EUR
FUNDAMENTAL BIAS: BEARISH
1. Monetary Policy
Less dovish than expected can sum up the ECB Dec decision. As expected, they announced that PEPP will discontinue from March 2022, but also announced a surprise decline in monthly purchases under the APP, which will see purchases increased to EUR 40bln from the current EUR 20bln from2Q22 and then subsequently lowered to EUR 30bln in 3Q22 and down to EUR 20bln in 4Q22. Markets were not expecting any reduced purchases under the APP, so expecting the APP amount to return to EUR 20 billion by end 2022 was less dovish than expected. On inflation there was no surprises with updated staff econ projections showing 2023 HICP at 1.8% which reiterated the bank’s view that inflation will return to below target in the med-term. President Lagarde struck a familiar tone regarding rates by reaffirming that rates are unlikely to rise in 2022. As usual, ECB sources provided more colour after the meeting by noting further disagreements among the GC, with hawks unhappy with extending PEPP reinvestments to 2024 and not setting an end-date to the APP, and of course argued that inflation risks as skewed higher. Overall, the ECB was less dovish than expected but the stark policy divergence with the Fed and BoE means the bias for the EUR remains tilted lower in the med-term.
2. Economic & Health Developments
Even though the recent activity data suggests the hit to the economy from previous lockdowns weren’t as bad as feared, the additional lockdown measures across Europe has weighed on incoming data. Growth differentials still favour places like the US and UK above that of the EZ and alongside the clear monetary policy divergence means the bearish bias is firmly in place. On the fiscal front, attention is on ongoing discussions to potentially allow purchases of ‘green bonds’ NOT to count against budget deficits. If approved, this could drastically change the fiscal landscape for the EZ and would be seen as a big positive for the EUR and EU equities.
3. Funding Characteristics
As a low yielder (like JPY & CHF), the EUR has been a funding choice among carry trades, especially during 2019 where it was a favourite against high yielding EM. As such, part of the EUR’s upside after the initial risk-off scare in March 2020 was attributed to a major unwind of large carry trades. As more central banks start normalizing policy and rate differentials widen, the EUR’s use as a funding currency could add additional pressure in the med-term, but keep in mind it could also spark risk off upside if some of those trades unwind.
4. CFTC Analysis
Latest CFTC data showed a positioning change of +6976 with a net non-commercial position of +31560. The divergence between large specs and leveraged funds continue to grow as large specs added back longs in size, while leveraged funds still hold the biggest net-short among the majors. What does that mean, well it means be careful, because being on the wrong side of any of these can be painful. Thus, looking for clear short-term drivers apart from tactical positioning considerations might be the ‘safest’ way to trade the EUR right now. It seems like large specs chose the exact wrong moment to add back to EUR longs and could see some reduction in longs in the sessions ahead if the EURUSD does not manage to claim back key support at 1.1220-1.1240
5. The Week Ahead
For the week ahead the main focus for the EUR would be flash CPI data on Wed and then the ECB meeting on Thursday. The bank surprised markets at the Dec meeting with a less dovish than expected tilt on the QE side with the APP beefing up from March as the PEPP phases out but then reducing APP purchases incrementally throughout the year. After that surprise, markets are not expecting much from the Jan meeting in terms of policy adjustments or announcements, which means all focus will fall on the assessing the tone and language towards the inflation outlook. After the Dec meeting, CPI has continued to surprise higher (YY CPI at 5.0% & Core YY at 2.7%). Some participants expect the ECB to gradually move away from a ‘transitory’ expectation for inflation, but any pivot away from that could risk an aggressive repricing in rate expectations, with money markets already pricing in 10bsp of tightening in Oct followed by 10bsp more in Dec (that’s 2 hikes). Thus, focus will be on how strongly the bank sticks to their med-term inflation outlook and how much room they leave for faster asset purchase reductions if the incoming data prove them wrong. The Q&A will likely bring up current Russia/Ukraine tensions and how that could impact the inflation outlook.
USD
FUNDAMENTAL BIAS: BULLISH
1. Monetary Policy
The Jan FOMC decision was hawkish on multiple fronts. The statement signalled a March hike as expected, but the press conference from Chair Powell portrayed a very hawkish message. Even though Powell said they can’t predict the rate path with certainty, he stressed the economy is in much better shape compared to the 2015 cycle and that will have implications for the pace of hikes. Furthermore, the Chair explained that there is ‘quite a bit of room’ to raise rates without dampening employment, which suggests upside risks to the rate path, especially coming from Powell. A big question markets wanted an answer for was whether the Fed was
concerned about recent equity market volatility. However, the Chair explained that markets and financial conditions are reflecting policy in advance and stressed that in aggregate their measures they look at is not showing red lights. This was a clear message to markets that any ‘Fed Put’ is much further away and that inflation is the biggest focus point for the Fed right now. The Chair also didn’t rule out the possibility of hiking 50bsp in March or possibly hiking at every meeting this year, which was seen as hawkish as it means the Fed is looking for optionality to move more aggressive if they need to. On the balance sheet, we didn’t really get new info and the Chair reiterated that they are contemplating a start of QT after the hiking cycle has begun but also reiterated that they will discuss this in coming meetings. Overall, the tone and language used by the Chair were a lot more hawkish than the Dec meeting and more hawkish than some were hoping for.
2. Global & Domestic Economy
As the reserve currency, the USD’s usage around the world means it usually has an inverse correlation to the health of the global economy and global trade. The USD usually gains strength when growth & inflation both slow (disinflation) and loses ground when growth & inflation accelerates (reflation). Thus, with expectations that both growth and inflation will decelerate this year, both in the US and the globe, that should be a positive input for the USD in the med-term. However, incoming data will also be important in relation to the ‘Fed Put’. There are many similarities between now and 4Q18, where the Fed were also tightening aggressively going into an economic slowdown. So, incoming data will be crucial to watch. As long as growth data slows and the Fed stays aggressive that would be a positive environment for the USD, but if it causes the Fed to pivot more dovish and causes a rate repricing in money markets it would be seen as a negative input for the USD.
3. CFTC Analysis
Latest CFTC data showed a positioning change of +427 with a net non-commercial position of +36861. The shortterm unwinding of stretched USD longs played out as expected at the start of the year but was also short-lived in the midst of the recent strong risk off sentiment in certain parts of the market and of course the continued hawkish stance from the Fed.
4. The Week Ahead
In the week ahead the party starts all over again with a new month which means we’ll get new ISM PMI releases as well as the Jan NFP report. It’s important to keep the current economic climate in mind when looking at possible reaction functions for the USD. Usually, positive data should be USD positive and negative data USD negative when the Fed is busy with a hiking cycle, but right now there are growing fears that economic data has been slowing much faster than expected and means the Fed could be on its way to make the same mistake it did back in the end of 2018. As long as those fears persist, we might see the USD having two different reaction functions to growth and inflation data. Reacting inverse to growth data but acting correlated to inflation data. That makes this week’s incoming ISM data very interesting as the Dec data decelerated much faster than expected on the growth side, and a further miss might spark more fears about a faster slowdown. The tricky part for the USD in the week ahead is that both the ISM prints as well as the NFP report has inflation components with the ISM priced paid components and the Average Hourly Earnings on the NFP side. If growth data slows very fast that could be USD positive, but if inflation data starts decelerating much faster that could also be USD negative as it means less need for aggressive Fed policy. A tricky one for the week ahead.
FUNDAMENTAL BIAS: BEARISH
1. Monetary Policy
Less dovish than expected can sum up the ECB Dec decision. As expected, they announced that PEPP will discontinue from March 2022, but also announced a surprise decline in monthly purchases under the APP, which will see purchases increased to EUR 40bln from the current EUR 20bln from2Q22 and then subsequently lowered to EUR 30bln in 3Q22 and down to EUR 20bln in 4Q22. Markets were not expecting any reduced purchases under the APP, so expecting the APP amount to return to EUR 20 billion by end 2022 was less dovish than expected. On inflation there was no surprises with updated staff econ projections showing 2023 HICP at 1.8% which reiterated the bank’s view that inflation will return to below target in the med-term. President Lagarde struck a familiar tone regarding rates by reaffirming that rates are unlikely to rise in 2022. As usual, ECB sources provided more colour after the meeting by noting further disagreements among the GC, with hawks unhappy with extending PEPP reinvestments to 2024 and not setting an end-date to the APP, and of course argued that inflation risks as skewed higher. Overall, the ECB was less dovish than expected but the stark policy divergence with the Fed and BoE means the bias for the EUR remains tilted lower in the med-term.
2. Economic & Health Developments
Even though the recent activity data suggests the hit to the economy from previous lockdowns weren’t as bad as feared, the additional lockdown measures across Europe has weighed on incoming data. Growth differentials still favour places like the US and UK above that of the EZ and alongside the clear monetary policy divergence means the bearish bias is firmly in place. On the fiscal front, attention is on ongoing discussions to potentially allow purchases of ‘green bonds’ NOT to count against budget deficits. If approved, this could drastically change the fiscal landscape for the EZ and would be seen as a big positive for the EUR and EU equities.
3. Funding Characteristics
As a low yielder (like JPY & CHF), the EUR has been a funding choice among carry trades, especially during 2019 where it was a favourite against high yielding EM. As such, part of the EUR’s upside after the initial risk-off scare in March 2020 was attributed to a major unwind of large carry trades. As more central banks start normalizing policy and rate differentials widen, the EUR’s use as a funding currency could add additional pressure in the med-term, but keep in mind it could also spark risk off upside if some of those trades unwind.
4. CFTC Analysis
Latest CFTC data showed a positioning change of +6976 with a net non-commercial position of +31560. The divergence between large specs and leveraged funds continue to grow as large specs added back longs in size, while leveraged funds still hold the biggest net-short among the majors. What does that mean, well it means be careful, because being on the wrong side of any of these can be painful. Thus, looking for clear short-term drivers apart from tactical positioning considerations might be the ‘safest’ way to trade the EUR right now. It seems like large specs chose the exact wrong moment to add back to EUR longs and could see some reduction in longs in the sessions ahead if the EURUSD does not manage to claim back key support at 1.1220-1.1240
5. The Week Ahead
For the week ahead the main focus for the EUR would be flash CPI data on Wed and then the ECB meeting on Thursday. The bank surprised markets at the Dec meeting with a less dovish than expected tilt on the QE side with the APP beefing up from March as the PEPP phases out but then reducing APP purchases incrementally throughout the year. After that surprise, markets are not expecting much from the Jan meeting in terms of policy adjustments or announcements, which means all focus will fall on the assessing the tone and language towards the inflation outlook. After the Dec meeting, CPI has continued to surprise higher (YY CPI at 5.0% & Core YY at 2.7%). Some participants expect the ECB to gradually move away from a ‘transitory’ expectation for inflation, but any pivot away from that could risk an aggressive repricing in rate expectations, with money markets already pricing in 10bsp of tightening in Oct followed by 10bsp more in Dec (that’s 2 hikes). Thus, focus will be on how strongly the bank sticks to their med-term inflation outlook and how much room they leave for faster asset purchase reductions if the incoming data prove them wrong. The Q&A will likely bring up current Russia/Ukraine tensions and how that could impact the inflation outlook.
USD
FUNDAMENTAL BIAS: BULLISH
1. Monetary Policy
The Jan FOMC decision was hawkish on multiple fronts. The statement signalled a March hike as expected, but the press conference from Chair Powell portrayed a very hawkish message. Even though Powell said they can’t predict the rate path with certainty, he stressed the economy is in much better shape compared to the 2015 cycle and that will have implications for the pace of hikes. Furthermore, the Chair explained that there is ‘quite a bit of room’ to raise rates without dampening employment, which suggests upside risks to the rate path, especially coming from Powell. A big question markets wanted an answer for was whether the Fed was
concerned about recent equity market volatility. However, the Chair explained that markets and financial conditions are reflecting policy in advance and stressed that in aggregate their measures they look at is not showing red lights. This was a clear message to markets that any ‘Fed Put’ is much further away and that inflation is the biggest focus point for the Fed right now. The Chair also didn’t rule out the possibility of hiking 50bsp in March or possibly hiking at every meeting this year, which was seen as hawkish as it means the Fed is looking for optionality to move more aggressive if they need to. On the balance sheet, we didn’t really get new info and the Chair reiterated that they are contemplating a start of QT after the hiking cycle has begun but also reiterated that they will discuss this in coming meetings. Overall, the tone and language used by the Chair were a lot more hawkish than the Dec meeting and more hawkish than some were hoping for.
2. Global & Domestic Economy
As the reserve currency, the USD’s usage around the world means it usually has an inverse correlation to the health of the global economy and global trade. The USD usually gains strength when growth & inflation both slow (disinflation) and loses ground when growth & inflation accelerates (reflation). Thus, with expectations that both growth and inflation will decelerate this year, both in the US and the globe, that should be a positive input for the USD in the med-term. However, incoming data will also be important in relation to the ‘Fed Put’. There are many similarities between now and 4Q18, where the Fed were also tightening aggressively going into an economic slowdown. So, incoming data will be crucial to watch. As long as growth data slows and the Fed stays aggressive that would be a positive environment for the USD, but if it causes the Fed to pivot more dovish and causes a rate repricing in money markets it would be seen as a negative input for the USD.
3. CFTC Analysis
Latest CFTC data showed a positioning change of +427 with a net non-commercial position of +36861. The shortterm unwinding of stretched USD longs played out as expected at the start of the year but was also short-lived in the midst of the recent strong risk off sentiment in certain parts of the market and of course the continued hawkish stance from the Fed.
4. The Week Ahead
In the week ahead the party starts all over again with a new month which means we’ll get new ISM PMI releases as well as the Jan NFP report. It’s important to keep the current economic climate in mind when looking at possible reaction functions for the USD. Usually, positive data should be USD positive and negative data USD negative when the Fed is busy with a hiking cycle, but right now there are growing fears that economic data has been slowing much faster than expected and means the Fed could be on its way to make the same mistake it did back in the end of 2018. As long as those fears persist, we might see the USD having two different reaction functions to growth and inflation data. Reacting inverse to growth data but acting correlated to inflation data. That makes this week’s incoming ISM data very interesting as the Dec data decelerated much faster than expected on the growth side, and a further miss might spark more fears about a faster slowdown. The tricky part for the USD in the week ahead is that both the ISM prints as well as the NFP report has inflation components with the ISM priced paid components and the Average Hourly Earnings on the NFP side. If growth data slows very fast that could be USD positive, but if inflation data starts decelerating much faster that could also be USD negative as it means less need for aggressive Fed policy. A tricky one for the week ahead.