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By XE Market Analysis December 7, 2020 4:48 am
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    XE Market Analysis: Europe - Dec 07, 2020

    Currency markets have been directionally uneventful, which is typical in early-week trading, especially in a December. The DXY dollar index has settled above the 32-month low see on Friday at 90.48. The nine-month dollar downtrend resumed over the last month after about a two month hiatus. We anticipate there is more to come in this trend, and possibly quite substantially. U.S. equity valuations are at extremes by many measures, including the so-called Buffett indicator (which measure the Wiltshire 5000 total market capitalization against GDP), though stock markets in many other regions, particularly Europe and in the developing world, are trading at much lower relative valuations. This backdrop has been propping up the dollar's downtrend. The outlook for global asset markets remain bullish. Low interest rates and low inflation (which enhances corporate earnings), spare capacity (which helps corporations maintain low costs), massive global liquidity and stimulus, central bank asset purchases programs (which reins in, or at least curtails, sovereign bond yields, thereby forcing investors to seek returns in equities), potential for a consumer spending boom (fuelled by household savings built up during the pandemic) and, essentially, the prospect for a vaccine-facilitated return to something approaching economic and societal normalcy in 2021, are all together a potently bullish tonic for global asst markets. The prevailing mood at the moment is one of caution after the main U.S. equity indices hit record peaks on Friday. Japan's Nikkei 225, fresh from 29-year highs, closed with a 0.76% decline. Chinese stock markets also turned lower, despite a much stronger than expected 21.1% y/y rise in China's November exports. U.S. and European equity index futures also turned lower, albeit modestly so. Commodities have softened, to, ebbing from recent multi-month and multi-year highs. A Reuters report citing sources stated that the U.S. is set to issue sanctions on another 12 Chinese government officials, drew attention. The protectionist stand-off between the U.S. and China, and Australia and China, haven't been have a significant impact in overall global trade, however, with China opening up its economy via the RCEP agreement, and, in the case of trade with Australia, many of the goods in question are fungible (meaning that net global demand will remain unchanged).

    [EUR, USD]
    EUR-USD has settled around the 1.2100 level after posting a 32-month peak at 1.2177 on Friday. The pair rallied by over 1.5% last week despite a concurrent 6bp-plus widening in the U.S. T-note 10-year yield differential versus the 10-year Bund yield. One particular downward driver of the dollar came into sharp focus at EUR-USD's upside break last Monday, which seemed to be sparked by initial estimate for November eurozone inflation coming slightly below expectations, with CPI at -0.3% y/y. The relevance of this is that it contrasts the relatively high inflation rate in the U.S. (at 1.3% y/y in October), the implication being that inflation is imparting a loosening impact on real interest rates in the U.S., while deflation is imparting a tightening impact on real interest rates in the eurozone, translating to higher nominal EUR-USD levels. The Fed's inflation tolerant, lower-for-longer policy rubric is a key consideration here, being conducive to dollar weakness. In a zero percent interest rate world, inflation differentials matter in exchange rate determination, and explains why the market discarded the widening in yield spreads in the dollar's favour. The market is factoring that recession-bound eurozone economies will see continued disinflationary pressures, with the ironic consequence of causing euro appreciation against the dollar, despite the disadvantageous growth differential between the eurozone and the U.S. Insofar that a higher euro will curb eurozone growth potential, a self-reinforcing process can be observed, though this overstates realities. Inflation will jump in the eurozone as and when negative y/y base effects drop out of the equation. Raw material prices have been surging, too, and there is potential for a strong rebound in Europe should Covid vaccination programs prove effective in Europe and globally. There are other factors behind dollar weakness at play, one being the search for value in global markets as uncertainties dissipate (the two central ones being the clearing U.S. political picture, which is raising the prospect for new fiscal stimulus, along with the rapid progress in Covid vaccines), which are a dollar negative, especially with the FAANG stocks shifting to massive outperformers to underperformers. The Fed's policy emphasis, along with the marked outperformance in European stock markets relative to global peers over the last month are other considerations, with European assets seen offering greater value opportunities in the vaccine-assisted view for a post-Covid return to economic normalcy. We retain a bullish view of EUR-USD.

    [USD, JPY]
    USD-JPY has been maintaining a sub-25-pip range in directionally uneventful currency markets. Investors' mood turned risk cautious after the main U.S. equity indices hit record peaks on Friday. Japan's Nikkei 225, fresh from 29-year highs, closed with a 0.76% decline. Chinese stock markets also turned lower, despite a much stronger than expected 21.1% y/y rise in China's November exports. U.S. and European equity index futures also turned lower, albeit modestly so. Commodities were softer, to, ebbing from recent multi-month and multi-year highs. A Reuters report citing sources stated that the U.S. is set to issue sanctions on another 12 Chinese government officials, drew attention but didn't have much impact. The protectionist stand-off between the U.S. and China, and Australia and China, haven't been have a significant impact in overall global trade, with China opening up its economy via the RCEP agreement, and, in the case of trade with Australia, many of the trade goods in question are fungible (meaning that net global demand will remain unchanged). The outlook for global asset markets remain bullish. Low interest rates and low inflation (which enhances corporate earnings), spare capacity (which helps corporations maintain low costs), massive global liquidity and stimulus, central bank asset purchases programs (which reins in, or at least curtails, sovereign bond yields, thereby forcing investors to seek returns in equities), and, essentially, the prospect for a vaccine-facilitated return to something approaching economic and societal normalcy, are all together a potently bullish tonic for global asst markets. Regarding the yen, and USD-JPY specifically, both currencies are safe haven, counter-cyclical currencies, which limits the directional scope for the pairing, though the real interest rate differential between the U.S. and Japan is a mathematical negative for the nominal exchange rate. Outside the case against the dollar, the yen is amid what we are tagging as a longer-term softening trend, especially against the cyclical currencies, including the dollar bloc. The yen's broader performance should continue to derive from the level of risk appetite in global markets. Japan's surplus economy, where yield-seeking domestic investors are apt to invest in foreign assets during times of confidence, but repatriate funds when times are uncertain, has established the yen as a low-beta haven currency.

    [GBP, USD]
    The pound has opened the week on a back foot, posting modest losses. Yet another deadline has come gone in the ongoing Brexit endgame saga. The start of the EU summit on Thursday is now reportedly the latest deadline. The EU and UK remain a loggerheads in trade talks on fishing, state aid rules and governance. UK prime minster Johnson make it known that he was ready to pull out of negotiations "within hours" if Brussels refuses to budge on its "outrageous demands." Talks are due to resume today in what is now touted as a final bid to reach an accord. One EU source said that fishing wasn't the real blocking point, according to the BBC, fitting other reports that governance is the real issue, with the EU wanting, for instance, the ability to respond to any UK breaches on state aid rules with tariff increases. Despite this, the pound -- the principal conduit of investor expression on all things Brexit -- has remained steady, overall. Germany's Merkel has been putting pressure on EU states to compromise. The French have bad cop form on Brexit, having consistently threatened to veto the multiple extensions in last year's negotiation over the UK withdrawal agreement, only to back down with equal consistency. Macron has political reason to play it tough, with fishing a hot potato issue into presidential elections in 2022, but he also has strong realpolitik reasons to maintain good faith with both EU states and the UK. The pound's steadiness amid all this shows that market participants are refusing to be draw in, having witnessed down-to-the-wire dramatics in previous Brexit negotiations, and waiting instead on concrete developments. We continue to expect a deal.

    [USD, CHF]
    EUR-CHF rallied to three-month highs above 1.0850, extending recent gains from sub-1.0700 levels. Recent risk-on positioning has been weighing on the Swiss franc with investors factoring in a sea change in optimism about a vaccine solution to the Covid-19 crisis. This will be pleasing to policymakers at the SNB, given it chronic disquietude about the franc's value. Unlike most central banks, the SNB explicitly incorporates the franc into monetary policy to ward off speculative purchases of the currency, which would impart deflationary forces (via cheaper imports) with the consequential impact of an unwelcome tightening in real interest rates. The central bank stated at its last quarterly monetary policy review that the franc remains "highly valued" and said it is ready to "intervene more strongly in the foreign exchange market."

    [USD, CAD]
    USD-CAD has found a footing, and may be in for a relatively sustained rebound after posting a 26-month low at 1.2770 on Monday. Oil prices have softened after reaching a nine-month peak on Friday, and there may be more to go in this theme. While the bigger picture prospects remain bullish for oil and oil-correlating currencies, such as the Canadian dollar, the nearer term looks more challenging. Oil supply is on the up, with Libyan supply going back to pre-blockade levels, Norway having announced a rise in output, and the OPEC+ group having announced a 500k barrels per day increase from January. There are also signs that OPEC dissent is increasing, as highlighted by a Chatham House last week, with multiple participants in the output quotas unwilling to comply any longer. There is also expectations that U.S. president-elect Biden will reduce will lift sanctions on Tehran, which would see Iranian output increase. All this comes amid increasing Covid-related restrictions across North America, and with Europe is maintaining restrictions. While Covid vaccination programs have started in Russia and will start in the UK this week, and in the U.S. as soon as next week, these won't have much impact in alleviating restrictions over the northern hemisphere winter. The scene looks to be set for a near-term correction in oil prices, which would see USD-CAD's directional bias shift from the downside to the upside for a period.

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