The first thing we would like to say is that we continue to believe that a global currency war is percolating. Central banks around the world remain very sensitive to currency strength and in some cases will try and weaken their currency through actual policies and in other cases through verbal commentary.
There is a basic problem that policymakers are struggling to deal with today. Debt remains staggeringly high and in most cases higher than it was during the last crisis. Economic growth remains sub-par and yet central banks are close to “tapped-out” and politicians mostly seem incapable of pursuing sensible fiscal policies. The risk is that when all other policies have failed, policymakers will aim for “beggar thy neighbour” policies including currency depreciation. Although the timing is uncertain, the potential for some big FX moves in the months ahead is very much present today.
Two weeks ago, we discussed the Euro in the wake of Draghi’s post ECB meeting comments that he is “comfortable” taking action at the June meeting to counteract too low inflation that is depressed by too strong a currency. At the close of trading that week the EUR/USD rate was at 1.3758 and we said “...it is time to be short the Euro not just against the US Dollar but against a number of currencies.”
What has somewhat surprised us over the intervening two weeks is the absolute lack of any bounce in the EUR/USD rate. This tells us two things. First, buyers are not being proactive in stepping forward and are waiting for the market to come to them. Second, anyone waiting to sell any bounce is being frustrated. The further EUR/USD falls, the greater the potential for selling to become more urgent as longs remain trapped and un-invested bears fear missing out on an emerging bearish trend in the Euro. We take the lack of any bounce during the last two weeks as another bearish signal for the Euro.
Moving on, we think it is time to revisit the weak Yen trade. Fundamentally, the big picture remains the same in that the Japanese government is broke. Inflation via currency printing is the most palatable and easily implementable policy. Furthermore, PM Abe is very nationalistic and has bet his credibility on Abenomics succeeding where other administrations have failed. We believe that Abe is willing to do whatever it takes. His team know they need to print more money than anyone else, and so when they see the ECB teeing up another round of policies deigned to weaken the Euro, and after a period of weakness in the Chinese Yuan and no Yen weakness for 12 months now, we think it is just a matter of time before further reforms and Bank of Japan QE are announced.
Furthermore, we believe the market is giving a good signal that the 12 months of sideways consolidation in USD/JPY is coming to an end. The chart below shows the USD/JPY weekly chart. We have marked in blue arrows a pattern whereby following a period of consolidation, price has spiked lower (testing support levels) only to reverse higher by the end of the week/bar, leaving a “tail” or reversal pattern. For good measure, we have also shown the 40 week moving average which acted as support late last year and we look for the same this time after price tested the moving average mid week.
It is possible that emerging weakness in the Yen and the Euro are currency specific issues and not symptomatic of emerging US Dollar strength. There is little doubt that QE has been a significant headwind for the US Dollar, but this is changing. The Fed is well on its way to ending QE and even the doves like William Dudley are talking about the need for interest rates to rise and discussion of exit strategies will only increase in the months ahead. We would also stress that there are two new voters on the FOMC from next month; Stanley Fisher the new deputy chairman who is widely thought to be against forward guidance and likes to be much more traditional and data dependent, and also Loretta Mester the new Cleveland Fed Governor who is thought to be very hawkish indeed. It is our expectation that the USD strength will broaden out in the weeks ahead to become quite broad based.
USD/JPY FX rate and 3 month implied at the money (ATM) volatiity
Fundamentally, we believe that the US Dollar is undervalued after years of extreme Fed policy. With the ECB and BoJ set to be more aggressive, and many other central banks bemoaning too much currency strength, the time is coming for a period of US Dollar strength and this is being supported by improving price action. For the time being, we are positioning for US Dollar strength against the Euro and Yen, however, we are also open to broader strength and are monitoring several other opportunities at this time. We would also add that buying call options on the US Dollar is extremely cheap at the moment (3 month USD/JPY implied volatility is 60% cheaper than this time last year and basically at multi-decade lows – see chart above) and we believe that buying calls is a better way to position for any US Dollar strength compared to simple cash trades.