The Impending Currency War

Rates and front-end bonds leading the charge – I touched on this pivotal thematic in a number of recent commentaries. But, as the year rolled on, the divergence between the aggressive easing priced into the interest rate markets (and the short-end of the bond curve), and the narrative from central banks, and what they feel is the correct policy path, has become ever more pronounced.

As we can see from the purple line on the Bloomberg chart, from October the market started pricing out rate hikes, flipping to expected cuts in December. I have overlapped this with the S&P 500 (white line) and USD index (blue).

Consider that in theory, when it comes to absolute insight on the economy, market participants and central banks have exactly the same information. Granted, central banks have an army of PhD research analysts who stress test every scenario and set policy based on their economic forecasts, and we are all taught that their actions guide and define the price of money.

However, despite what central banks have portrayed in their forward guidance, financial market participants (again, as seen in the Bloomberg chart above) have overlooked this and been two steps ahead throughout all of 2019, holding a consistent view that future economic fragility would require a global central bank response. Of course, Mr. Trump and his use of tariffs to achieve an economic, social or political objective have caught the headlines, and we can’t deny this level of

unpredictability has had a profound effect on the psyche of the US and even global corporate landscape, with supply chains radically altered.

Do not underestimate the effect of quantitative tightening

However, what I feel gets overlooked is the liquidity dynamic and the idea that the Fed, tasked with the insurmountable challenge of normalising the excesses of eight years of aggressive balance sheet expansion, have a challenge that is simply too problematic. So, while we have now seen nine rate hikes since December 2015, we have importantly seen the Fed’s balance sheet (of accumulated US Treasury’s and mortgage-backed securities) reduced by some $600b (since January 2018), in-turn, starving the world of USD liquidity and excess reserves. We can blame Trump all we want about the turn in global trade and manufacturing, but I’d argue balance sheet normalisation, and a strong USD has been a far greater influence, and in reality, the world now needs a weaker USD and as we can see from the weekly chart is that a weaker USD is no certainty.

USD Technicals

A break of the double-top in USDX (DXY on MT4/5) could re-enforce my view that the main reason the Fed needs to cut rates is actually that a strong USD will be their biggest problem. While we watch USDCNH as our guide on trade tensions, the weekly chart of the USD index (DXY) offers a rhythm and feel to the greenback more broadly.

Setting the scene for increased currency wars in 2019

So, for 2019, it’s been the rates and bond show, with investment funds weighting portfolios to shorter-duration assets. This has resonated, with flatter yields curves and an ever-increasing pool of global negative yielding debt – where the total USD value of global bonds traded in the secondary market, currently commanding a negative yield, sits at a staggering $11.7t. It’s no surprise that gold resides at $1341, and why Bitcoin is flying.

Given the market’s belief that the bond market is one of, if not the best predictor of future recessionary conditions out there, the inversion between the 3-month and 10-year US Treasury, or 2s and 5s, shows the market feels Fed policy is just too tight. Now, whether the extent of the policy easing portrayed by markets is correct, I guess we’ll likely need to revisit later in the year.

(The far-right column shows the extent of expected easing in basis points priced into markets)

One suspects a certain Mr Trump holds a few cards here, with the Federal Reserve and other influential central banks all watching proceedings on trade closely, and all express a view that they will react appropriately to keep the economic expansion in place.

The need for a weaker exchange rate

I focus specifically on the Fed, but that is because they are just that important to the global economy. When global economics are looking shaky, oil is in a bear market, and inflation expectations (we look at instruments called ‘5-year inflation swaps’ here) are trending lower, the desire for a weaker currency should be paramount. It is a macro theme I feel should be on the radar, especially if the rates market is proved correct and we do see these major central banks embarking on an easing cycle. We’ve already seen action from the RBNZ and RBA, with the RBA open to ease again at its July meeting (2 July). The market considers a July cut from the Fed price at 86%, which should open the door to two more this calendar year.

The ECB can go lower, but the probability is that they restart quantitative easing (QE), as is the case in Japan, with the BoJ potentially doing more. Now I know fear sells, and I am not personally predicting a doomsday affair, I am merely detailing what is priced, but if the rates market is correct and then the need for a weaker currency becomes a preeminent goal of an easier monetary policy regime. Then, traders need to consider is that if every central bank is easing, then how do we determine how each currency may fare in this environment?

There are many countries, mostly classed as ‘emerging’, who have issued government bonds in USD (and therefore in a currency, they don’t control), and as such, have racked up incredible USD liabilities. For them, a weaker USD is obviously advantageous, and this is why the Fed is considered the ‘world’s central bank’, and, on balance, why the world needs a weaker USD. But if we are staring at another race to the bottom, then we could be revisiting this notion of currency wars, and this is where FX volatility could really pick-up as we hit what causes lasting trends in FX markets – divergence at a central bank policy level. It’s where I’d imagine gold to trade north of $1500.

The AUD a key loser in a backdrop of currency wars

It may take some time to play out, but it’s for this reason that once the cash rate moves sub-1%, that I feel we will be talking about starting point for the RBA to start radically expanding base money and undertaking quantitative easing (QE). While this is, therefore, a consideration for later in the year, the time when this becomes a mainstream view and is portrayed by perhaps even one or two words in an RBA speech is when the bid completely comes out of the AUD, AUD implied volatility ramps up, and the biggest consideration for discretionary and non-systematic players is actually how long you hold onto shorts for.

The set up in AUDUSD, on the daily or weekly timeframe, looks heavy and that will enthuse the RBA. Although, while the trade-weighted AUD sits at the weakest levels since 2016, we can see 10-year inflation expectations are not rising despite currency weakness. Quite the opposite.

Implied volatility offers strong insight

My preference is to look at the implied volatility (IV) of an FX pair, and to understand how the market prophesies increased range expansion. Or, when traders feel price distributions have a higher probability of moving more intently (which we measure in standard deviations) from the at-the-money (ATM) strike. We can combine the options market incredibly effectively with spot FX trading for greater control of our risk. This, in turn, enhances our ability to achieve correct position sizing. As we can see, implied vol in global FX markets is still very subdued. I expect this to change if we see a pickup in currency war fears.

GBP affected by politics not central bank actions

One currency I had identified as being a potential superstar for 2019 was GBP, on the notion that the BoE wanted to hike, and at the time, the probability was that the risk was skewed for agreement in the UK Commons. Obviously, that hasn’t happened, and while I can look at IV in GBPUSD or GBP crosses over different periods and see this at surpassingly subdued levels, it feels as though we are going to see materially higher volatility here. So, while the USD is pivotal for all markets, and while other G10 central banks may start indirectly targeting its exchange rate later this year, if not early 2020, GBP is firmly entrenched as the stand-alone political currency in G10 FX.

We should have a new Tory leader BY late July (if not sooner), and as I write, Boris Johnson is the clear favourite. My base case is that the EU will not change its negotiating stance, although we should see a “technical extension” to the current 31 October deadline, taking this out to end-January 2020 to prepare for a “controlled no-deal”. That said, in the absence of (potential) PM Johnson securing changes to the Withdrawal Agreement, which seems very unlikely, then we should see a vote of no-confidence pulled on the Tory government resulting in a general election.

A new general election seems likely

With the Tories taking inspiration from Nigel Farage’s newly formed Brexit party and representing the ‘no-deal’ Brexit camp. While Labour should align its mandate to that of the re-emerged Lib Dems and represent the ‘remain’ camp, one thing is brewing. That being, the mother of political showdowns, with the public set to choose in one last binary event. How GBP volatility doesn’t ramp up into this possible scenario is beyond me, with most roads seemingly leading to a lower GBP.

The ability to read volatility, harness expectations and adapt will be key, as I can imagine, a volatile GBP will be magnate to retail traders.

So, the stage is set for what could be a very telling 2H19, and while the dovish rates pricing maybe wholly incorrect, if it is on the money then FX markets, gold and Bitcoin could offer incredible opportunities.

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Chris Weston, Head of Research at Pepperstone