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By XE Market Analysis October 22, 2020 3:50 am
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    XE Market Analysis: Europe - Oct 22, 2020

    The dollar has settled after dropping quiet sharply in recent days. The DXY USD index has come to rest around the 92.70-75 area after diving over the previous four days, from levels near 94.00. EUR-USD has settled off the five-week high that was seen yesterday at 1.1882. USD-JPY has steadied in the mid 104.00s after dropping 1.1% yesterday, which is an unusually large magnitude of movement for this pairing by the norms of recent years. One dollar bearish structure to be aware of is a combination of real interest rate differentials and the Fed's recent regime shift to a lower-for-longer policy rubric, which is specifically aimed at stimulating inflation. September U.S. inflation was at 1.4% y/y in the headline and 1.7% y/y in the core, which compares to the near zero or negative rates in Japan and the Eurozone. U.S. inflation is also some way higher than other major economies, including the UK and Canada. With nominal interests in all at or near zero, this leaves the U.S. with the lowest real interest rate. This, combined with the Fed's policy stance, establishes a mechanism for nominal dollar weakening, all else equal (and is something that ECB policymakers have been aware of, with one complaining that "the market may interpret interest rates as being structurally higher in the euro area, which could lead to further appreciation of the euro"). Add in suspected down weighting of Treasuries by China. The lower dollar/lower global stock market dynamic this week shows that that the market hasn't been trading the dollar as safe haven at this juncture. The strong showing of investor demand this week for the EU's first joint offering of social bonds, which will finance a jobs program, has shored up the reputation of the euro. The pound, meanwhile, has rallied quite strongly as markets discount a limited free trade deal between the EU and UK. Face-to-face talks between the two will resume today. Market participants are still having to navigate a sea of uncertainty, including the surge in Covid cases in Europe and in many U.S. states and Canada, and the associated restrictions they bring, along with continued uncertainty about the next fiscal package in the U.S. The approaching U.S. elections present event risk, given the perceived risk of the outcome being contested, which in the event would throw the country into political disarray.

    [EUR, USD]
    EUR-USD has settled off the five-week high that was seen yesterday at 1.1882. The peak was the product of recent broad dollar declines and broad euro gains. Over the last week, the dollar has softened against all of the other main currencies, while the euro has risen against all except the pound. One consideration is that the dollar in recent days does not appear to have found significant safe haven demand despite the concurrent stagger lower of global stock markets. Various influencing factors are at play. One is dollar negative real interest rate differentials brought about by the relatively high inflation rate in the U.S. versus other major economies. The inflation-adjusted yield on U.S. bonds is also at a negative differential to real Bund yields, at least out to the 10-year maturity. Combined with the Fed's policy stance, which aimed at driving inflation, establishes a mechanism for nominal dollar weakening, all else equal (and is something that ECB policymakers have been aware of, with one complaining that "the market may interpret interest rates as being structurally higher in the euro area, which could lead to further appreciation of the euro"). Add in suspected down weighting of Treasuries in Chinese reserve holdings. Another consideration is this week's strong showing of investor demand for the EU's first joint offering of social bonds, which will finance a jobs program, has shored up the reputation of the euro. The pound, meanwhile, has rallied quite strongly as markets discount a limited free trade deal between the EU and UK, and this, too, is a positive for the euro. Data also showed a rise in the Eurozone's current account surplus (net inflow of remittances, the trade surplus, and net inflow of international interest receipts). Overall, a bullish scene for EUR-USD. But, there are countervailing forces and risks. The most obvious one is the surging Covid cases across Europe, which is leading to more stringent containing measures relative to the U.S., which could create a growth differential in favour of the U.S. The upcoming U.S. elections present risks, too, given the perceived chance of the election being contested. Markets are anticipating another U.S. fiscal package, although legislation is unlikely to be passed this side of the elections, and the size and scope of future stimulus will be dependent on the election result. Overall, we are bullish on EUR-USD, especially in the longer term.

    [USD, JPY]
    USD-JPY has settled today after dropping 1.1%, on a close-to-close basis, yesterday, which is an unusually large magnitude of movement for this pairing by the norms of recent years. The move mostly reflected broad dollar weakness. Some yen crosses, including EUR-JPY and CAD-JPY, also declined, by around 0.5%, while AUD-JPY was flat and GBP-JPY rose, so a somewhat mixed performance for the yen. One dollar bearish structure to be aware of is a combination of real interest rate differentials and the Fed's recent regime shift to a lower-for-longer policy rubric, which is specifically aimed at stimulating inflation. September U.S. inflation was at 1.4% y/y in the headline and 1.7% y/y in the core, which compares to the near zero or negative rates in Japan and the Eurozone. U.S. inflation is also some way higher than other major economies, including the UK and Canada. With nominal interests in all at or near zero, this leaves the U.S. with the lowest real interest rate. This, combined with the Fed's policy stance, sets up a structural mechanism for dollar declines, all else equal, and is something that some of the more dovish ECB policymakers have recent spoken about (being concerned about the ascent of the euro in recent months). Recent Chinese demand for JGBs, which reached record levels in the three months to August, has also been noted in some narratives, along with planning in Japan for a third so-called extra budget, expected to be implemented in mid December, which contrasts with the continued uncertainty about the next fiscal package in the U.S. The event risk of approaching U.S. elections is also a negative for the dollar, given the perceived risk of the outcome being contested, which could throw the country into political disarray. If we continue to look for other USD-JPY bearish factors, it could also be asserted that Chinese and Asian economies are looking in better shape, with less Covid-related restrictions. The biggest directional force on the Japanese currency will likely remain shifting risk premia 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, is recognized in the currency market and has established the yen as a low-beta haven currency.

    [GBP, USD]
    The pound has rallied quite strongly this week as markets discount a limited free trade deal between the EU and UK. Face-to-face talks between the two will resume today. Cable yesterday posted a six-week peak at 1.3171, and EUR-GBP a six-day low at 0.9010. The currency market hasn't been fooled by the game of chicken between Boris Johnson and EU. Johnson's stated position has been that the EU must fundamentally change its stance, while France's European affairs minister Clément Beaune asserted that there would be "no new approach." The bullish stance of France fits with a BBC article earlier in the week reporting that Barnier has been feeling "frustrated" with leaders of coastal EU nations for not (yet) allowing him to proceed on tackling inevitable compromises on fishing rights. While fishing is a low GDP contributor on both sides of the Channel, it's a politically highly sensitive area for all, and is totemic for Brexiteers. From the perspective of the so-called EU's coastal 8, it's a choice between no fishing rights in UK waters under a no deal scenario versus reduced quotas with an agreement. Given that under prevailing arrangements more than half of the UK's annual fishing quota is foreign owned (mostly by the coastal 8), a sensible resolution would seem likely. U.S. Trade Representative Robert Lighthizer also said yesterday that that a trade agreement with the UK would come "reasonably soon." Also in the mix was Johnson stating that there will not be another national Covid lockdown, which may have cheered sterling bulls further. Despite the strongly bullish prevailing bias, we remain bearish on the pound over the medium to longer term. Swapping unfettered access to the EU's single market and customs union in place of a narrow free trade deal will see trading friction and costs rise.

    [USD, CHF]
    The Swiss franc has been continuing to trade with a firming bias, consistently rebounding from bouts of weakness in recent months. This has seen EUR-CHF repeatedly ebb back from brief forays above 1.0800, and the cross has fallen to the lower 1.0700s in the latest phase as markets anticipate revamped monetary easing measures from the ECB. This along with Brexit risk, which has been weighing on the euro. The franc has a proclivity to ascend on the influence of incoming interest and other domestically owned investment receipts from assets held abroad, alongside net inflows generated by Switzerland's trade surplus. A higher franc has been imparting deflation, which to a degree offsets any loss in export competitiveness that a nominally firmer currency might otherwise entail as there is a high import component in the production of Swiss exports (perpetuating the nominal trend by limiting the decline in the real effective exchange rate). The SNB, nonetheless, explicitly targets the exchange rate as one of the means to achieve its policy goals. At its quarterly monetary policy review last month, the central bank stated that the franc remains "highly valued" and said it is ready to "intervene more strongly in the foreign exchange market".

    [USD, CAD]
    USD-CAD posted a two-day high at 1.3177, tracking softer oil prices, while the U.S. dollar has also found a footing after dropping across-the-board in recent days. The trend is to the downside, though there are derailing risks, including the U.S. election and the trend toward ever more draconian Covid-related measures as the northern hemisphere heads into winter, which is crimping global growth.

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