EUR USD - FUNDAMENTAL DRIVERSEUR
FUNDAMENTAL OUTLOOK: WEAK BEARISH
BASELINE
Inflation >9% saw the ECB hike rates 75bsp at their September meeting, with post ECB sources saying the bank is planning to discuss Quantitative Tightening at the October meeting. It seems like President Lagarde learnt from here July mistakes by being very careful not to give any clues away on where the ECB thinks the terminal rate is. On spread fragmentation, the bank didn’t provide any new info, and didn’t add any new clarity on how the eligibility might impact how countries like Italy and Spain will be able to take advantage of the tool in the first place. Until the BTP/ Bund spread reaches above 2.55% markets we’ll have to wait and see whether this program can make a difference. Even though policy is important, the main driver for the EUR is the economic outlook. Recent Nord Stream comments opened up a lot of potential downside risks, but for now markets need more details on how it’ll impact energy levels in the winter. Apart from that, focus will also turn to the ongoing Ukraine/Russia war where weekend developments have been more positive.
POSSIBLE BULLISH SURPRISES
De-escalation or cease fire in Ukraine would open up a lot of EUR upside. Stagflation risks remains, but with lots of bad news priced any materially better-than-expected data could spark some relief. Any TPI comments that convinces markets it can solve spread fragmentation issues should be supportive for the EUR. If Russia re-opens Nord Stream gas flows, it should be a positive catalyst for the EUR. If gas storage levels, see Europe through winter that could ease some of the pressure so storage levels will be watched.
POSSIBLE BEARISH SURPRISES
Any escalation in the Ukraine war that risks including NATO would be big negative risks. Stagflation risks remains, even with lots of bad news priced any materially worse-than-expected data could see more pressure. If ECB fails to act on the TPI when we see big jolts higher in the BTP/ Bund spread could trigger bearish reactions in the EUR. If Russia keeps Nord Stream one shut, it should add downside risks to the EUR. If gas storage levels are not enough to see Europe through the winter that should increase energy supply concerns for the EUR.
BIGGER PICTURE
The fundamental outlook remains bearish with recent leading indicators pointing to a much faster economic slowdown than markets previously expected. The current bearish drivers (geopolitics, stagflation, spread fragmentation, energy supply concerns) far outweigh the positives from a hawkish ECB. Recession risks have opened up a narrative change for the EUR which have seen markets adjust forecasts to reflect higher recession probabilities which has continued to weigh on the EUR. However, with lots of bad news priced in there is risks in chasing the EUR lower from the current levels, which means waiting for more attractive levels to short or waiting for a strong enough catalyst to short would be the preferred strategy for the EUR right now.
USD
FUNDAMENTAL OUTLOOK: BULLISH
BASELINE
With headline CPI above 8%, the Fed is under pressure to continue hiking rates and ramping up QT this month to try and bring demand and supply back in balance. They hiked rates 75bsp in July, and whether they go 50bsp or 75bsp in September will come down to this week’s CPI . At the Jackson Hole the Fed took a hawkish turn by pushing back against rate cuts in 2023 and stressing they not only envision hiking rates to close to 4% by early 2023 but also expect to keep rates high throughout 2023. However, the Fed did announce a data-dependent (meeting-by-meeting) policy stance in July, explaining that the pace of hikes is likely to slow as rates get more restrictive and as more data becomes available. This means incoming growth, inflation and jobs data will be key drivers for short-term USD price action where we expect a cyclical reaction to incoming data (good data being good for the USD and US10Y and bad data being bad for the USD and US10Y ). Even though a resolute Fed can put further cyclically driven pressure on bonds and equities and support the USD, the most recent economic data has painted a bit of a goldilocks environment where most growth & labour data has surprised higher while inflation data has surprised lower. This has seen some ‘soft landing’ expectations surfacing which we would expect to support equities and bonds and to pressure the USD should the goldilocks pattern with incoming data continue.
POSSIBLE BULLISH SURPRISES
With the Fed signalling a data dependent policy stance, we expect a cyclical reaction from the USD with incoming US data. Thus, extremely good growth, inflation or jobs data is expected to trigger short-term bullish reactions in the USD. If the cyclical outlook continues to weaken, the USD’s safe haven status still matters. Any incoming data that exacerbates fears of a deep recession and triggers strong moves lower in risk assets & bonds can trigger safe haven flows into the USD. Various data is pointing to downward pressure on CPI , enough for 1-year inflation expectations to trade below the Fed’s 2% target. With the ‘peak inflation’ narrative back in full force, a huge upside surprise in CPI this week could disappoint risk buyers and see further upside pressure on the USD.
POSSIBLE BEARISH SURPRISES
With the Fed signalling a data dependent policy stance, we expect a cyclical reaction from the USD with incoming US data. Thus, extremely bad growth, inflation or jobs data is expected to trigger short-term bearish reactions in the USD. With some growing expectations of a possible ‘soft landing’ for the US economy surfacing, further goldilocks data (higher growth & labour but lower inflation ) could trigger safe haven outflows from the USD and into US equities. With a lot priced in for the Fed and the USD, it won’t take much to disappoint on the dovish side. With the Fed in their blackout period, all eyes will be on the incoming data. If inflation confirms new calls for peak inflation with another miss across the board that could trigger downside for the USD.
BIGGER PICTURE
The fundamental outlook for the USD remains bullish as long as the Fed stays hawkish and cyclical concerns put pressure on risk assets. But the data dependence stance from the Fed means that short-term data surprises can pull the USD either way. The recent string of data has triggered some ‘soft landing’ expectations for the US economy, which is expected to weigh on the USD given all of the safe haven inflows based on recession fears. In the short-term, with positioning in mind, and speculation of both ‘peak inflation’ and a ‘soft landing’, we would expect a softer USD in the week ahead running into the CPI print. A beat or a big miss can create equally big reactions in the short-term, but we would prefer shorting opportunities on a surprise CPI miss.
