Headfakemania - Global Exchanges

Greg Anderson:

Hi, I'm Greg Anderson from BMO FX Strategy. Welcome to episode 62 of Global Exchanges, a podcast about foreign exchange markets and related issues.

In this week's episode, my co-host, Stephen Gallo, and I discuss the recent price action in foreign exchange surrounding central bank decisions from the Bank of Canada, Fed, ECB and Bank of England.

We reflect on why central bank signaling seems to have lost its influence over FX, and propose alternative macro catalysts for the days and weeks ahead.

The title of this episode is Head Fake Mania.

Stephen Gallo:

Hi, I'm Stephen Gallo, a London-based FX strategist. Welcome to Global Exchanges, presented by BMO Capital Markets.

Greg Anderson:

Hi, I'm Greg Anderson, a New York-based FX strategist. I'm Stephen's co-host.

Stephen Gallo:

In each weekly podcast, like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets, like commodities.

Greg Anderson:

We strive to make this show as interactive as possible, so don't hesitate to reach out by going to bmocm.com/globalexchanges.

Thanks for joining us.

Stephen Gallo:

Okay, it's February 2nd, 2023. Welcome to Global Exchanges. And thanks for tuning in during what has been a week of central bank and economic data intrigue.

Greg, what I want to do to get the ball rolling this episode is set the scene.

As noted in the intro by yourself, we're talking about catalysts for movement in the FX market. And on the sidelines of this podcast we talked about three different potential catalysts.

First is central banks. And what we determined there on that issue is that based on how things are shaping up so far this year, we can devise scenarios for various different currency pairs based on certain outcomes. But on the whole, the impact of central banks on the FX market is not going to be straightforward.

Another catalyst is energy and commodity prices. And the gist here is that a breakout up or down in commodity prices, particularly fossil fuels, that would be straightforward for various currency pairs. But at the same time, it's not yet clear that the impact of China's reopening on the commodity complex will be straightforward.

And the third and final catalyst I think we're going to briefly touch on today is the directional flow of risk capital, much of which is being put to work this year after stagnation last year in terms of investors' willingness to take on risk.

So Greg, I want to pass it over to you at this point and start with the central bank catalyst by mentioning the Fed.

Now yesterday, Jerome Powell was about as hawkish as he could have been during the press conference, and yet the dollar went into a tailspin. So what's your take on this, and maybe more importantly, why doesn't the FX market seem to be listening to what the Fed and Powell are saying?

Greg Anderson:

So let me set the scene from yesterday.

The Fed probably had discussions during its meeting about markets, getting ahead of themselves, and chose to lean back a bit. So they retained the big capital letter S in their forward guidance paragraph, saying, "The committee anticipates that ongoing increases in the target range will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive, blah, blah, blah."

That guidance pushed up two-year yields by a few basis points as we awaited Powell's press conference. He came out of the gate in the press conference and read that line and sort of did his best to highlight and bold the "S".

He also reiterated his view that he didn't think that the Fed would be cutting in 2023, in part because, as he said, he viewed the risk of not finishing the job as potentially being more damaging for the economy than the risk of over tightening.

But somewhere in the middle of all that discussion, markets decided they didn't care what he said. Stocks rallied first. And when that happened, the dollar index began to slide. Then interest rates joined in and started to move forcefully lower.

Now, I will argue that Powell did feed the dollar bears with one little tidbit laid in his presser. He basically said that if US inflation comes in substantially lower than the 3.1% medium projection from the December summary of economic projections, that we would see that reflected in their policy.

That comment somewhat gave his blessing to the money markets pricing in of about 50 basis points worth of rate cuts in the second half of the year.

But here's the deal: that comment came slightly after 3:00 PM, and the bulk of the US dollar selloff was largely complete by then. And actually we're now about 0.3% higher in Bloomberg's dollar index than we were before he dropped that little nugget of dovishness.

The benchmark two-year yield is down about four basis points today and about six basis points since that comment from Powell, but yet the dollar index is higher.

So for anyone trading FX based primarily on the monetary impulse, it's got to be frustrating. What a head fake.

But actually, now let me point out another.

We were at about 1.3370 in Dollar Canada just prior to the BOC decision back on January 25th. The BOC full on signaled a pause, which was a bit more decisive than expected. Dollar Canada immediately jumped above 1.34 the figure and into the 1.3420's.

The BOC's new economic projections supported the pause and Macklem's comments in the press conference generally did too.

So we stayed above 1.34 the figure during the press conference and then for a few hours afterwards, but within 48 hours, we were right back down to 1.33 the figure in Dollar Canada, as the market just seemed to cast aside this BOC signal.

And putting the BOC and the Fed together, over the span of eight days, we've had the BOC signal that it's done hiking, the Fed signal that it expects to hike at least twice more, and yet Dollar Canada is lower than where we started that sequence.

That's a bigger head fake, Stephen.

Now, you asked me for an explanation for these head fakes, but I guess I feel like this situation still deserves just a little bit more venting.

So I first want to ask you about today's ECB and Bank of England juxtaposition.

We had the BOE seeming to signal it could be done hiking, while Lagarde sounded pretty darn determined to hike at least another 50 basis points at the next meeting.

Shouldn't that juxtaposition have sent Euro/Sterling higher?

And I'll point out, yes, rates fell in both currencies, but the two-year interest rate differential moved about five basis points in Euro's favor today. So why is Euro/Sterling lower now than it was before the central bank policy announcements?

Stephen Gallo:

I think you're absolutely right, Greg. That was a dovish hike from the Bank of England, because the central projection for inflation in Q4 2023, that was cut to 3% year over year from 5.2% in the November forecast round. The lone MPC member wanting to hike 75 basis points in December, at the time of the last meeting, dropped that call and went with the consensus for a 50 basis point hike this month. And the conditionality around the pace and timing of future hikes was increased and made more data dependent.

So it was a dovish hike.

And simultaneously, or almost simultaneously, by almost every measure, the ECB was more hawkish. There was no mention of a pause in the hiking cycle [inaudible 00:08:37] communicate pre-committed the bank to another 50 basis points worth of a hike in March. And during the press conference, Christine Lagarde suggested that rates could continue to move higher after March.

Now, the ECB was expected to be more hawkish by the FX market and the rates market to begin with. So I think a lot of that was in the price already, prior to the ECB's policy announcement. But you'd think that Euro/Sterling would be perhaps through 0.9 on that divergence. And we may yet get to that level before we see a rounded top in the pair.

But I think the bigger issue here, Greg, is what you last mentioned. The fact is that neither central bank opened the door to policy easing this year, much like the Fed did not. And the front end of the rates curves in both currencies saw parallel shifts lower today. And I suspect that when this occurred, [inaudible 00:09:31] positions were squeezed out on various different crosses.

And in my personal opinion, the bigger theme here is that the major European currencies are both running out of a bit of steam versus the dollar on the day because FX investors don't seem to be buying ECB or BOE promises to keep lifting benchmark rates or hold them at terminal for an extended period.

And this seems to me like it's going to be a battle between investors and the European central banks that will go on for some time, Greg.

The other battle I think is worth mentioning, and definitely has to be reconciled somehow, is the one between European central banks and inflation and growth, so to speak.

Neither the BOE nor the ECB want to be responsible for causing a hard landing, reading between the lines, but they also don't want to do too little on policy tightening.

This is why the decline in short-term interest rates is even more remarkable, in my opinion, in the context of some extremely tight labor markets and sticky core inflation in Europe.

So yeah, head fakes galore.

Greg Anderson:

Okay. Good vent, Stephen. And I think we've covered all of the central bank angles.

So I guess it's now time to come back to what you alluded to in your introductory remarks. That's the fact that we don't seem to have a clear catalyst for FX markets to follow right now.

If central bank impulses are causing head fake mania, now what? What should we focus on instead?

Stephen Gallo:

Well, as I noted earlier, Greg, the Chinese reopening theme is getting a lot of airplay within the policy sphere as well as in financial markets amongst investors.

There's a demand story here for global materials as China reopens, I'm sure of it. But there seems to be a lot of uncertainty over just how much, and I certainly can't precisely figure out how much either.

But what is remarkable to me is that there have been huge waves of buying and risk assets in the Asia [inaudible 00:11:32] space on this China reopening theme; some of that flow being on hedge for currency risk, no doubt. But yet when we look at broad baskets of commodity prices, numerous indices are flat to lower year to date.

Now without drifting too far outside of the FX space, Greg, it does look to me like there are gaps between the performance of Asian currencies and the performance in other markets.

I think part of the issue here is that we haven't yet seen concrete evidence of the growth rebound in China. We know it's coming, we think we know roughly when it's going to show up in the data, but there's still a bit of uncertainty over how much or how quick. So that may be holding net commodity exporting currencies back a bit.

Another factor is perhaps the sluggishness of the property sector rebound in China. We know it's probably going to remain that way.

There are probably other factors I'm missing regarding the balance of supply and demand in specific markets, and it's not for me to comment on those, but regardless of the precise reason, I think the straightforward answer is that some of the currencies which I cover, like NKI, like the South African Rand, they should be better performers year to date versus the dollar on this China reopening theme. But instead, the performance has been lackluster. And if I look at the one month returns in both currencies, which is roughly year to date, they're lower versus the dollar.

And on one of our top CAD crosses, I would love for there to be a breakout here one way or another in Euro/CAD; trading around 145 now.

My personal bias based on medium term outlook would be to fade rallies in the pair.

But here's my chance to toss the microphone back over to you, Greg. If China alone isn't going to drive energy prices higher, what will?

Greg Anderson:

According to the IEA's January oil market report, just general global demand. That report predicted a 1.9 million barrel per day increase in global demand, with about half that increase coming from China and the other half coming from the rest of the world.

But one of the things that I think commodity and FX markets will need to grapple with, and this also comes with its own set of head fakes, is what was happening while China's demand was suppressed by COVID zero last year.

China was stockpiling a lot of raw commodities. So this year's reopening may not lead to immediate realities in commodity prices.

I saw a statistic yesterday that showed that movement in China during the main week of Chinese New Year basically doubled relative to last year. So that in theory should mean a lot more energy demand, but yet Brent Crude was at $86 a barrel the Friday before Chinese New Year; now it's at 82.

So there's another head fake.

Look, in the grand scheme of things, a $4 move in Brent is nothing. It's just statistical noise.

I do think that $5 to $10 per barrel moves in the price of oil will end up getting reflected in currencies, and particularly in importer versus exporter crosses like Euro/CAD. And I still think that oil will generally trend higher this year. So I'm with you on wanting to be long CAD via Euro/CAD and CAD/Yen etc.

But I think this trade is going to require some patience and it may require something else to clear first.

That something else is what I would call the reinvestment trade. And that is just what I would characterize the first month of 2023 as being.

I think we entered this year with a whole lot of cash on the sidelines that needed to find its way back into stocks and bonds, which both have rallied sharply alongside of each other in many different currencies.

Stephen Gallo:

Those are all very fair points, Greg. And here is what I would run with shifting back to the European currency theme.

As you noted, and I completely agree, and we've picked it up with anecdotes, a lot of risk capital has flowed back into European currencies, including the Euro this year, and underlying assets, given the moderation in energy prices, lack of escalation in the war, the China reopening theme, and what seems to have been a peak in rates, particularly at the longer end of the curve in Europe.

I think this risk capital story goes a long way to explaining why FX markets and yields in Europe seem to be ignoring the Fed on the one hand, the ECB on the other, and so to speak, a number of medium-term risks on both hands.

So here's what I would give you, Greg, in terms of my tactical outlook for Euro/Dollar.

I think the pair is primed to move back above 110 again.

If it happens in the immediate future, I would probably look to sell that rally and then buy the pair back again below 110 until this dynamic regarding portfolio allocations and shifts in exposures has run its course.

And we may not yet be at the point where net long positioning in Euro/Dollar on the part of investors is completely maxed out.

But looking at the bigger picture, and perhaps beyond the very near term, if we do get a two to three big figure move higher in Euro/Dollar over the next month or so, I would argue that there are selling opportunities in that vicinity, unless a number of fundamentals shift in order for the Euro to sustain itself up there or move higher.

Number one, I think global monetary tightening has to come to a halt. We have to be clear of these risks pretty much entirely.

Secondly, I think core inflation in Europe has to prove itself to be non-sticky in nature.

I have some sympathy with this view that the ECB moving at a 50 basis point rate height clip per meeting while the Fed is doing 25 is supportive for the Euro, but if inflation ends up being sticky in the Euro area, very sticky, I don't think I want to be overweight Europe.

Thirdly, I think we need some kind of resolution in the Ukraine war, although it's hard to say exactly what that would entail.

And finally, I think we need to be clear of upside risk to energy prices, given Europe's weak medium-term energy fundamental.

Greg Anderson:

So just to summarize, we're a bit dizzy from the head fakes and we've got more questions than answers right now. But so would the market, it would seem.

There is a lot to think about, but one has to stay nimble, both in terms of positioning, as well as attaching oneself to a particular set of ideas about how market interrelationships should work.

Anything to add onto that, Mr. Gallo?

Stephen Gallo:

Great. Let's wrap it up here, Greg. Thanks for listening. Bye for now.

Greg Anderson:

Thanks for listening to Global Exchanges.

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Speaker 3:

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