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 PEPP, 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 massive climb in case numbers across Europe have seen more restrictive measures which will drag on growth. Further lockdown measures will probably see a further divergence in growth differentials between the EU and other major economies (and combined with ongoing central bank policy divergence) the fundamental outlook remains bearish. On the fiscal front, attention is still on ongoing discussions among EU states to potentially allow the purchase of green bonds NOT to count against budget deficits. Such a decision could drastically change the fiscal picture and we would expect it to be a big positive for the EUR and EU equities if that change should come to pass.
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 +18579 with a net non-commercial position of +24584. The divergence between large speculators and leveraged funds continue to grow as large specs added back 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.
5. The Week Ahead
In the week ahead, the majority of focus for the EUR will fall on the overall trajectory for the USD, with plenty of big events that can spark some meaningful short-term reaction in the Greenback. Thus, keeping track of the USD will be a very important driver for the EUR across the board. The currency’s low yielding characteristics does mean that further attention on the overall risk sentiment will be important in the week ahead as well. We also have a fresh round of flash PMI’s due for the Eurozone on Monday, which can often create some shortterm volatility for the single currency, and after the softer than expected forward-looking growth data out of the US in the past two weeks the EU PMI data is slightly more interesting.
USD
FUNDAMENTAL BIAS: BULLISH
1. Monetary Policy
The Fed turned a lot more hawkish than expected in Dec. They doubled the pace of tapering to $30 billion per month which will see QE concluded by March 2022 as was widely expected. Surprisingly though the Summary of Econ Projections showed the median dot plot pencilled in 3 hikes for 2022 (up from the previous 1), confirming Fed Fund Future expectations. Fed Chair Powell explained they hadn’t decided whether to pause between the end of tapering and a first hike but reiterated that rates will likely only rise when QE has concluded. Another positive shift was Powell’s comments that they could raise rates before full employment has been met due to high inflation , and stated that with inflation above target, they cannot wait too long to get to maximum employment as current inflation levels is seen as a threat to max employment. The hawkish tilt went further to note that the bank started discussing the balance sheet but said no decisions were made on when QT might commence. Even though the dots projected 3 hikes for 2022, the updated rate trajectory only showed 1 additional hike over the forecast horizon, which combined with a lower terminal rate was less hawkish than some had feared. Nonetheless, the meeting marked a material hawkish shift from the Fed, putting it on par with the likes of the RBNZ. The meeting minutes also revealed that the QT discussion saw majority of members thinking it appropriate to start QT soon after rate lift off and another more hawkish tilt than expected from the Fed.
2. Global Risk Outlook
The growth & inflation outlook for the US and the globe will be key for the USD. The USD is often inversely correlated to global growth & inflation , doing bad during reflationary environments (growth and inflation accelerating), while the USD usually does well in disinflationary environments (growth and inflation decelerating). 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 to see how the Fed responds to it, where a worsening outlook that deteriorates much faster than expected could see a dovish pivot from the Fed which could mean downside for the USD if money markets start pricing out hikes (especially with markets now expected just over 4 hikes for 2022).
3. CFTC Analysis
Latest CFTC data showed a positioning change of -1458 with a net non-commercial position of +36434. The shortterm unwinding of stretched USD longs played out exactly as expected but was also short-lived in the midst of the recent strong risk off moves in certain parts of the market. Surprisingly, the big flush lower in the USD has not showed up in the CFTC data as expected with very little change to the overall positioning. In the current context, the stretched long positioning makes the USD vulnerable in the event that the Fed does not deliver the very hawkish tone expected of them in this week’s upcoming FOMC meeting.
4. The Week Ahead
For the USD the big focus this week will be overall risk sentiment and the first FOMC meeting for 2022 on Wednesday, followed by Friday’s Core PCE and Employment Cost index prints. The latter will of course be important given the inflation outlook with more emphasis recently on the odds of a possible wage spiral affect. However, the main event will be the FOMC, where the meeting is expected to serve as a signalling meeting to pave the way for a 25bsp hike in March and to provide more clarity on the bank’s balance sheet plans. With a March hike sitting close to a 90% probability, and markets already fully pricing in 4 hikes this year, the bar has been set quite high for a hawkish surprise. However, there are also some participants that think the recent econ data ( CPI YY >7% and Unemployment <4%) justifies an early end to the Fed’s QE program instead of allowing tapering to run it’s planned course until March. That would certainly give a more hawkish feel to the meeting and could see markets pricing in an even earlier and faster pace of QT if confirmed. But, if the Fed does not deliver on an early end to QE , and does not offer a strong enough signal that the 4 hikes priced by the market is justified, we could be in store for some moderation in the rise in yields and the USD and could also prove to be supportive for equities which ended last week in quite bad shape.
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 PEPP, 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 massive climb in case numbers across Europe have seen more restrictive measures which will drag on growth. Further lockdown measures will probably see a further divergence in growth differentials between the EU and other major economies (and combined with ongoing central bank policy divergence) the fundamental outlook remains bearish. On the fiscal front, attention is still on ongoing discussions among EU states to potentially allow the purchase of green bonds NOT to count against budget deficits. Such a decision could drastically change the fiscal picture and we would expect it to be a big positive for the EUR and EU equities if that change should come to pass.
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 +18579 with a net non-commercial position of +24584. The divergence between large speculators and leveraged funds continue to grow as large specs added back 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.
5. The Week Ahead
In the week ahead, the majority of focus for the EUR will fall on the overall trajectory for the USD, with plenty of big events that can spark some meaningful short-term reaction in the Greenback. Thus, keeping track of the USD will be a very important driver for the EUR across the board. The currency’s low yielding characteristics does mean that further attention on the overall risk sentiment will be important in the week ahead as well. We also have a fresh round of flash PMI’s due for the Eurozone on Monday, which can often create some shortterm volatility for the single currency, and after the softer than expected forward-looking growth data out of the US in the past two weeks the EU PMI data is slightly more interesting.
USD
FUNDAMENTAL BIAS: BULLISH
1. Monetary Policy
The Fed turned a lot more hawkish than expected in Dec. They doubled the pace of tapering to $30 billion per month which will see QE concluded by March 2022 as was widely expected. Surprisingly though the Summary of Econ Projections showed the median dot plot pencilled in 3 hikes for 2022 (up from the previous 1), confirming Fed Fund Future expectations. Fed Chair Powell explained they hadn’t decided whether to pause between the end of tapering and a first hike but reiterated that rates will likely only rise when QE has concluded. Another positive shift was Powell’s comments that they could raise rates before full employment has been met due to high inflation , and stated that with inflation above target, they cannot wait too long to get to maximum employment as current inflation levels is seen as a threat to max employment. The hawkish tilt went further to note that the bank started discussing the balance sheet but said no decisions were made on when QT might commence. Even though the dots projected 3 hikes for 2022, the updated rate trajectory only showed 1 additional hike over the forecast horizon, which combined with a lower terminal rate was less hawkish than some had feared. Nonetheless, the meeting marked a material hawkish shift from the Fed, putting it on par with the likes of the RBNZ. The meeting minutes also revealed that the QT discussion saw majority of members thinking it appropriate to start QT soon after rate lift off and another more hawkish tilt than expected from the Fed.
2. Global Risk Outlook
The growth & inflation outlook for the US and the globe will be key for the USD. The USD is often inversely correlated to global growth & inflation , doing bad during reflationary environments (growth and inflation accelerating), while the USD usually does well in disinflationary environments (growth and inflation decelerating). 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 to see how the Fed responds to it, where a worsening outlook that deteriorates much faster than expected could see a dovish pivot from the Fed which could mean downside for the USD if money markets start pricing out hikes (especially with markets now expected just over 4 hikes for 2022).
3. CFTC Analysis
Latest CFTC data showed a positioning change of -1458 with a net non-commercial position of +36434. The shortterm unwinding of stretched USD longs played out exactly as expected but was also short-lived in the midst of the recent strong risk off moves in certain parts of the market. Surprisingly, the big flush lower in the USD has not showed up in the CFTC data as expected with very little change to the overall positioning. In the current context, the stretched long positioning makes the USD vulnerable in the event that the Fed does not deliver the very hawkish tone expected of them in this week’s upcoming FOMC meeting.
4. The Week Ahead
For the USD the big focus this week will be overall risk sentiment and the first FOMC meeting for 2022 on Wednesday, followed by Friday’s Core PCE and Employment Cost index prints. The latter will of course be important given the inflation outlook with more emphasis recently on the odds of a possible wage spiral affect. However, the main event will be the FOMC, where the meeting is expected to serve as a signalling meeting to pave the way for a 25bsp hike in March and to provide more clarity on the bank’s balance sheet plans. With a March hike sitting close to a 90% probability, and markets already fully pricing in 4 hikes this year, the bar has been set quite high for a hawkish surprise. However, there are also some participants that think the recent econ data ( CPI YY >7% and Unemployment <4%) justifies an early end to the Fed’s QE program instead of allowing tapering to run it’s planned course until March. That would certainly give a more hawkish feel to the meeting and could see markets pricing in an even earlier and faster pace of QT if confirmed. But, if the Fed does not deliver on an early end to QE , and does not offer a strong enough signal that the 4 hikes priced by the market is justified, we could be in store for some moderation in the rise in yields and the USD and could also prove to be supportive for equities which ended last week in quite bad shape.