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Key Themes for January - Global Exchanges

FICC Podcasts 11 janvier 2022
FICC Podcasts 11 janvier 2022


Disponible en anglais seulement

In this week's episode, we discuss the evolution of major exchange rates over the first few trading sessions of 2022 and the background issues underneath them.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Disponible en anglais seulement

Greg Anderson:

Hi welcome, to episode 29 of Global Exchanges, a podcast about foreign exchange markets and related issues. I'm Greg Anderson.

Greg Anderson:

In this week's episode, my co-host Stephen Gallo, and I will be talking about the evolution of major exchange rates over the first few trading sessions of 2022. And the background issues underneath them. The title for this episode is Key Themes for January.

Stephen Gallo:

Hi, I'm Stephen Gallo, a London based FX strategist. Welcome to Global Exchanges presented by MO 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.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates or subsidiaries.

Stephen Gallo:

Okay, it's January 11th, 2022. This is our first Global Exchanges podcast of 2022 of the new year. Thanks for joining us.

Stephen Gallo:

Greg, you mentioned the evolution of major exchange rates since the start of the calendar year. And really, quite frankly, there hasn't been much evolution. That's the honest truth. And again, to be quite blunt about it, this is a continuation of 2021, particularly because there's been a decent amount of volatility in the rates and commodities spaces, but virtually vol to speak of in FX. The range and the BBDXY has been just 0.8% wide since the very beginning of the year.

Stephen Gallo:

Greg, it seems to me that investors in FX have basically parked themselves and are waiting to see how one of the key themes of January unfolds. And, by that I mean, The Fed. In other words, The Fed has basically given us this laundry list of potential policy normalization steps, but it's now a question of when, how much, and for how long? Let me pass it to you on that point.

Greg Anderson:

Let me start by noting the price action and a few key variables since the December 15th FOMC, which I would characterize as considerably more hawkish than expected. First off, the BBDXY US Dollar Index hit a calendar year high on that FOMC date. It then drifted about 1.6% lower between then, and the December 31st closeout. My gut response would be to ascribe that US dollar slide back, call it, as year end position squaring. With reducing US dollar longs for years end. However, CFTC data, admittedly, doesn't show that. The USD slide back in late December might also have been the result of the ebbing of turn pressures, or the postponement of Russia-Ukraine risk.

Greg Anderson:

At any rate, we have an interesting contrast going on here because the benchmark US two year yield has moved 0.71%, or 71 basis points to 0.93%, or 93 basis points. Since that FOMC. And it's 10 year friend has moved from 144 to 177. And meanwhile, WTI grade crude has moved from $70 a barrel to call it $79 a barrel today. By the reaction function that we saw from June through November of last year, the US dollar should have gained 2 to 3% since the December FOMC but instead, it has slid lower.

Greg Anderson:

So, why hasn't the dollar rallied? I admit that I'm perplexed and don't really know. But I don't think that the FX market is sitting on the sidelines and waiting for information before trading on, what I'll call, The Fed is going to tighten faster theme. From what we've seen, FX volumes are pretty robust. So, the market is in fact trading the theme. It's just that it has brought more short-term cross currents than maybe we realized. But cross currents be darned, I still think this Fed is going to tighten faster theme is still a big US dollar positive for the first half of this year.

Stephen Gallo:

Okay Greg, so investors according to what you're saying aren't really sitting on the sidelines, but cross currents related to other asset classes have gotten in the way of the dollar higher theme.

Stephen Gallo:

So, on that note, let me ask you about quantitative tightening, also known as QT. This is a new angle of The Fed is going to tighten faster theme for 2022, which you already mentioned. Why has QT not impacted the dollar much?

Greg Anderson:

Great extension of the why isn't the dollar rallying question. Coming out of that December FOMC and Powell's post-meeting press conference, the prospect of QT seemed to be pretty far off. But then, we got some chatter from a couple of Fed hawks in the first couple of days of January. And then, the surprise on Wednesday last week of Fed minutes, making it sound like the commencement of balance sheet reduction, or QT could be a very real possibility by the end of the first half.

Greg Anderson:

Look, this is an issue that is probably better explained with a written piece that includes historical graphs than with a podcast. So, on that note, I will promote to our listeners, the FX Weekly that we published on January 10th entitled QT Adds Upside to the USD. I will just say that I believe that. From the previous instance of The Fed reducing its balance sheet between 2017 and 2019, the dollar rallied during that period. So, that historical perspective says that is what we should see.

Greg Anderson:

And any economic story that involves relative supply is going to say that making US dollar cash relatively more scarce. And, I guess, assuming other central banks don't pursue QT too, which none have indicated that they will, in the days following The Fed's QT ticker bomb. At any rate, relatively increased scarcity of dollar cash should lift the dollar. And then, lastly it's designed to push USs rates higher. And higher rates are normally considered positive for a currency. So, all the theory and the historical experience says this should lift the dollar. And I'm going to stick with that on a six month horizon, even if that's not what we've seen over the last four sessions.

Greg Anderson:

So, back to your question of why hasn't that happened yet. Let me just point out that the 10 year yield is up about 10 basis points since The Fed minutes were released. And in equities, the S&P 500 is down about 2.1%. So, for an international investor community that is overweight US in its bond holdings and also overweight US in its stock holdings that's just bad news. So, to the extent that QT leads global investors to move their US country weights to benchmark that may lead to kind of a initial wave of US dollar selling, even if this new angle of Fed is tightening faster theme should make everyone more US dollar bullish.

Greg Anderson:

Anyway, that's my best story for an explanation of the price action of the last few days. And I would just say to buy dollars on this kind of surprising non-rally. And I'm particularly bold up on dollar yen, which I think should have gone to 117 or 118 based on the moves higher in oil and US rates, but has not yet.

Stephen Gallo:

All right, Greg let's switch topics and also continents and talk about the Russia-Ukraine theme.

Greg Anderson:

Yeah, let's switch up who's on the hot seat and start asking you some questions. So, the Russia-Ukraine story, where are we at in that particular theme and why isn't Euro dollar facing downward pressure? Or is there someplace else that we should be looking for the geopolitical risk premium/discount?

Stephen Gallo:

Okay, Greg, let me dig into that question. I'm going to break it up a little bit and come at it sort of from the last point first. Being completely honest, I think the geopolitical risk premium is getting more difficult to pinpoint. And part of the reason for this is the drop in European natural gas prices on the back of, well, I think mild winter weather conditions so far across Europe. And also a big pick up in LNG imports into Europe from North America. So, in spite of a muted net inflow of natural gas from Russia into Europe, I guess what we might refer to as gas flowing the wrong way from an EU perspective, the risk premium associated with the geopolitical backdrop just isn't as apparent. And the drop in natural gas price is relative to their late December high point, certainly, has not hurt the Euro.

Stephen Gallo:

Another reason I think the geopolitical risk premium is a little bit covered up, or not easy to locate is that the SMB has recently been very active in propping up Euro Swiss. And that is, certainly, what the FX reserve day and the site deposit data of Swiss commercial banks with the SMB suggest.

Stephen Gallo:

And on your point about what the current state of play is regarding Russia and Ukraine, look another opportunity, Greg, for me to be brutally honest. It's tough for me to see why Russia would climb down from its list of US native demands at this stage. And I think probably the best possible outcome this week is that talks between Russia and the West simply carry over into the rest of January or into February. But in terms of the minimal market response, again, going back to this difficulty I've been having in identifying the geopolitical risk premium, it's possible that markets haven't moved all that much because they have come to the conclusion that even if Russia does start to retake parts of Ukraine, NATO is not really in a position to respond aggressively. And any resulting sanctions are unlikely to cause dramatic economic pain for the global economy. That's, certainly, a distinct possibility we have to consider, especially with investors focusing on other issues like the inflation backdrop and The Fed.

Greg Anderson:

So, focusing back to the Euro-USD exchange rate, it's been surprisingly perky over the last three weeks. What do you think here?

Stephen Gallo:

Here's the way I would break down my base case scenario for you, Greg, on the Euro. I think Euro dollar is going to run into resistance from either Fed ECB policy diversions or from interest to sell the Euro against various non-dollar currencies or long non-dollar crosses. And that latter scenario is much more likely to stick with us if risk appetite holds firm. And maybe we can talk about specific Euro cross rates in a few minutes.

Stephen Gallo:

That being said, that being the base case scenario centered around those two issues, I think it's also a good opportunity to highlight one of the main risks to the short Euro trade, which is a more abrupt hawkish shift from the ECB on policy. We left last year, 2021, discussing this as one of the important risks for 2022. And it's definitely still out there. If the inflation backdrop ties the ECB's hands in a not [un-quantitative 00:12:07] easing, I have no doubt that short Euro positions will be squeezed. But where the Euro rally potentially loses steam again, runs into headwinds is if a QE cliff edge dense demand for weaker Euro area credit, or other assets, or causes a material repricing of credit spreads in Europe, I don't think that would be conducive to sustain Euro strength.

Greg Anderson:

So, we've talked about at The Fed as a key January theme. We've talked about the Russian-Ukraine geopolitical theme. But what we haven't talked about yet is Omicron. What do you think Stephen, is this a key January theme for FX markets?

Stephen Gallo:

You know what Greg, I think at this stage markets are relatively immune to Omicron news. Equity markets in particular seem to be a lot more preoccupied with The Fed and inflation. I think in FX there's been a bit of a downside response in Euro Sterling to relatively more restrictive measures in parts of the EU compared with the UK. But if you take the UK as a template, the government strategy has been to ride Omicron out with a vaccine booster jab campaign and relatively mild restrictions. And I think, as I said, that's probably going to be a template for other economies in other countries too.

Stephen Gallo:

Eventually, I think at this stage, investors are probably more worried about Omicron disruptions affecting the supply side and potentially resulting in additional central bank say normalization, than negative demand shocks. That would be my take anyway.

Stephen Gallo:

All right, let me throw it back to you for one final topic for the month of January Greg, the oil price. What's notable, in my opinion, is that WTI Crude has retraced almost all of the decline from late 2021 related to the emergence of Omicron what do you make of this price action in oil, Greg?

Greg Anderson:

Yep, Stephen, oil is big again. In fact, it was on the 79 handle when we started our podcast. Now, it's on an 81 handle. Omicron was one of the factors that pushed WTI from, let's call it, $84 a barrel in early November to the low of 62 on December 2nd.

Greg Anderson:

But the other issue was the US led pressure campaign that included an effort to coordinate strategic reserve releases. Let's just say that that pressure campaign hasn't worked real well. But then again, hey, we're not at a hundred dollars a barrel yet, and maybe we would be there if there hadn't been that consumer nation pushback.

Greg Anderson:

For FX, this is an old theme that the market knows perfectly well how to trade. You just buy exporter currencies and sell importers as oil grinds higher. When we published our annual outlook back on December 16th, that was one of the key reasons for a call that CAD would show substantial gains against Euro in the end. With oil making its way back into the 80s and potentially higher and, honestly, $100 a barrel by midyear really wouldn't shock me. I would just reaffirm our bullish CAD on crosses call here. Barring a reversal in oil Euro-CAD should head below 140 and CAD-Yen should head on up to 95.

Stephen Gallo:

This sounds good, Greg. Let's wrap up episode 29 here with those four key themes for January. We're planning to be back with episode 30 this time next week. Thanks for listening.

Greg Anderson:

Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts at bmocm.com/globalexchanges.

Stephen Gallo:

We'd love to hear what you thought of today's episode, you can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:

This show and resources are supported by our team here at BMO, including the FICC Macro Strategy group and BMO's Marketing team. This show is produced and edited by Puddle Creative.

Speaker 3:

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Speaker 3:

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Greg Anderson Chef mondial, Stratégie de change
Stephen Gallo Chef de la stratégie de change pour l’Europe

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