Morning Commentary: Context Matters

Foreign Exchange - Morning Commentary
Context Matters
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
From a high level, FX markets have lacked direction.  Over the past month, the broad dollar has basically been unchanged as markets oscillate between positive news and concerns over a broadening re-acceleration of COVID-19 cases.  

Despite the lack of direction in the FX markets, cross-market correlation remains at an elevated level.  This suggests that markets are still fragile with all asset classes struggling to answer the same macro question: what will be the shape of the post-shutdown global economy.  Will it continue on a “V” shaped path or will it double dip because of renewed shutdowns.  

From a US dollar perspective, markets are likely wondering whether the re-spike in US cases will be a negative for the US economy and the dollar or whether it will impact risk sentiment and strengthen the dollar due to its anti-cyclical qualities.  To me, the bias is for the latter as markets rarely ignore sharply negative US dynamics.  Further it remains to be seen how much of the resurgence in US COVID cases is due to idiosyncratic factors related to the US’s handling of the virus and how much is due to the undesirable tradeoff between a quick re-opening and control of the virus’ spread.  

Another key variable for the USD is the potential rollback of Trump’s tax cuts.  Democrats have proposed rolling back these cuts for a while now but the relatively new prospect of a Democratic sweep of Congress substantially increases the odds of this happening.  The Republicans only needed a simple majority in the Senate to pass the cuts as they used reconciliation procedures.  Should Democrats use the same procedures, they will only need a simple majority too.    

Legislative procedures aside, the FX impact of Trump’s tax cuts were complicated. In essence the impact from the tax cut was highly context dependent.  The USD actually weakened around the cut as the world was focused on global synchronized growth.  Eventually the USD strengthened when the US-China trade war hit global growth and underscored US exceptionalism.  

If context mattered when tax cuts were implemented then it should matter when evaluating the FX impact of a potential unwind.  Prior to the COVID-19 crisis, the prospects of higher US taxes would have been an idiosyncratic shock.  However, with the massive fiscal response to COVID-19 shutdowns driving historically large fiscal deficits around the world, the impact of an unwind of Trump’s tax cuts will likely be obscured.  So once again, context matters. 
  • Virus headlines remain negative with infection numbers worsening.  Officials announced a new 6 week lockdown in Melbourne as the city sees its largest outbreak since the pandemic began.  In the US, an increasing number of states are pausing their re-opening process and mandating masks as US cases are now approaching 3 million.  On the vaccine/treatment front, Novavax and Regeneron both were awarded funding for further development. 
  • Several Fed speakers are expected today.  Among them is Raphael Bostic who expressed the view that the rebound could be leveling off as a result of the spike in infections.  While Bostic isn’t a voter this year, most, if not all, Fed officials appear to be on the same page. 
  • The European Commission cut its forecast for the euro area once again and is now predicting a -8.7% contraction.  Along this line, Germany’s industrial production data disappointed with last night’s MoM data rising only 7.8% against expectations for an 11.1% increase.  
  • The Reserve Bank of Australia kept its policy rate unchanged as expected.  The overnight and 3 year rate remains at 0.25% as the bank noted the downturn has been less severe than expected.  However, the bank underscored how it expects to hold an accommodative policy for a long time due to the high degree of uncertainty in the markets. 
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