G10 FX Weekly: Recent UST and USD Price Action Offers Clues for H2 2023

Summary

• Softer-than-forecast US non-farm payrolls (NFP) and CPI data over the past few weeks saw Treasury (UST) yields and the dollar (USD) decline materially.
• This price action is telling, and we think that this trend of lower US yields and a weaker dollar will continue in H2 2023.
• We like holding core long UST exposures (adding on price dips) and core short USD exposure (fading upward retracements).

Market Implications

• Bullish 2-year USTs – Twice this year, the 2-year UST yield has briefly traded above 5% and, both times, fell sharply shortly thereafter. We have seen value in a dip-buying strategy for several months, and recent price action has increased our conviction that yields will trade materially lower in H2 2023.
• Bearish USD, especially against EUR, CHF and JPY – The US Dollar Index (DXY) currently trades near its 15-month low, having fallen about 3.5% in the past two weeks. This downward trend will continue in H2 2023, with the dollar set to fall most against the EUR, CHF and JPY.

Introduction

The start of H2 has seen two critical US economic data prints, both softer than expected and weaker than the previous readings. Between 7 and 12 July, employment data disappointed, and CPI surprised on the downside.

Both UST yields and the USD dropped sharply in response to these data points. Since 6 July, the 2-year UST yield is ~35bps lower, while the DXY is ~3.5% lower.

We expect this price action to be a harbinger of market direction in H2 2023. We therefore like to fade any upside in UST yields and in the USD. Specifically, we like owning 2-year USTs, being long EUR/USD, and being short USD/CHF and USD/JPY.

What Has Happened With US Data?

As my colleague Dominique Dwor-Frecaut reviewed, the 7 July US employment report showed that NFP increased by 209,000 in June. This was lower than the consensus expectation of 230,000 and lower than the revised 306,000 increase in May.

The May data was revised lower from the original 339,000 print, and the total net revisions for the prior two months were -110,000. Employment growth in June was the weakest since December 2020.

Five days later, the US CPI report for June showed inflation was softer than expected across the board. On a headline basis, both the MoM (0.2% vs 0.3% consensus) and YoY (3.0% vs 3.1%) prints surprised to the downside.

The core readings (ex-food and energy) also came in softer than expected across the board. The core MoM reading was 0.2% vs 0.3% expected, while the YoY reading was 4.8% vs 5.0% expected.

While Dominique warns of strong underlying dynamics, the most recent headline and core YoY readings extend the trend of US inflation slowing. Headline inflation peaked in June last year at 9.1% YoY and has since slowed materially, coming in weaker every month.

Core inflation peaked in September last year at 6.6% and, although disinflation has been less pronounced than in the headline measure, the trends in both readings are similar.

The direction of travel is exactly what the Fed wants to see.

What Has Happened With US Federal Reserve Pricing?

Over the past few weeks, as this data has hit the wires, Fed pricing has shifted slightly more dovish.

Despite this, we argue the market has not yet started to aggressively reprice Fed expectations. Instead, the move has been measured and, as a result, we think more dovish pricing can gain further traction in the coming months.

At the close of business on 6 July, the day before the weaker-than-expected employment report, the end-of-year expectation for the Fed Effective rate was ~5.4%. At that time, for the end of next year, the expected Fed Effective was ~4.24%.

Now, after the softer jobs and inflation data, the expectation for yearend is 5.35%, and for next year it is 3.94%

This is a modest shift in expectations. Yes, it is more dovish, but the market is not getting ahead of itself.

And, more importantly for the near term, the softer data has not dented market expectations for a 25bp rate hike next week. The probability is about 96% now versus 89% two weeks ago.

Market pricing, therefore, sees a rate hike on 26 July as virtually certain, as does Dominique. Further out the curve, market expectations have become more dovish, albeit in a measured way. For us, there is more to come.

Our Favoured Trades

In rates, we like maintaining a long 2-year UST position and adding to it on price dips. In FX, we like a short USD position, increasing exposure on any USD strength, in EUR/USD, USD/CHF and USD/JPY.

Bullish 2-Year USTs

We have seen value in a buy-on-dips approach since Q1 in the US short-end. After this recent reversal lower in the 2-year UST yield, our conviction has grown.

We like being long 2-year USTs, looking to add to the position on any yield increases. We would view these instances as corrective and opportunities to buy bonds. For us, the trend is now for lower yields.

Twice this year, in March and earlier this month, the 2-year UST yield has risen above 5%. And, in both cases, the yield quickly plummeted.

We think there is more downside to come. Although there are several intermediate supports before reaching ~3.55% (which is currently the 2023 intra-day low), we think the current move has scope to revisit that level, which is our eventual target.

Bullish EUR/USD

As with the US short end, we have been bullish EUR/USD since Q1. After recently printing a new year-to-date high this week, our conviction for further upside is stronger.

We like holding a core long position and adding to this exposure on any price dips. After breaking through the previous resistance at ~1.11, this will probably serve as a solid support area.

We see a weaker dollar as the predominant H2 20023 trend in G10 FX and think the euro will be among the bigger gainers versus the greenback.

The pair’s climb since Q3/Q4 last year has been durable despite reasonable pullbacks.

We expect more upside to come. Rather than a sharp rise, we think the pair will grind higher in coming months. As such, we expect EUR/USD to trade back to the 1.13/1.15 level seen in February 2022, before the start of the Ukrainian war.

Bearish USD/CHF

We have been onboard with the surging Swiss franc since May, and its performance in the past couple of months has fed our belief that the franc can remain the top-performing G10 currency in 2023.

USD/CHF traded to an ~8.5-year low last week and has meandered broadly sideways since then. The franc is the strongest G10 currency in 2023.

Given the franc’s multi-year strength, arguing that USD/CHF is overdue a bounce from its recent trough is easy and sensible.

This might happen but, if it does, we think that the bounce will be modest and would view any USD/CHF upside as a selling opportunity.

Given the pair is plumbing depths not seen for a long time, we think USD/CHF has potential to trade to 0.8000. Round numbers attract, and this level is a reasonable target to expect.

Bearish USD/JPY

Of the three USD pairs highlighted in this piece, we think USD/JPY is the trickiest to call. We have been cautiously constructive on JPY, calling (in May) for the currency to reverse some of its losses in early 2023.

Back then, USD/JPY was trading at ~134, and we saw scope for the pair to trade back down to 127. How wrong we were!

The pair then traded up to ~145, topping out earlier this month. Since then, the pair had traded back to a 138-handle last week and now sits at ~139.5

USD/JPY is tricky to call because of the two central bank rate decisions next week – the Fed (on 26 July) and the BoJ (on 28 July).

We argue the USD/JPY fall this month stems mostly from the broad USD retreat due to the slightly more dovish Fed repricing.

Some argue part of the JPY ascent comes from expectations that the BoJ might tweak its Yield Curve Control policy next week. After recent messaging from BoJ Governor Ueda, however, tighter Japanese monetary policy is unlikely.

So, what does this mean for the yen?

We think the broad dollar weakness we expect in H2 2023 will also filter through to USD/JPY. When we made our constructive JPY call back in May, we argued that the end of tightening cycles outside Japan would lift the yen.

We think this is still valid and therefore expect USD/JPY to establish further modest downside momentum. As a result, we set a target of 135 for the pair in the coming months.

An Important Caveat

While the FX and rates markets moved sharply on the softer US data earlier this month, it is too soon to conclude that the Fed’s tightening cycle is finished.

By fully pricing a 25bps rate hike next week, and only modestly repricing expectations further out the curve, we think the market has reacted prudently.

Dominique’s take on the most recent US CPI release is worth revisiting. She argues the weaker-than-expected inflation data by itself added little to the disinflationary trend and that the headline reading at 3% reflected mainly base effects.

Furthermore, Dominique was cautious about future inflation. Beyond the nailed-on rate hike this month, she expects another in November.

The market currently prices about a 25% chance of this happening.

Richard Jones is a Macro Strategist for VDK Capital, a London-based venture capital firm. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side. 

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)