Renewed Confidence in Divergence

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The diverging paths of the major central banks remains a powerful driver in the foreign exchange markets, and the capital market more broadly.  Although last year’s dollar sell-off was thought to be the beginning of a new paradigm, one of convergence, it is clear after the recent central bank meetings that peak divergence is still at least a year away.  

The G3 central banks met, and the main take away is that the Federal Reserve will continue to hike interest rates, while the ECB confirmed it is still a year away from its first hike, which will begin with the deposit rate at minus 40 bp. The BOJ shaved its assessment of inflation, and although it reduced the amount of JGBs it will buy this month, few are recognizing it as tapering.  The BOJ is seen to be more than 18 months from beginning its exit.  On the back of a series of economic reports pointing to slowing credit growth and softer economic activity in China, the PBOC refrain from raising interest rates a token 5 bp after the Fed moved, as it did last December and in March of this year.

Investors responded by giving the US dollar one of its best weeks this year. Divergence, whose demise, helped spark a record long speculative position in the euro futures and raised the decibel of the constant low ebb of cries that the dollar is being displaced, is back in full force.   EPFR reports flows out of European and emerging markets and into the US.  US equity funds saw their sixth consecutive week of inflows.

While we still think that the third major dollar rally since the end of Bretton Woods is still intact (the 12-14 month decline did not surpass retracement levels that are associated with corrections), we wonder if the market, likely due to positioning, over-reacted to last week’s developments.  The market, for example, does not believe the Fed will tighten as much as it signaled through its dot-plot.  The December 2019 Euribor futures contract does not imply a lower rate than it did in late May.  And unremarked by many, in the eurozone, compensation per employee rose at 1.9% year-over-year pace in May, the most since Q3 13.

So, with this as a backdrop, let’s turn to the charts.  The large price swings, especially the dollar’s big upside reversal on June 4, when the euro experienced its single biggest day loss since the response to the UK referendum results in June 2016.

Recall that last week, we thought the dollar’s downside technical correction was not quite over.  The Dollar Index did make a marginal new low, but that was the fake, and it reversed sharply higher.  The outside up day was so big it set the stage for outside up week, with the Dollar Index rising to its best level since November 2017. In that session, Dollar Index threatened the bottom Bollinger Band (two standard deviations from the 20-day moving average) and closed above the upper band.  While the price action itself is favorable, the technical indicators are mixed, and in any event, have not confirmed the new highs.  It is not clear what to make of this, but we see it as a risk of back-and-filling as positions get reset.

The price action for the euro was the inverse of the Dollar Index with one important difference:  The euro did not make a new high for the year.  It held the late May low of $1.1510 and finished above $1.16 ahead of the weekend.  Some technical schools (Elliott Wave?) may see the price action as a failure (failed fifth wave?), despite the bearish outside down day and week.  The MACD and especially the Slow Stochastics are not encouraging picking a bottom.  A move above the $1.1650 area would lift the tone, or at least neutralize some of the negativity.  On the downside, if $1.1500 is offered, the next important target is near $1.1450.  It corresponds to a 50% retracement of the euro’s run-up from the start of last year.  The 61.8% retracement is found a little below $1.12.

We often find the yen is a range-trading currency, and most of the time when it may appear to be trending, it is simply moving into a new range.  The first several weeks of the year was the movement of the dollar to a new and lower range of mostly JPY105 to JPY108.  At the start of the new fiscal year in Japan and Q2, the dollar recovered and entered a new range, which it can still be found.  That range maybe roughly JPY108-JPY112, though the high so far has only been JPY111.40 in late May.  A trendline drawn off the late May lows and several in June came in near JPY109.75 at the start of the week and finished near JPY110.20 on June 22.

Sterling, like the euro, held the late May low (~$1.32).  Similarly, the technical indicators are not giving much confidence that a low of much significance is in place.  Recall that the objective of the old double top (near $1.44) is in the $1.30-$1.31 area.  Resistance is likely to be seen near $1.3350.  Sterling may be support by the prospects of a BOE that moves closer to a rate hike by possibly a couple of dissents in favor of an immediate increase, and minutes that suggest others are not so far behind.  On the other hand, Prime Minister May remains embattled within her own government, and the fight between parliament and the government will continue in the days ahead.  The risks of a hard Brexit, or no agreement in extremis, is seen as sterling negative.

We had anticipated a better week for the Canadian dollar.  Its nearly two percent loss was the worst week here in Q2. Even though the Bank of Canada may be the next central bank to hike rates (next month, ~70% chance discounted), the divergence with the US is growing.  The premium the US pays over Canada for two-year money rose to through the 60 bp cap that had been in place to its highest level since the financial crisis.  The US dollar rose to CAD1.32,  it best level since last June. It pushed through the down trendline drawn off the January 2016 high (~CAD1.47) and the May 2017 high (~CAD1.38) and the previous week’s high (~CAD1.31).  The CAD1.3130 area represented a 61.8% retracement of the greenback’s losses since the May 2017 high.  We see the next important technical target in the CAD1.3350-CAD1.3400 area.  Support is likely to be found in the CAD1.3050-CAD1.3100 range.

The Australian dollar did not make new lows for the year last week.  But its inability to bounce amid the greenback’s heavier tone ahead of the week warns it is a matter of time.   The US interest rate premium over Australia’s is the most since 2000 at the short-end and the most at the long-end since at least 1990.  The Aussie took out a three-year uptrend in April and retested it from underneath in early June.   A break of $0.7400 signals scope for another cent loss.  A move back above $0.7500 would begin neutralizing the technical damage.  In the bigger picture,  double top near $0.8135 in September 2017 and January 2018 projects toward $0.67.

The recovery in WTI for August delivery since June 5 fizzled in front of the 38.2% retracement objective of the more than $10 sell-off that began in late-May as it became clear that world’s three largest producers were boosting output.  Given the unilateral steps by the US (most certainly not isolationist, though it is finding itself isolated) to withdraw from the agreement with Iran, the sanctions are unlikely to prove as effective as previously.  The growing trade tensions with China, the largest buyer of Iranian oil, give it little reason to cooperate with the US.  The asymmetry of trade means that China cannot retaliate in a reciprocal fashion against US action.  This implies an asymmetrical response and one potentially more costly than the $12.5 bln that will be raised by the new tariffs that have been announced.

At $64.60, the August contract retraced 50% of the rally in H1 from Feb’s low near $62.70.  The technical indicators on a weekly basis are decidedly negative, but the daily readings are mixed.  OPEC output is understood to be about a million barrels a day below the quota, and there is not much spare capacity outside of Russia and Saudi Arabia, and if our geopolitical assessment is correct, the US sanctions will likely remove less Iranian oil than it wishes.  The combination of rising supply, a strong dollar, late-cycle activity in the US and Europe (ECB staff forecasts anticipate growth slowing next year and in 2020), and the poor technicals,  we would not be surprised to see oil back in the mid-$50s later in the year.

The US 10-year yield briefly traded above 3.0% in a knee-jerk response to the FOMC announcement, but it has not closed with the three-handle in nearly a month (May 22).  The market seems uncertain and the yield chops in 2 7/8% and 3.00% range.  The September note futures saw good buying on the pullback to 119-00 on the FOMC statement.  There were reports in the past of last week of a very large bullish play in the options market that would have the maximum payout in the 10-year yield fell to 2.60% in the next two months.  It is not clear whether it is a hedge, though the option strategy is often associated with a directional view.

The 2-10 year curve has flattened by nearly 20 bp since the middle of May. Recall the curve initially steepened in the first few weeks of the year, reaching 80 bp near mid-February is trended lower and entered a range in April and May between around 43 and 54 bp.  It spent all of the pre-weekend session (June 15) below 40 bp for the first time since 2007.  There is a difference of opinion among Fed officials of the significance of the flattening and potential inversion of the curve.

There are also some contextual factors that may make a difference, like how the supply is being managed by the US Treasury and a large number of negative yielding bonds that make US debt all the more attractive.  We are agnostic but would quickly add that we would include the curve in a discussion of late-cycle indicators and that we can see how it can become a self-fulfilling process.  The longer the curve is inverted stronger the headwind for businesses, especially small and medium businesses.

Fear of escalating trade tensions weighed on the S&P 500 ahead of the weekend, but it recouped the lion’s share of the losses and managed to hold on to the smallest of gains (less than 0.1%) for the week.   Technically, the S&P 500 was stalling in front of the 2800 target, which is also the March high and high since the lows of the year were recorded in those frantic days in February.  The strong close leaves the benchmark poised for another attempt at the cap.  As the quarter draws to a close, and the near earnings season kicks off, buyback may slow.  This may be offset by the savings drawn in US equity market.  Reports of fund flows show money continues to come into the US equity market and leaving Europe and Emerging Markets.  The technical indicators warn of more downside potential.  A break of 2750 would be disappointing, and there is an old gap that extends to 2736 that may draw prices.