FX Update: Final FX thoughts ahead of the US Election Night.Summary: The market seems to be putting on the reflationary trade today ahead of the uncertainties of the US Election as the USD and JPY wilt, while the AUD rushes higher after brushing off the well flagged easing moves from the RBA overnight. Any strong turn-out among Democrats could support an extension of this development, while a contested election scenario would very likely do the opposite.
Today’s FX Trading focus:
Market putting on reflation trade for Blue Wave scenario today
The market seems to be moving in favour of a Blue Wave scenario this morning, with the USD and JPY offered and commodity currencies generally bid, together with risk sentiment. AUD managing to rise back above 0.7100 is particularly impressive and shows how thoroughly the RBA easing overnight was fully priced in.
I generally agree with the consensus that a strong Democratic showing is a boost for the USD bears and especially commodity and EM FX on the prospects for a torrent of further stimulus next year that will not be offset with a big tax overhaul focus in the initial stages (counterproductive for the growth narrative), although the longer term risk of progressive adjustments to the US tax code loom as a spectre. Massive fiscal deficits in a reflationary economy that is hopefully mostly or fully moving beyond the Covid-19 pandemic by spring could mean heady moves in FX between now and next summer, if this view is correct. Such an outcome would favour positioning in upside optionality in AUDUSD call options for 3-6 months with additional spot trades if we see a Blue Wave outcome and the market reaction is supportive.
The wild card for me in the above that has me sitting slightly uncomfortably is the long end of the US yield curve and bets on a steepening there – the speculative market there seems long the 10 years and very short the 30-year T-bond. Is this a Fed yield-curve-control bet on the anticipation of exploding US yields on a Blue Wave outcome, or any outcome eventually? Certainly, the long-term weak US dollar argument is that US inflation will rise far faster than the Fed will make any adjustments to its policy rate under its new “flexible average inflation targeting” regime. And eventually, the Fed could super-charge USD weakness if it does decide to cap yields out to 10 years, for example if it fears that the rising yields are dampening the prospects for further improvements in the labour market. But for now, I’m curious if some kind of reversal of what seems a crowded trade is a risk and whether this has any implications for the US dollar as well.
The scenario market participants don’t want to see
As I have underlined nearly everywhere in my commentary on the US Election, the market fears most that this election will see a contested outcome in which the losing side refuses to concede and as I noted yesterday, the worst of worlds is the Murphy’s Law outcome in which the state of Pennsylvania is the deciding margin in the electoral college.
So despite a clear general lean in favour of a Democratic Blue Wave of sufficient magnitude to at least see the Democrats take marginal control of the Senate in addition to winning the presidency, there are plenty of market participants who are uncertain and who believe otherwise, so two-way risks are prominent on this election outcome. But really, few are well prepared for an ugly, contested election scenario if the vote proves close and the uncertainty drags out for days and weeks. In a contested election scenario, watch for hefty yield curve flattening in the US, a possible USD spike, but a very likely strong JPY spike and then ugly volatility in some of the currencies best positioned for the reflationary narrative, from commodity currencies to EM.
Chart: USDNOK weekly
Here is a currency pair on the major fault-line going into the Election result tonight – the US dollar versus the Norwegian krone. The US dollar outlook is heavily dependent on whether the negative US real rates (inflation running hot and far beyond the policy rate) story pans out next year and beyond in a Blue Wave election outcome (or even if Trump wins, really – but that realization would take far longer. The NOK outlook is reliant on the reflation narrative generally, on the oil market re-discovering its supply vs. demand balancing point, and linked to that on a global- and especially EU outlook improvement beyond the Covid-19 disaster. The pair has twice found resistance just above 9.50 and not far from the 200-day (40-week) moving average – and all USD/commodity currency and USD/EM pairs will be interesting to watch in the days after the election result. A weaker USD world and recovery in oil prices could have the pair trading close to 8.00 or lower by late next year.
John Hardy
Head of FX Strategy
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