- Idiosyncratic and relative-value (RV) trades are currently appealing. Look for monetary policy divergences (Bank of England repricing lower, rates re-pricing in CEE), sensitivity to ongoing muted Chinese growth, and energy prices.
- Carry should also hold up well, assuming global equities trade in a range.
- Sterling should underperform mainly the oil-linked currencies. MXN should continue its strong performance, especially against low yielders in Asia. In CEE, PLN is likely to lag.
Dollar to Struggle for Direction
The dollar has been on a tear since mid-July. However, the 1260 level (BBDXY) has held firmly, increasing the likelihood that the greenback will stay in the 1200-1260 range for the foreseeable future.
I will detail my USD view in a subsequent article, but my base case is for the dollar to struggle for clear direction this and most of next quarter. If so, FX investors would do better to focus on idiosyncratic and RV trades, several of which I discuss below.
Ignore EUR/USD, But Upside for EUR/GBP and EUR/AUD
If FX was the only market you watched last Thursday, you may have concluded the European Central Bank (ECB) did not hike and/or was uber dovish. That is not exactly what happened! The central bank raised the depo rate to 4% and effectively communicated that, in its base case, it is done hiking. Yet it kept optionality by reiterating ‘data dependence’.
I do not think this classifies as a dovish message when the market was pricing about 15bps for the meeting with no subsequent tightening. I therefore take the nearly 1% drop in EUR/USD on the day with a pinch of salt and likely tie it to positioning. Although CFTC data show leveraged accounts and asset managers had reduced exposure, the market is still net long. And I am sure stops were triggered just below the 1.07 level.
I see neither a big story nor big drama for EUR/USD. I still see a non-negligible risk for the ECB to hike again (mostly owing to – underappreciated – pipeline wage growth pressures likely to keep inflation sticky on the way down). However, EUR/USD cannot find sustained tailwinds on the growth front as regional activity is bleak. Meanwhile, the rise in oil and NatGas prices (Chevron LNG strikes) – up 62% and 43% since mid-July – threatens to worsen EA’s ToT.
Also, as long as 1.05 does not break, EUR/USD declines are unlikely to be particularly painful and lead to a significant short squeeze, as most positions had been built up between 0.95 and 1.00. A break below, however, could change that.
If pushed, I would be tactically somewhat long but reduce risk on rallies – I currently see no big story for EUR/USD.
That said, I see value in two relative trades: longs in EUR/GBP (monetary policy divergence and sterling factor – see below) and EUR/AUD, with the latter capturing continued underperformance of the Chinese property sector, while reducing beta to the dollar. The risk here is Chinese authorities increasing growth measures, but the experience of the last couple of years suggests otherwise.
Recent Sterling Correction Has Legs
No doubt sterling’s strong performance has surprised many this year (including myself!), with GBP the best performer – alongside CHF – against the USD (G10). But I think now is the wrong time to give up on the sterling weakness trade.
PMIs show an accelerated slowdown while the housing market is nosediving again, following a brief reprieve. Despite Bank of England (BoE) Governor Andrew Bailey’s dovish speech recently, the market is still pricing about 35bps of additional tightening, while there are (only) 20bps of cuts priced over the next 9-12 months.
I see room for a correction (my read is that the BoE has largely finished hiking). Therefore, it makes sense to sell sterling against currencies in which central banks are still hiking (or are in a hawkish hold) and/or currencies that find renewed support on higher oil prices.
Alongside long EUR/GBP (where economic surprises suggest upside potential) and short GBP/USD, this means short GBP/NOK and short GBP/CAD – where yield differentials have also started correcting lower but should go further.
In EM, Carry Should Hold Up Well
Assuming my base case of no equity bear market/recession until yearend, carry should continue to hold up. And despite its significant rally this year, I see little in the way of further MXN appreciation. Aside from great carry, support comes from good momentum, higher oil prices, increasing nearshoring with the US (the share of Mexico in US imports has risen recently) and a central bank that has guided towards a hawkish hold. I like playing the carry trade, funding MXN positions via low carry in Asia such as TWD and KRW.
In CEE, Poland’s Monetary Policy Council (MPC) appears to be panicking. The surprise mammoth 75bps cut argues for EUR/PLN upside, though it could be worth waiting for a correction towards 4.55.
The Polish central bank has turned very pessimistic on the growth outlook and is convinced inflation will fall rapidly. That is no big surprise given the economy’s high beta to Germany and the broader euro area.
However, the MPC chairman exhibited a remarkable aversion to positive real rates as the central bank sees a ‘radically changed’ outlook, which gives an outright dovish guidance. While this communication may have brushed over several upside inflation risks, the MPC seems likely to ease monetary policy further before yearend.
Similar monetary policy shocks by central banks in Hungary and Czech Republic are less likely (the NBH’s August communication updated its forward guidance, giving a hawkish tone). Accordingly, the recent moves lower in PLN/HUF (where negative carry has widened) and PLN/CZK should extend.