Morning Commentary: The USD is King, Long Live the King

Foreign Exchange - Morning Commentary
The USD is King, Long Live the King
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
Over the past two months, the USD index has moved sideways, but as optimistic risk sentiment builds, it looks vulnerable to break outs to the downside of this.  To be fair, market optimism is understandable as developed markets continue to re-open and data series show early signs of stabilization.  However, the view remains that it is too soon to expect broad based USD weakness. 

While the USD has retraced less from its peak than other assets, its pricing still embeds expectations for an optimistic rebound.  This is because the panic move for the USD was less extreme in March making the starting point for a rebound less stretched. 

Additionally, the news headlines around a coordinated fiscal response out of Europe, while positive, isn’t a game changer for EURUSD.  Certainly, the European Commission’s proposal for EUR 500 billion in grants to member states hardest hit by the pandemic is a major step forward.  Additionally, Germany moving from its opposition against fiscal transfers is also significant.  However, it is important to remember that everything is still just a proposal and unanimous agreement is needed.  The frugal four have already express opposition against grants and in favor of loans meaning there will be weeks of bargaining until a compromise, if any, can be reached.  

Moreover, the notion that a precedent has been set for the sharing of fiscal burdens and will extend to Euro area countries assuming responsibility for each other’s existing debt burden is very premature.  Germany’s concessions were for COVID-19 specific shocks.  This means recent euro developments warrant a reduction in euro risk premium more than it does a full re-think of debt sustainability-related challenges. 

As a final point, US-China tensions continue to escalate and broaden at a worrisome pace.  Thus far, the market’s reaction to these tensions have been relatively measured which raises risks for catch up pricing as risks of further escalation are clearly on the rise across a number of issues.  Expect the USD to strengthen if the markets start to believe in a higher probability that rhetoric can turn into action and especially if it actually does.
  • Overall market risk sentiment remains positive even though US-China tensions remain high.  Overnight, news reports suggest that the US is considering a range of sanctions on Chinese entities.  Based on past examples, it is possible that rising equity prices could embolden Trump to take actions, but this is clearly a dangerous game.  Monetary and fiscal stimulus have supported risk assets and driven the gap between equites and the real economy to multi-decade highs.  The fact remains the real economy is much weaker than equity prices would suggest.  
  • Protests continue in Hong Kong over China’s new national security laws.  Over 300 people have been arrested with the US pledging action by the end of the week. 
  • Japan announced another round of fiscal stimulus.  The most recent package totals JPY 117 trillion ($1.1 trillion) and will target struggling companies, rent subsidies and healthcare assistance.  The Japanese government has also increased its bond issuances which may drive the BoJ to increase its purchases. 
  • The Aussie dollar is under pressure as China indicated that it may impose import restrictions on coal.  Relations between the two countries have been strained since Australia called for an inquiry into the origins of COVID-19.
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