Morning Commentary: Bliss in the Face of Risk

Foreign Exchange - Morning Commentary
Bliss in the Face of Risk
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
One of the most notable aspects of the FX markets over the past 3 months has been the lack of responsiveness to fundamentals.  In fact, the US dollar has weakened despite relatively strong US economic performance.  However, during this same period US dollar weakness, US equity markets have moved up sharply, delivering their best quarterly performance in multiple decades.  

FX factor analysis data that looks at FX drivers since mid-June shows the unprecedented dominance of a single factor—US equity markets—in explaining FX price action.  As risk assets moved higher, FX risk premium eroded and the US dollar softened.  Continuing this logic, a downturn in relative US economic performance should have little consequence if policy support keeps risk assets buoyant and relevant sensitivities remain unchanged.     

But history has shown single factor dominance in the FX markets to be unsustainable.  To this point there are signs of shift in the factors driving FX price action.  FX factor analysis that focuses on the most recent data shows nascent signs that markets are beginning to pay attention to the evolving pattern of the global recovery.  Specifically the steepness of the forward rate curve—which is seen as a proxy of growth, inflation and monetary policy—is becoming statistically significant in explaining FX movements.

In a way this makes sense.  During the initial stages of the crisis there was much unknown and a dearth of data on relative growth.  That has started to change and could mark the reversion back to relative fundamentals driving price action. 
  • Virus news continues to skew negative with case numbers continuing to rise in the US.  Sun Belt states continue to be of particular concern.  US case counts rose by 63,000 yesterday which took total cases north of 3.12 million.  However, positive news came out on the treatment front with Gilead reporting positive findings on remdesivir-treated patients.  74.4% of patients treated with the drug recovered by Day 14 versus 59.0% of patients receiving standard care.  
  • The US 10 year yield currently sits around its low of the year with the 30 year yield also trending lower.  Additionally, Fed futures are back to pricing in negative rates after moving up after the huge May jobs report.  Fed officials have been unfailingly dovish but the view remains for stronger forward guidance and yield curve control to come before negative rates.  
  • US-European tensions are back in focus as reports indicate the US is preparing to place tariffs worth $500 to $700 million on French goods.  It is possible that these measures could be announced today but implementation will likely be delayed until France starts collecting taxes on US internet companies such as Google and Facebook.  These tensions build on existing tensions from issues such as the Airbus-Boeing dispute.  Under any situation, trade disputes are an economic headwind.  But in the current situation makes the global economy especially vulnerable as the global economy is in a recession and COVID-19 related issues are with us for the foreseeable future.  
  • The EU released a revised recovery plan that still includes grants and loans but proposes earlier repayments.  Opposition to grants from the Frugal Four is still expected so expect further negotiations leading up to and through the EU summit scheduled for 17-18 July.  
  • Canada’s jobs report came in better than expected with the country adding 953K jobs against estimates for 700K jobs.  This was a solid jobs report with gains split roughly evenly between full and part time workers.  Nevertheless there is still a ways to go before the labor market recovers to where it was pre-COVID.    
  • China took steps to slow down its equity market rally overnight.  Earlier this week, a state run newspaper expressed support for Chinese equities.  However the Shanghai index fell ~1.9% as government owned funds trimmed their big cap holdings and state run newspapers warned of a “crazy” bull market. 
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