Australian Dollar Prone to Further Weakness
Although Australia recently has produced strong job growth figures on the November 12 release with strongest job growth since 2010 (58K actual vs 15K projected) and a drop in the jobless rate from 6.2% to 5.8%, which helped prop up the AUD by helping reduce further need to ease for 2016, the currency remains at risk for further declines. Across the past year, the AUD has been sensitive for obvious reasons with commodity prices—specifically, copper and iron ore prices. Copper and Iron ore are continuing to hit new lows, while the AUD is currently having a relief rally from the overall down-trend, producing a short term divergence. Sure the RBA might not be expected to cut rates heading into year-end, but they will most definitely refrain from reacting to just one month of jobs data. We believe that the AUD is poised for further declines, possibly aiming for the 0.7000 figure within the next two weeks. In addition to further commodity price pressure to the downside, 2-year bond yield spreads also show a similar picture, where the AUD has to play catch-up, to the downside. In addition to this, risk-reversals also indicate a possible exhaustion in short-term bullishness for the currency, trading at 2015 highs on the 1-month risk-reversal.
Expressing a view short via the AUDUSD seems to be alright, although it might be a good idea to diversify away from the USD, due to the incoming NFP event risk, Fed meeting, as well as the prospect of net USD positioning which are now at highs again. Because of this, we view that expressing the bearish AUD view via long GBPAUD should prove optimal as well, especially with the recent sell-off in the GBP driven by BoE dovishness on a lowering of growth and inflation forecasts. The GBPAUD cross remains largely reactive to monetary policy expectations from the BoE and RBA, with the pair tracking 2y rate spreads well in recent history. Arguably despite the recent downward revision in the UK’s inflation projections by the BoE, the trajectory for possible hawkish surprises is by far, still skewed towards the BoE vs the RBA, which should support the GBP/AUD. The technical picture looks to complement the bullish bias as well with a recent touch of the 30 threshold on the 14-day RSI, which has produced reasonable re-entries to the uptrend. Although we should not expect any large directional moves on spot as we head into year end, a trade back to 2.1500 seems reasonable for the pair.
10yr UK-US Bond Yield Spread Widening
The two bond yields have exhibited a tight co-movement over the past couple of years, moving generally in lock-step. Matt Roberts-Sklar,Senior BoE economists from Bank Underground comments that this is due to reasons such as the expectation of correlation of the policy rate path between the UK and the US, the correlated movement of advanced economy risk-premia, and a globalized attitude towards risk.
The spread between the two bonds has been largely rangebound for two years between 40bps and 20bps, roughly. The recent short-term repricing of the BoE’s stance on monetary policy has also widened the spread between the yields on the 10yr US and UK bonds. Arguably, if the Fed is expected to embark on its tightening path, despite talks of Brexit, etc the BoE could move towards to more of a hawkish tone in future commentary, which could push the spread back down to around 25bps, presenting quite an enticing RV trade.
Risk:Reward to be Significantly Long USD Not There
It is difficult to express a clear-cut bias on the USD, especially before we see accompanying commentary from Fed officials after the December meeting in regards to the overall hiking cycle. With the Dollar Index at the 100.00 figure along with net-long positioning at highs, the dollar looks ripe for some profit-taking, and a short-term retracement. @TheGreatGama mentions a good point that market participants underprice the correlation risk of very similarly Fed/USD driven trades reversing, which are namely: Long Dollar, Short EM Equities, and Short commodities. For the upcoming week, the NFP event risk may present itself with an opportunity to fade a positive USD spike for a short term retracement in the USD’s recent gains. If the Fed were to hike in the December meeting, there should be very little reason for them to be duly bothered by a single month’s jobs report, and hence is not one to affect the decision, providing a decent fading opportunity.
EDZ6 Recently Fading NFP Releases
Not that I normally ever cover fixed income/STIRs, but a quick glance on the EDZ6 (3-month Eurodollar futures, Dec-16) shows quite an interesting post NFP-spike reaction of fading almost all of the move on the hour of the release for the past 2 releases. Worth a punt perhaps for a third time fade for Friday’s NFP?
If you scroll down to my usual weekly thoughts, i've been liking the EURNZD short and EURAUD bias of which both have been doing well (AUD more than the NZD). I think it's time to revisit the EURNZD and analyze the underlying justifications for the short bias. Let's first examine the volatility aspect of the currency pair. Because of the interest rate differential between NZD and the EUR, the 'carry' factor of the currency pair puts forward the assumption that downward developments in risk-appetite should drive the EURNZD pair up, as 'carry trades/risk-on' trades unwind, and that volatility for the pair increases, and vice versa in the market environment where risk sentiment is bolstered. The chart above shows the relationship between Global FX Volatility (Orange) and EURNZD 1m vols since 2007. As we can see in general, EURNZD vols tend to trade lower relative to overall FX market volatility. However recently, since the August China-driven market turmoil, EURNZD vols moved higher relatively to global FX volatility. I think this short term dislocation would correct itself, primarily because 1) risk sentiment indicators such as the VIX has retraced from August highs, USDJPY and SP500 have remained to trade northbound 2) The falling commodity price factor directly impacting FX may be assumed to have diminished (see EURNOK here). 3) The macro picture behind the NZD isn't doing too badly 4) Fed Hike is increasingly priced in that the market won't find it surprising unless Fed signals that future trajectory of rate hikes is faster than 'slow and gradual'. Falling volatility, has, and should correlate to lower EURNZD.
Despite a large rebound in dairy prices in the New Zealand GDT index, prices have started to fall again, concerning some market participants to the overall outlook for the NZD economy. Despite the argument that dairy prices are important to keep an eye on for the NZD, it's not always a major factor. I have not been in the markets long enough to know if it's just a fad thing to pay attention to recently, but if we examine the news count for 'NZD and Dairy', we've only really seen headlines talking about it in the past couple of years, with comparatively little coverage before. I forgot to screen-capture a chart that overlays the GDT with the EURNZD, but a look at it would show that it is not incredibly a major driver of price movement. Yes, it has caused the current account to deteriorate slightly, but the deficit is not something to worry about significantly, at this point in time, as everyone has figured out that yes, commodity prices have impacted commodity-dollars severely, and that it would be less compelling for a further price fall in the NZD. Additionally, a more interesting development is how the RBNZ is stuck at a position where it's most likely to hold rates at 2.50%, with the odd coin-flip change of a rate cut in December, of which might be one-off, with inflation setting a trough at 0.3% this year in March, expected to pickup as base-effects fall out next year, where CPI is expected to achieve RBNZ's band midpoint of 2.0% in H2 2016, forecast courtesy of BNZ FX Research. The EUR factor of the equation similarly presents a case that should help drive the EUR/NZD rate lower, primarily on the grounds of a strong easing bias from the ECB, which has undoubtedly attracted the thought that the EUR could be a good funding currency for higher yielding currencies (like the NZD!).
The technical picture is also supporting the downside bias, where the pair on the daily chart is currently developing a flag formation, of which is generally considered to be a corrective phase in price, prior to a further break lower as momentum picks up. I have always traded spot, and hence, I still have much to learn about FX derivatives, though to keep things simple as my first shot, the idea here would be to buy a no-touch (up-and-out) barrier option at 1.6650 with an expiry of 1 month, a level of which if the flag successfully confirms further momentum to the downside, should not be returned to. On a 50K Notional, the premium paid would be around 15K, with a possible payout of 36K, giving a risk:reward of around 2.4. The risk reward is standard and isn't amazing but in my opinion is superior to a short in spot. If we traded short on spot, at the break of the flag, say at 1.6350, a conservative stop placement would be above the flag formation, but would be quite wide, at 2.0% away from the assumed breakout price. To achieve a similar risk:reward, you would need price to drop 4.0% further lower at least for a 2.0 Risk:Reward ratio. From the two, I think that even with the bearish bias for the pair, there is a higher probability for the pair to not touch 1.6650 in a month's time, then drop an extra 4.0%.