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Can you trust the USD rally?

Chris Weston
Head of Research
5 Feb 2023
Well, the broad-based USD rally on Friday was certainly impressive and caused shockwaves in commodities, with XAUUSD -2.8%, silver -4.8% and crude -3.6%. USD shorts, of which the market had built a sizeable position in, saw a change in the flow and covered.

As I explain below, I am not in the camp that we’re on for a new one-way USD bull market, as this would take many of the recent negative factors to reverse.

The correlation between the USD and equity market has fallen since late November, but if equity markets roll over and head sharply lower, taking the VIX into 30, then demand for USD hedges should increase. At this point that isn’t the case – equity traders may have seen the USD sharply higher on Friday, but the fact we had a nirvana economic backdrop – with huge job growth, service sector expansion but falling wage pressure, meant holding the line on selling equity – had we seen average hourly earnings above 4.6% (and not 4.4%) then one could have envisaged a world with the NAS100 -3%.

Headline jobs creation was incredible (at 517k jobs), while weekly jobless claims fall and the services ISM pulls strongly into expansion – granted, manufacturing and small business surveys are in a dour spot, but the US labour market hardly suggests business is pulling back too greatly here – at this stage. This has the market challenging its rates expectations/pricing and we’ve seen terminal Fed pricing pushing very modestly above 5%. While we approach an end to the hiking cycle from the BoC, BoE and ECB, the market will feel some uncertainty for pricing fed funds terminal – this is a USD positive, but unlikely one that causes a lasting USD trend.  

In fact, the US recession callers will beat the drum that higher fed funds will only increase the prospect of a recession, but that timeline has been pushed back.

The Fed are data-dependant, so the jobs print does give them the confidence to hike two more times – it certainly subtracts from the view we’ll see rate cuts this year. And it suggests US real rates may have further upside – again, a USD positive. On Friday we saw an impressive 18bp rally in US 5yr real rates to close at 1.32% - A push into 1.50% and the USD will likely rally another 2-3%.

Under the USD ‘smile theory’, one can say the right-hand side has worked modestly in the USD’s favour – but we’d need to see global economic data sour to get the USD really pumping – European and Asian data would need to roll over and bring back the US exceptionalism story in vogue.

European real-money funds have been repatriating capital to Europe and these inflows have boosted the EUR - so an underperformance from EU asset markets would also be helpful for USD bulls.

USD carry is falling - EURUSD 1yr forwards rates fell from 272bp in November to a low recently of 200bp – so the cost to rollover EUR exposure into the future is falling and you’re not paying as great a level of carry; a big source of USD strength in 2021/22. Granted, we saw EURUSD forward rates lift on Friday, but for the USD to really get a sustained lift then I’d want to see USD forward rates head towards levels seen in Q422, and funds buying USD again for carry purposes.

In essence the USD bull market checklist needs:

  • The US looking comparatively better than other G10 and EM economies
  • Idiosyncratic factors returning – complications rise around the Chinese reopening, higher EU Nat Gas
  • Equity markets to revisit the October lows amid levels of realised and implied volatility
  • Higher US real rates relative to other G10 countries
  • Increased USD carry
  • QT and balance sheet reduction would need to really inspire USD bulls

I don’t see a world where these dynamics make a convincing return, at least in the near term, and therefore see the USD move as having limited upside – i.e. it seems unlikely we’ll get more than 3%, maybe 5% at a push.

Trading though is different from strategy. We react to price moves, look to have position sizing relative to the volatility in the market and manage risk accordingly – the job of the trader is to max out the reward relative to the risk we’re taking, and this means we can often be wrong.  

One factor to focus on for traders is the broad set-up in USD pairs. The weekly timeframe gets less airtime for short-term traders, but it does give excellent oversight into where the balance of risk sits. Here we see several failed breaks and big reversals in USD pairs and if Friday’s lows in the likes of AUDUSD, EURUSD and GBPUSD get taken out then the prospect of a 3% move higher in the USD naturally increases.

Fed speakers this week

Certainly, EURUSD was well traded by clients last week, with a heavy short skew on the move above 1.0900, although that is far more balanced now – the key risk to manage will be the raft of Fed and ECB speakers due this week. The 15 Dec high of 1.0736 looks interesting as a near-term support level, which likely coincides with a re-test of the Dec range lows of 103.04 in the USDX. GBPUSD has an eye on the 6 Jan pivot low of 1.1841, while AUDUSD saw a big liquidation and looks closely at the 19 Jan low of .6871 – of course, tomorrow's RBA meeting could offer a catalyst here.

So some big levels to watch as many of the USD shorts/bears keenly review their exposure and potentially act – recall strength breeds strength in times like this so momentum is the name of the game. That said, my overly simplistic USD bull market checklist needs work and suggests a higher probability that the USD upside will be limited to 3% or so – so I don’t trust the USD rally, but when I adopt a momentum approach my trust doesn’t matter, if it's going up then I just want it to run.

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