Morning Commentary: The Rule, Not the Exception

Foreign Exchange - Morning Commentary
The Rule, Not the Exception
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
Rising risk aversion has been a dominant theme over the markets these past two weeks.  With the US presidential election fast approaching and COVID-19 infections rising in Europe, this recent trend is likely to continue in the near term. 

Historically speaking, the US dollar tends to appreciate during sell-off in global equities and fades during periods of improving sentiment.  This illustrates the USD’s preferred safe haven status.  However, given the nature of the US presidential election, there is some uncertainty around the USD’s near term performance. 

There have only been two periods in 2020 when the USD failed to exhibit its normal negative (safe haven) correlation with risky assets.  The first came during the early stages of the pandemic when the unwinding of euro-funded carry trades led to euro strength and pushed the USD lower.  The second came around the middle of summer when COVID-19 cases were surging in the US while the euro was benefiting from positive sentiment following the EC’s fiscal support package.  The relevant question then is whether or not the markets can see another period of risk unwinding without USD strength. 

A key upcoming unknown is the US presidential election.  This poses a risk not only due to the unknown policy direction of the next US president but also due to the possibility for a drawn out and contentious election process including potential social unrest.  Tomorrow brings the first presidential debate and should Biden’s lead shrink afterwards, uncertainty would only increase.  One measure of rising election uncertainty is the difference between implied 1-day USDJPY volatility on election and implied 1-month USDJPY volatility starting after the election.  This measure has shown a steady increase in uncertainty since June.  More recently, however, the 1-month implied volatility has started to rise more relative to Election Day implied volatility.  This implies that the markets are getting more concerned about a prolonged post-election legal dispute and social unrest than the election itself. 

Aside from US election uncertainty, there is the recent acceleration in European COVID-19 cases that should weigh on global sentiment due to potential and already implemented anti-COVID-19 policy measures that will hinder an already weak economic rebound.  With European COVID-19 measures already relatively tighter than those in the US, further European measures should be euro negative.

In an effort to predict FX performance during periods of slowing or decreasing economic sentiment, we turn to a data series that plots the relationship between FX and surprises to economic sentiment.   What this shows is that the USD and the JPY are the best hedges to economic deterioration.  Despite the USD weakening twice in 2020 during periods of elevated uncertainty, history shows that it is hard to find a safe haven alternative for it.
  • There has been incremental news on the stimulus front with House Speaker Pelosi sounding more optimistic on reaching a deal with Treasury Secretary Mnuchin.  However, given that both sides are still far apart on the dollar amount and the White House’s decision to move ahead with its Supreme Court nomination, a workable compromise between the two political parties seems unlikely.
  • The lack of additional stimulus is a concern because stimulus was meant to be a bridge loan not a cure to the pandemic.  Virus numbers remain high and are now rising after a modest summer dip.  With the economy not fully open, economic headwinds remain and will only get more difficult during the winter months, underscoring the need for further fiscal stimulus.
  • US-China tensions remain elevated as the US has imposed export restrictions on SMIC, China’s largest chipmaker.  US firms will now have to apply for a license to export certain products to SMIC.
  • The GBP is being supported this morning by positive Brexit headlines out of the EU and UK.  There is roughly 1-month left for negotiations to reach a deal in order to leave a realistic amount of time for ratification.  If Brexit history is any guide, most, if not all, of the action will happen last minute.
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