2021 General Outlook for Major FX pairs
The conclusion of the Georgia Senate runoff races were not without chaos as pro Trump protestors stormed the Capitol building, resulting in calls for Trump to be impeached again. VP Pence has since rejected this. With the dust now settled for the final big US political event, it’s a good time to take a quick lay of the land and the implications for markets going forward. The Democrat win caused an initial kneejerk reaction with stocks and the USD lower. Since then these price moves have reversed with quite strangely both stocks and the USD catching a bid simultaneously. The reflation theme is now front and centre which follows the script of small caps, cyclicals and value outperforming. In the FX markets, the consensus trade is a weak USD coupled with stronger commodity/high beta FX and EM FX. Loose fiscal and monetary policy combined with the effective distribution of the Covid vaccine should see us return to a semblance of normality gradually. However, the biggest risk to this optimistic outlook would be the new strains in SA and UK potentially rendering the vaccine ineffectual. A new more contagious strain has also just yesterday been found in Texas. Distribution of said vaccine should be less of an issue given developed countries already have the infrastructure in place from annual flu vaccinations and the standard storage requirements for the Oxford/AZN vaccine helps too. Supply bottlenecks would be the more limiting factor as many countries rush to secure their own supply.
In terms of the specifics, the victory gives the Dems only a slim majority which will not be enough for radical policy changes since major legislation requires a 60 super majority. Therefore, legislation around infrastructure, a minimum wage increase, anti-trust regulation for tech and environmental policies would need bipartisan support. However, fiscal policies can be changed via the budget reconciliation process, which only requires a simple majority. Theoretically, Dems could abolish the filibuster to remove the 60 majority requirement, but this would be a nuclear option and would receive pushback.
On the data front markets continue to look through the recent weakening of jobs data. The ADP December payroll figures showed a fall of 125,000, which implies today’s non-farm payrolls report might also come in weaker than economists expect. Consensus estimates are for an increase of 71k for last month’s non-farm payrolls. Initial and continuing jobless claims came in marginally better than expected. Any further weak labour data today should be assuaged by the larger fiscal package imminently on its way.
The consensus view is for a weak dollar over the medium to longer term, which would lead one to take a short the rallies approach. The logic behind this narrative is the new much larger stimulus package will lead to higher inflation while the Fed keeps rates pinned down, thereby keeping real rates in negative territory. This rests on the assumption that other countries will tighten monetary policy quicker relative to the Fed. A more traditional and less protectionist administration will also aid the dollar’s decline. The currency of the country which imposes tariffs usually benefits as the dollar did while Trump was president.
Yield differentials have in the past been a primary driver of FX moves, however, with central banks globally converging to zero rate policies, this factor is now no longer as important. A new factor has emerged – mobility i.e. how quickly is the economy moving back to normality and hence recovering. The US seems to be one of the top performers in the vaccine rollout, causing a mobility premium to be priced in. While monetary policy divergence remains extremely limited, focus will now shift to relative/regional economic performance. Regional economic outperformers will benefit with inflows into their equity markets which will also cause a bid in their respective currencies.
However, some have already begun to challenge the weak dollar consensus view. A fiscally-driven better relative growth profile could actually attract flows into the US as rates markets re-price. It could be similar to what we saw back in 2017 after the Tax Cut and Jobs Act. If the Fed is happy with how growth progresses there is no fixed rule for them to lean on yields. Yesterday, the Fed’s Kaplan actually remarked that he expects yields to rise due to a better economic outlook. The US 10 year has breached the all-important 1% yield level and the 2s10s curve is steepening dramatically all aiding the dollar’s recent strength. Lastly, Net specs is skewed heavily on the short side, leaving little room for further shorts to build and the spectre of short squeezes.
On the technical front the RSI has begun to move from out of oversold and there is positive divergence between the RSI and price action. This occurs when the price makes a lower low, but the RSI makes a higher low – indicating the momentum of the downward move is beginning to wane and a trend change upwards could be on the cards. There is some resistance at 90 that needs to be cleared first. Thereafter, the upper band of the Bollinger Band and 50-day SMA around 91 would be the next resistance area.
With Brexit now in the rear view mirror that chunky Risk premium has now been unwound. The FTA signed will still require further mini agreements to be made over the coming months and years. One being of particular interest to the UK economy - financial services. The BoE’s Bailey provided an informal deadline of end of March for talks with the EU on financial services trade.
The big drivers for Cable remain – negative interest rates (becoming a funding currency), general risk sentiment and the speed at which the economy can recover with a strong health response.
Unfortunately, another national lockdown has been imposed to deal with the rapid spread of the more contagious strain. It’s not all doom and gloom though. UK has been one of the leading countries in the vaccine rollout and the Health Secretary remarked overnight that he believes this will be the final lockdown. However, one knows politicians can sometimes be “economical” with their promises. I think we are close to the peak of daily cases, the rate of increases has decreased - 52,618 new cases were recorded on Thursday as opposed to 62,322 on Wednesday. We will have to see if this trend persists. Chancellor of the Exchequer Rishi Sunak announced on Tuesday, 4.6 billion pounds of emergency support to help U.K. businesses survive the restrictions. Additionally, The Sun reported that the Treasury is also considering a scheme to bailout up to a million small business owners excluded from previous Covid support. Johnson has also vowed to slash business rules in an attempt to not handbrake the economy during its recovery. Freeports to encourage investment and employment are also planned to be opened rapidly.
The Scottish elections on the 6th of May should be an interesting event. The SNP are likely to win a majority, however, frustration with lockdowns etc may dent some of that majority. Another majority would certainly allow for the SNP to increase the rhetoric around another independence referendum. I am certain the current government which will remain in power until May 2024 will reject this outright. The last thing the UK needs is another referendum.
The FTSE finished down 14.3% in 2020 and remains relatively cheap. Furthermore, the large cyclical and value composition of the FTSE should see substantial inflows as the global reflation theme gains steam. This should create a tailwind for the pound as to buy UK assets when needs to buy the currency too.
Cable has continued its ascent and looks to be in a good uptrend with both the 50-day and 200-day SMAs pointing upwards. Previous resistance at 1.35 will now be support for any further pullbacks. A slow grind up to the 1.37 area would be the next target. There is some minor negative divergence occurring where price has made higher highs while the RSI has made lower highs. Could buying momentum be slowing down?
The single currency seems to be suffering from some high altitude sickness. It is struggling to reach its 2018 highs of 1.25 against the dollar. From a domestic fundamental perspective, the euro remains unattractive and further gains will come from a weaker dollar. However, the ECB will be uneasy about further dollar depreciation as the last thing they want when trying to recover from a pandemic is a strong currency for their export-dependent economies. Vaccine rollout has been slow and will lead to a longer recovery time. The much vaunted recovery fund will certainly help, but it’s a far cry from solving the EU’s woes. Distribution of the funds will only occur mid-2021 which is late relative to the rest of the world in terms of support packages. There are wide disparities amongst the economies of the EU, and Spain and Italy have a poor track record in effective deployment of cash from Brussels. Could easily see a K-shape recovery with the South dragging down EU overall economic performance. At least breakup risk for the time being has receded dramatically as evidenced by the BTP-Bund spread which is now registering at 100bps – narrowest since 2016. The next big political event are the German Federal elections on the 26th of September.
Just recently the EU have sealed an investment deal with China which may be viewed with some consternation in Washington by the new administration. Does this mean a relaxation of tariffs and a new era for US-EU relations may not come to fruition as quickly as some expect?
On the data front the EU’s inflation remains paltry with a small miss yesterday, however, there was a slight beat on today’s unemployment data. I can’t see the ECB tapering QE or raising rates anytime soon as inflation looks set to remain low for an extended period of time. The large long positioning in the euro makes it vulnerable to any sell-offs and one has to wonder where the new buyers will come from.
The one feature working in the common currency’s favour is the reflation trade which would see a rotation into cyclical sectors, such as financials, which have a circa 15% weighting in the Euro Stoxx 600 benchmark index.
The euro continues to hug its upper Bollinger Band and is showing negative divergence similar to Cable. This could see a pullback towards the 1.22 support level with a deeper sell-off reaching the lower Bollinger Band/50-day SMA around the 1.20-1.205 area. However, the trend still does remain up for the time being.