncertainty.

Taken all together, the current environment still calls for a defensive position and supports the view for the USD to move higher as the preeminent safe haven currency.   
  • The official count of COVID-19 deaths topped 251K worldwide although the lack of testing in many countries means the true number is likely higher than this.  Finland, Hong Kong, California and Arizona have all announced plans to reopen.  In California, the first phase of eased measures will allow stores to sell certain items via curbside pickup.  Individual counties can also relax stay-at-home rules if they can effectively track and trace infections.  
  • US Non-Manufacturing ISM came in at 41.8, beating expectations for a 38.0 print. 
  • The RBA met overnight and kept rates unchanged as expected.  The bank has already taken aggressive action so it is able to take a “wait and see” stance.  The bank will release its Statement on Monetary Policy on Friday along with a new set of forecasts.  
  • The euro remains under pressure as a German court challenges the legality of the ECB’s stimulus plan.  In the ruling, the German court accused the EU Court of Justice of overstepping its powers when it backed the ECB’s QE policy.  Per the German court ruling, the ECB’s bond purchases are legal but it violated its obligation to act “proportionately.”  The ECB has 3 months to fix the flaws in its program.  Should the ECB not fix its flaws, the German central bank would no longer be allowed to participate in the QE program and would have to sell its substantial holdings.  This ruling does not impact recent virus-related ECB action. 
  • The Chinese have hit back at the US over comments on the coronavirus outbreak with state media attacking Secretary of State Pompeo but, noticeably, not directly attacking President Trump.  This tactic has been used by the Chinese in the past to avoid direct confrontation while satisfying its domestic audience.  Additionally, it has been reported that the US is considering an extension of some tariffs on China.  The yuan is outperforming in the Asian space on these headlines.   
  • UK services PMI beat estimates at 13.4 versus expectations for a 12.3 print.  The UK will announce its reopening roadmap on Sunday.  
  • Oil prices are up on the session as additional production cuts and re-opening economies helps to balance out the supply/demand picture.  
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