e-markets.nordea.com/article/45706/fx-weekly-the-conte-trump-alliance

26 August 2018

FX weekly: TheConte-Trump alliance

Martin Enlund | Andreas Steno Larsen

The US economy will slow from here, but short-term there are reasons to fadethe EUR/USD rally, as i) a SOMA-day is coming up, ii) Trump buying Italianbonds is not necessarily a EUR positive and iii) a hawkish part of Powell’sspeech was overlooked

Table 1: Our current list of convictions

One potential driver of the dollar which was often mentioned at the start of this year but oddly forgottenduring the twin deficit scare was the idea of repatriation of capital to the US. Why oddly forgotten? WhenGeorge Bush signed the ACA/Homeland Investment Act of 2004-2005 (which triggered repatriation ofcapital) it took a few months before the USD turned higher. The initial move after Bush signing the bill wasthat the dollar weakened(!). This example suggested that market participants were underappreciating thepotential for a come-back in the dollar. Here we are, almost six months later, and the USD has picked upsubstantially.

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Chart 1: History doesn’t repeat, but it rhymes

The Donald seems keen to weaken the dollar, and he has seen his wishes fulfilled at least over the pastweek. Market participants has had to grapple with the President’s critique of the Fed’s rate hikes, about othercurrencies being too weak (CNY, EUR), a jump in perceived impeachment risks (dollar-negative because of itsKeynesian growth implications) and the odd idea that the US could buy Italian bonds.

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Chart 2: The Donald and the dollar

The US buying Italian bonds is an intriguing idea. It is generally thought that the White House is no big friendof the EU, and it would obviously be a bad idea to own Italian bonds if EU/EMU break-up risks were to rise.But the President would like to see a weaker USD, so that’s a definite positive (for him). The persuasionangle is the most interesting, if we assume the White House wants to break up EU/EMU. By indicatingthe US could buy Italian bonds it encourages the Italian government ahead of its budget battle withthe European Commission this fall. This is not EUR-positive (if you consider selling USD, there are betterways to express this than in EUR/USD). If the Trump-Conte alliance could achieve i) Lower BTP yields, ii) abroadly weaker USD (not necessarily versus EUR) and iii) EU-turmoil as the Italians are incentivized to spendmore, then it looks like an alliance where both parties will gain.

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Chart 3: EUR should have been sold on Friday gauging from BTPs

Anyway, the US buying Italian bonds would entail sterilised FX intervention. This is the least successful kind.Even if the G7 were to join in (good luck with that), it wouldn’t have any eect beyond three months (ECBresearch). Non-sterilised FX intervention could have an eect, but then we’re basically talking about a new QEprogramme by the Fed (printing money to buy Italian govies). And that’s another, ahem, dicult sell at thisjuncture.

The market by the way sold o BTPs after the June figure for the net foreign purchase of BTPs becameknown (another terrible flow month for BTPs after a weak May as well). In our view this is though mostlyold news, as you have a variable that captures the in/outflow of capital into Italy a month earlier thanthe BTP flow statistics. Judged from the Target-2 balance development in July, you should expect also theforeign holdings of BTPs to have picked up again. The Target-2 deficit actually decreased a little in July (asign that capital has filtered back in to Italy).

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Chart 4: The target-2 balance is a timelier in/outflow of capital variable

This gets us to the Fed and the Jackson Hole. Fed Chair Powell praised Greenspan’s “risk-management”strategy of the late nineties in his speech while saying “we have seen no clear sign of an acceleration [ofinflation] above 2 percent”. The take-away so far is thus a tad dovish, and one of boring gradualism.

Another part of his speech was however hawkish, as well as under-covered by the media. The Fed Chair’scomment on excesses echoed recent remarks by BIS’ Borio: “in the run-up to the past two recessions,destabilizing excesses appeared mainly in financial markets rather than in inflation. Thus, risk managementsuggests looking beyond inflation for signs of excesses”.

Back in 2012-2013 the credit cycle and financial excesses were widely discussed among central bankers, butas dollar soared and oil prices collapsed in 2014 all such concerns were put away as central banks insteaddecided to fight deflation risks. That Fed Powell included this reasoning might represent a slight hawkish shiftwithin the Fed, as it suggests the Fed can keep hiking rates (to rinse away, or prevent, excesses), even ina scenario where inflation disappoints.

Curve flattening googled the most ever

Elsewhere, the curve remains the talk of the town, and rightly so, perhaps... If the recent flattening pacepersists, the 10y/2y curve will have inverted by early next year. With the yield curve often used as arecession indicator, the market’s attention should be of no surprise. Curve flattening is furthermorebeing googled the most ever – now surpassing the peaks in 2004 and 2005.

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Chart 5: Curve remains in focus

The consensus among central bankers is that this is nothing to worry about, but market participantsappear sceptical and worry anyway. After all, it’s not as if the track record of central bankers is spotless, nomatter how many academic titles they possess.

The flattening of the curve, inversion of US money-market curves, underperformance of cyclicals vs defensiveequities over the summer, underperforming high-vol equities vs low-vol equities are all signs of a late-cyclical mind-set present in the market: the US economy will start slowing. With this we agree, and weconsequently expect more of these market developments. If ISM manufacturing mean-reverts to its historicalaverage, then cyclical equities might underperform by another 15%.

This story should ultimately also prove USD negative later this year, but for now we decide to fade theJackson Hole rally in EUR/USD.

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Chart 6: Cyclical equities have underperformed since the beginning of the summer

SOMA redemption day approaching

One reason why we keep a positive tilt for the USD in the week ahead is that another SOMA redemptionday is approaching (August 31), when 20.9bn worth of Treasury notes and bonds mature in the Fed’s SOMAportfolio. This implies a negative impact on US excess liquidity by 11.4bn, not a record but nonetheless worthnoting.

We have noted time and time again that it usually pays o to buy the USD on such SOMA days, for instancegoing long between Europe’s lunch hours and CEST14:30, and closing the long around close. It may also beinteresting to note that both the NOK and the SEK tends to weaken on those days, not that they need helpweakening in the current macro climate. Of all SOMA redemption days since February, EUR/SEK has risen80% of the time, and EUR/NOK has risen 70% of the time.

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Table 2: Another SOMA redemption days approaching

EUR/SEK is partying like its 1998

EUR/SEK is partying like its 1998, with the upcoming Riksbank meeting on 6 September and thegeneral election on 9 September being two domestic negative drivers. The two most positive thingswhich can be said about the krona currently is: i) it is cheap and ii) speculative accounts are likely short thekrona – and that when exiting SEK shorts the door may be quite narrow. A pattern of higher highs in thecross was a sign of momentum funds selling the krona in late April, and the door got crowded when theRiksbank eventually triggered position-squaring in May.

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Chart 7: EUR/SEK pattern of higher highs a sign of crowded positioning

Fears ahead of the Swedish election are definitely impacting the SEK. While domestic accounts see thelikelihood of the so-called populist Sweden Democrats getting any influence at all as small since other partiesmore or less promise to shut them out in an extension of the December deal made in 2014, foreign accountsremember Brexit, Trump and recent Italian developments. For instance, there weren’t many pundits norpolitical scientists who expected the League to form government together with the Five-Star Movement, andwho knows what will happen after the election in Sweden.

The recent rhetoric from the currently largest party Social Democrats (which has called the other parties“small” while also promising hiked taxes on capital) have been polarizing the political landscape further. Morepolarization, the greater the diculty to form government, the longer it will take to form government, and thehigher is the likelihood of unusual constellations.

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Chart 8: EUR/SEK is partying like its 1998

We expect political worries to keep influencing the SEK negatively ahead of the election. But, if SD were toget to form part of government, or get lots of influence, it would probably be good news for the SEK, as itmight boost both domestic demand and core inflation.

Brexit did not trigger WW3, neither did the Trumpening. Despite what the Nobel laureates said at the time,the US economy and US markets have performed admirably since then. For now we stay long EUR/SEKahead of the election.

AUD: Fade the positive politics move

AUD/USD has rebounded after the new PM (Scott Morrison) in Australia was announced Friday morning.

The new PM Scott Morrison is a less controversial choice than Peter Dutton, who tried to beat former PMMalcolm Turnbull a few days prior to the contest on Friday, but this is not necessarily equal to short-termgood news for AUD anyway. These internal leadership contests are a well-known phenomenon in Australianpolitics and usually AUD/USD heads south after a new PM is announced in these internal battles. Beingshort AUD/USD 7 trading days after a new PM was found in an internal battle has had a 100% trackrecord since 2010.

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Chart 9: Fade positive political news in AUD/USD – a 100% track-record since 2010

Another reason to stay sceptical towards the AUD is the lack of positive impulses from China. Whilewe have argued in recent weeks that there are good reasons to believe in a comeback in China in roughly 9months from now, as i) SHIBOR-rates have dropped like a stone, ii) The CNY has weakened materially andiii) fiscal stimulus is on the cards, we judge that it is too early to expect those impulses to have a positiveside-eect on the AUD.

On our models, there is in between 12 and 15 months of lag time from falling SHIBOR-rates and untilthe Chinese momentum has gathered enough pace to lift AUD as well. AUD could make a solid comeback down the road, but it is still too early. We re-add short AUD/USD to our tactical convictions after therecent rally and would only consider reversing the trade, if AUD/USD breaks above 0.7450 (the top of thebearish channel since February)

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Chart 10: Dropping SHIBOR-rates are helpful for AUD, but only after 12-15 months of lag-time

GBP: Falling inflation is about fairly priced now

On the 18th of April we wrote four reasons not to buy in to the Sterling positive consensus at the time andadded that we favored to play a Sterling negative bet via a short cable position (pretty spot on timing).

The major reason behind our negative GBP tilt was that the market did not price in the upcoming dropin inflation, which was as certain as the “amen” in the church on Sundays. Now almost five months laterthe inflation market is finally more or less on par with the inflation outlook in UK (see chart 11). Given thatBank of England seems to have a very low tolerance for further GBP weakening (FX weekly: Is the cyclicalmomentum overpriced?), we add a short EUR/GBP conviction to our tactical bets, as a short EUR/GBPposition from levels around 0.9050 also looks compelling from a technical perspective.

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Chart 11: Inflation markets are now on par with the upcoming FX eects on inflation

Previous FX weeklies:

·FX weekly: Fat-burning shorts (19 Aug)

·FX weekly: Time to call in Steven Seagal(12 Aug)

·FX weekly: Is the cyclical momentum over-priced? (05 Aug)

·FX weekly: How to trade a cease-fire? (29 Jul)

·FX weekly: What's that curve? (22 Jul)

·FX weekly: The China Factor (15 Jul)

·FX weekly: Take a short trade war breather (08 Jul)

·FX weekly: Trump will never #238 (01 Jul)

·FX weekly: The USD is the best carry currency in the world (24 Jun)

·FX weekly: Dollar to provide headwinds for earning estimates (17 Jun)

·FX weekly: Fire and fury risks for the USD (10 Jun)

·FX weekly:  It's not only Italy.. (03 Jun)

e-markets.nordea.com/article/45706/fx-weekly-the-conte-trump-alliance

·FX weekly:  The Sumo SOMA days (27 May)

·FX weekly: EM won't be sprinting, if the Fed is unprinting (20 May)

·FX weekly: The two final nails in the dovish FOMC-con (13 May)

·FX weekly: Is there anything left in the USD bull-run? (06 May)

·FX weekly: Dragon Energy (29 Apr)

·FX weekly: Relative curvature is the new king of FX (22 Apr)

·FX weekly: Why is EUR/USD not trading lower? (15 Apr)

·FX weekly: Like watching paint dry, they said (08 Apr)

·FX weekly: The list of potential USD-positives is getting longer (01 Apr)

·FX weekly: 2 reasons why EUR/USD has decoupled from rates spreads (25 Mar)

·FX weekly: Time to buy a USD lottery ticket? (18 Mar)

·FX weekly: Taxation mirror on the wall, who is the fairest of them all? (11 Mar)

·FX weekly: Trump's game of chicken (04 Mar)

·FX weekly: Will the market neglect the clutch of canaries? (25 Feb)

·FX weekly: Is the correlation break-down driven by FX hedges? (18 Feb)

·FX weekly: The liquidity tide is ebbing (11 Feb)

·FX weekly: Hawkish spectacles (04 Feb)

·FX weekly: Who will stop EUR/USD from moving higher? (28 Jan)

·FX weekly: Did the Democrats dent the Dollar? (21 Jan)

·FX weekly: Is 1.25 the new 1.20? (14 Jan)

·FX weekly: The euphoria rises (07 Jan)

·FX weekly: Paging Dr. Pangloss (01 Jan)

·FX weekly: The R-star of Bethlehem (24 Dec)

·FX weekly: A numbers game (17 Dec)

·FX weekly: The year-end liquidty shrink (10 Dec)

·FX weekly: Three reasons why EUR/USD isn't trading lower (03 Dec)

·FX weekly: Which currencies to sell if the housing downturn continues? (26 Nov)

e-markets.nordea.com/article/45706/fx-weekly-the-conte-trump-alliance

·FX weekly:  The global industrial cycle is set to weaken (19 Nov)

·FX weekly: Is high-yield a canary in the global coal mine? (12 Nov)

·FX weekly: Is this the end of the inflation convergence trade in EUR/USD? (5 Nov)

·FX weekly: Was that it for the EUR bulls? (29 Oct)

·FX weekly: Hawks in opposition, doves in charge (22 Oct)

· FX weekly:Continued convergence or re-divergence?(15 Oct)

·FX weekly: Thingsdon't matter until they do(08 Oct)

·FX weekly:"October seasonality is strong" (01 Oct)

·FX weekly:“Is 1.20 the new 1.15?”(24 Sep)

· FX weekly:Honey, I shrunk the balance sheet(17 Sep)

· FX weekly: “USD liquidity will turn scarcer, but when?” (10 Sep)

· FX weekly:“Strong currencies and inflation”(3 Sep)

· FX weekly:“USD in the (Jackson) hole” (27 Aug)

· FX weekly:“Q4 is the USD quarter”(20 Aug)

· FX weekly:“In the year 2525”(13 Aug)

· FX weekly:“EUR/USD ceiling or debt ceiling?”(6 Aug)

· FX weekly:“Elevator up, stairs down “(30 Jul)

· FX weekly:Trump “spices” up EUR/USD(23 Jul)

· FX weekly:Flip-flop?(16 Jul)

· FX weekly:Consolidation time?(9 Jul)

· FX weekly:Hawks R Us(2 Jul)

· FX weekly:Another lowflation week?(25 Jun)

· FX weekly:No Fed put?(18 Jun)

· FX weekly:A bouncy dollar?(11 Jun)

· FX weekly:Heating up(4 Jun)

· FX weekly:Summertime sadness(28 May)

· FX weekly:Special counsel lessens Trumpbulence, while OPEC looms(21 May)

e-markets.nordea.com/article/45706/fx-weekly-the-conte-trump-alliance

· FX weekly:Are China worries old hat?(14 May)

· FX weekly:Inflation week…(7 May)

Martin EnlundChief AnalystMartin.Enlund@nordea.com

Andreas Steno LarsenGlobal FX/FI Strategistandreas.steno.larsen@nordea.com+45 55 46 72 29

28.9.2017

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