October16

Greg Anderson ([email protected])

Stephen Gallo ([email protected])

Week of January 9, 2017

A long-USD market looks to central banks for direction 2017 has launched with several days of relatively choppy trading. Market participants came into the year bullish on the USD but moves by China and Mexico to cap USD strength helped push it lower mid-week. Solid data helped spur a USD recovery on Friday. This week doesn’t have a lot of first tier economic data, but there are key speeches by Fed’s Yellen and BoE’s Carney. The BoC releases two quarterly surveys and the ECB releases the minutes of its December meeting. There are also a number of secondary central bank speakers that will capture the FX market’s attention as it awaits further clarity on the first policy moves of the Trump presidency.

Brief summary of last week Financial markets started 2017 with a bang last week—particularly equities. The MSCI World equity index gained 1.8% for the week to put a nice exclamation point on its 5.3% gain in 2016. Interest rates generally followed equities higher; the USD-denominated 2Y swap rate rose 3bps while the EUR-denominated 2Y swap rate rose a fraction of a basis point. Commodities also fared well, with the CRB index gaining 0.5% last week (after a 9.9% return in 2016). In FX, Bloomberg’s liquidity-weighted USD index (BBDXY) was flat on the week (after gaining 2.8% in 2016). That final result understates the sharp day-to-day volatility, as shown in Figure 1. The USD started the year with a rally on Tuesday but was driven back on Wednesday and Thursday. The currencies of China and Mexico are key elements of BBDXY (and the Fed’s broad trade-weighted USD index). Both countries intervened against the USD, which seemed to feed through into the USD’s performance against other currencies too. China’s tactics helped make CNH the best performer. Mexico’s interventions on Thursday and Friday helped, but their influence was trumped by worries about Trump’s initial policies. The spectrum of 1W returns of the BBDXY currencies is shown in Figure 2. Figure 1. Bloomberg DXY daily returns

Figure 2. Spot returns against USD for week ended 06-Jan

Source: Bloomberg, BMO FX Strategy

Source: Bloomberg, BMO FX Strategy

FX market positioning According to the most recent Commitment of Traders report by the CFTC (for the close of Tuesday 03-Jan), the biggest currency position in notional terms is the short side of EUR, which was worth USD 20.3bn. It is normal for EURUSD to have the most activity and biggest positions, so we like to scale it by comparing the positions in each currency side to their respective 3Y maximums. By this metric, this week’s EUR short was sizeable but nowhere near its max. To be precise, it stood at 66% of its 3Y max. As shown in Figure 3, other currencies can also be compared to their 3Y extremes (by side). By that metric, short-JPY was the biggest position at 68% of its 3Y extreme. Short-GBP (61%), short-CHF (58%) and long-NZD (57%) are the other positions that are noteworthy.

Greg Anderson, Global Head of FX Strategy, +1 212 605 1409

Stephen Gallo, European Head of FX Strategy, +44 20 7664 8124

Canada Sales Toronto +1 416 359 8681 Montreal +1 514 282 5950

Europe Sales London +44 20 7248 0424

U.S. Sales Chicago +1 312 845 4080 New York +1 212 702 1284 San Francisco +1 415 591 2102

Asia Sales Guangzhou +86 20 8669 5148 Hong Kong +85 2 3406 0670 Shanghai +86 21 6136 3628

To gauge the size of positions in the USD itself, we look at the aggregate of {AUD,EUR,CAD,CHF,GBP,JPY,NZD}. For that aggregate, the long-USD side was worth USD 46.5bn, which is 77% of the 3Y max. That makes long-USD against the aggregate of other currencies the most crowded position. The aggregate short-USD position is worth 16.8bn (34% of 3Y max). The net position was therefore long-USD by 29.7bn—the biggest since 08-Dec-2015. As shown in Figure 4, the net long-USD position has surged over the past two weeks, but the Fed’s (narrow) USD index hasn’t moved higher with all that speculative buying. This disconnect doesn’t mean the USD will collapse, but it does mean that there is a vulnerability if ‘real money’ flows don’t come along to backfill the speculative positions. Figure 3. IMM leveraged funds’ positions by side and currency relative to historical extremes (USDmn)

Figure 4. IMM leveraged funds’ aggregate net position in USD against the 7 currencies in Figure 1 (USDbn)

Sources: CFTC, Bloomberg, BMO FX Strategy

Sources: CFTC, Bloomberg, BMO FX Strategy

Big dollar deliberations There continue to be two main factors driving the US dollar. The first is expectations regarding Fed policy. Those expectations have been relatively static over the past two weeks, with markets continuing to price in slightly more than two hikes in 2017 vs the three hikes that were communicated in the December FOMC. We think it is unlikely that Fed-speak closes that gap this week, but it’s not impossible. There are six Fed speakers on the docket this week, including Chair Yellen on Thursday. We look for Fed hawkishness to continue to support the USD and keep any dips shallow. We would generally be USD buyers on dips, despite the risk of further positioning squeezes. The other factor that is in the background for the USD is the political transition and outlook for new tax policies such as a VAT-like ‘border tax’ on foreign goods and a reduced taxation window for unrepatriated overseas earnings. The former of those two policies seems to be getting the most airplay with key powerbrokers in Congress at present. We would view news that raises the likelihood of either tax reform being enacted as unquestionably USD positive. Markets have been left to sit long-USD while wondering if and when news to support their rising-USD thesis will emerge. We don’t think it’s this week. The way things look right now, corporate tax reform is unlikely to hit the Congressional agenda until roughly April.

CAD considerations CAD rallied 1.5% against the USD last week. It also gained 1.5% on a trade-weighted basis. Strong trade and employment data helped CAD outperform on Friday. Canada’s trade surplus for November suggests that Canada may be able to return to balanced trade with oil above $50—even if Trump and the strong CAD steer a bit more production into the US in 2017. Another key factor behind CAD strength for the entire week was the rise in commodity prices. Spot WTI grade crude only gained 0.5% last week, but Western Canada Select rose 6.2% to an 8-month high. If that trend continues this week, CAD can continue to outperform other G10 currencies. However, if that factor stagnates, USDCAD will go back to being Fed driven, which favors further USDCAD upside in our view. We reiterate that we would be USD buyers below 1.3200. For more on that thought, see our latest CAD Monthly (look for it under News & Insights).

The key event for Canada this week is Monday’s joint release of the BoC’s Quarterly Business Outlook Survey and Senior Loan Officer Survey. After a positive evolution in October, our economists aren’t looking for much of a change in tone in January, but strong Canadian data in Q4 leaves open the possibility of further CAD-positive headlines. See page 10 of 06Jan2017 Focus for more on the surveys.

RMB: temporary pause ahead of some further depreciation As noted previously, last week’s price action in USDRMB resulted in a cumulative 1.8% rally in the CNH. For RMB, this is enormous volatility. We don’t think the size or the timing of the move were accidental. Coming at very beginning of 2017, we think PBoC is clearly signalling a preference for limited RMB weakness in the year ahead. PBOC’s behaviour towards the USDCNY mid-rate has indicated a preference for resisting RMB weakness for months. That same behaviour was still evident last week, and we expect it to persist for the time being (Figure 5). China reported over the weekend that its FX reserves account dropped by USD41bn to $3,011bn. December’s decline was slightly less-than-expected. According to our calculations, which adjust for the likely valuation change due to the decline in bond prices and in various currencies, China’s actual reserve account net flow in December was a bleed of $57 billion, which was more than the officially reported bleed of $41 billion. However, on a valuation-adjusted basis, the net flow for the whole of 2016 was an FX reserve build of $62 billion, vs. bleed of $102 billion in 2015. We expect 6.90/6.92 to be a point of key resistance this week, especially in light of the rise in 3M HIBOR. That rate ended last week above 10.5%. For those with a 2-3M investment horizon, we would view any dip below 6.80 as a good buying opportunity. We think USDCNH is likely to again challenge the 7.00 area within 2-3M. For the week ahead, the most important data point is December’s trade balance release on Friday. The data will allow analysis of whole-year exports and imports, which is an important topic geopolitically. Ahead of that, December CPI data will be released on Tuesday. We think a hotter-than-expected CPI reading would be another reason to avoid getting aggressively short of the CNH in the 6.90/6.92 range, since elevated inflation is unlikely to make PBoC comfortable with aggressive weakness in its currency. Figure 5. USDCNY mid-rate vs USDCNY spot

Figure 6. EURUSD spot vs 5Y swap rate differential

Source: Bloomberg, BMO FX Strategy

Source: Bloomberg, BMO FX Strategy

EUR rangey ahead of next week’s ECB rate decision Last week was marked by the liquidation of short-EURUSD positions that were initiated below the 1.0500 mark. The move higher was more sparked by USD weakness than EUR strength, but rising German and Eurozone CPI prints didn’t help matters for EUR shorts. Rising German inflation and calls from Germany for a quicker end to ECB QE pinpoint a distinct area of tension. However, we do not believe higher levels that result from those tensions should be viewed as near-term EUR buying opportunities, especially with French and Italian credit spreads still relatively wide. Moreover, some swap rate differentials suggest levels above the 1.0550 mark in EURUSD are expensive (Figure 6). With so many Eurozone political risks on the horizon, we would view any rallies above 1.0600 as good selling opportunities. The data calendar is sparsely populated this week. The key event is likely to be the release of the December ECB meeting on Thursday. Given the convoluted outcome of the December ECB meeting, we don’t think the minutes will

include any firm signals from the ECB on policy as of this stage, as there currently seems to be a significant amount of tension between the doves and the hawks within the Governing Council. Investors are already looking towards the th ECB rate decision on January 19 as the best opportunity for direction. We expect the 1.0350 level to continue to offer strong support this week.

GBP: political risks still dominate The GBP suffered the biggest decline among G10 currencies last week. This happened despite strong UK survey data and readings on consumer credit. The press and FX market are renewing their fretting about the lack of a clear plan for Brexit from 10 Downing Street. Since this week is not a huge one for UK data (November trade, industrial output data and December’s GDP estimate from NIESR are due on Wednesday), we would expect the aforementioned theme to stick. Therefore, weaker data prints would likely carry more weight than stronger ones. However, by and large, FX investors are in a holding pattern on the GBP until the government’s Brexit strategy becomes clearer, and we expect GBPUSD to remain confined to a 1.2150/1.2400 range. The lack of Brexit-related developments has caused swap rate differentials to drop completely out of the equation for GBPUSD, and this should also help contain price action in the pair. In EURGBP, we expect continued resistance in the 0.8630/50 range.

Yen super volatile again Last week was another wild ride in USDJPY. The pair rallied above 118 early in the week and then nearly broke below 115 about 36 hours later. A rebound back to a low 117 handle put the pair right where it started the year in terms of level, but it is a whole lot emptier in terms of positioning for the moment. We believe the market’s bias is to be long and to want to buy on dips, but dips are always frightening to manage in this pair. We look for another run at 118 this week, so we would be tepidly long here. The key data point for the week is November Balance of Payments data, which is released on Thursday. Japan’s current account surplus grew substantially in 2016, but higher oil prices should eat into that, so that is the key issue to watch from the data. If Japan’s current account surplus shows no signs of stabilizing, the market will be reluctant to take USDJPY above 120 due to worries that the country won’t be able to consistently recycle its surplus.

Weekly Economic Diary: G10 (and China) Europe

th

th

th

th

Thursday (12 )

Friday (13 )

FR Nov Industrial/Manuf. Prod’n, Bank of Italy Publishes Monthly Report “Money and Banks”

SP Nov Industrial Output

FR Dec F CPI, EC/IT Nov Industrial Prod’n, ECB Publishes Account of Monetary Policy Meeting

SP Dec F CPI

U.K.

Dec Halifax House Price, BoE bond buying operation

BRC Like-fo-Like Sales (Dec), BoE bond buying operation

Nov Trade Balance, Nov Industrial Prod’n, Nov Construction Output, BoE’s Carney Parliament testimony

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BoE’s Saunders speaks

Sweden

-

Nov Industrial Prod./Orders, Dec Budget Balance

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Dec PES Unempl., Dec CPI, Riksbank Bond Purchase Results

Riksbank I/L Bond Purchase Results

Norway

-

Dec CPI, Dec PPI

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Norges Bank’s Nicolaisen in panel debate

Switzerland

Nov Retail Sales, SNB Preliminary Full-Year Results, SNB Sight Deposits

Dec Unempl.

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-

North America

Monday (9 )

Tuesday (10 )

United States

Nov Consumer Credit, Fed’s Rosengren & Lockhart speak

Canada

4Q BoC Business Outlook Survey & Senior Loan Officer Survey

Asia

Monday (9 )

Japan

Market Holiday

GE Nov Industrial Prod., GE Nov Trade Balance, FR Dec Bank of France Sentiment, EC Nov Unempl.

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th

Tuesday (10 )

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Wednesday (11 )

Eurozone

Monday (9 )

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th

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-

th

th

Wednesday (11 )

Thursday (12 )

Friday (13 )

Dec NFIB Small Bus. Optimism, Nov F Wholesale Trade

Weekly MBA Mortgage Apps.

Dec Import Price Index, Weekly Jobless Claims, Fed’s Harker, Evans, Lockhart & Bullard speak, Fed’s Yellen Q&A session

Dec PPI, Dec Retail Sales, Nov Business Invent., Jan P U of Mich. Sentiment, Dec Monthly Budget Statement

Dec Housing Starts, Nov Building Permits

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Nov New Housing Price Index

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th

th

th

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Tuesday (10 )

Wednesday (11 )

Thursday (12 )

Friday (13 )

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Nov BoP Current Account Balance

Dec Eco Watchers Survey, Dec Money Stock M2/M3

Australia

Nov Building Approvals

Dec Foreign Reserves, Nov Retail Sales

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New Zealand

REINZ House Sales

Dec QV House Prices

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China

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Dec CPI, Dec PPI

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Dec Trade Balance

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