With currency markets currently operating within a holding pattern, now could be a good time to align future trading strategies to the objectives of central banks around the world. While there’s a watching brief warranted on numerous central banks right now, Chris Weston chief market strategist at IG says pondering a world in which the Fed finally exits its QE phase two should be ‘front and centre’ for all traders.
With the market currently moving through an adjustment phase, he says all eyes are on what a handful of central banks will do next. Central banks commanding closer attention include the European Central Bank (ECB), the Bank of Canada (BoC), Bank of England (BoE) and the Reserve Bank of NZ (RBNZ) which may not move as much as initially expected. “While NZ appears to have priced in far too much in rate hikes, the bold consensus is that the AUD will remain on hold for at least the remainder of the year,” says Weston.
With the Fed’s exit plans so well known to markets, Matt Simpson market analyst with TF Global Markets says a lack of tapering would cause more of a stir for the dollar than the tapering itself, as this would indicate that the Fed had miscalculated its timing. The Greenback is artificially weak due to QE and markets appear increasingly frustrated with the lack of solid clues from the Fed in regards to interest rate hikes – leading to choppy price action.
Nevertheless, Simpson suspects bullish opportunities may soon be occurring. Currently the USD Index trades at similar historical volatility levels to the lows of 2008, before it appreciated 13.5% in just under six months.
But given the Fed’s commitment to be out of the market by October at the very latest, Weston says the bigger issue confronting traders is what happens if the market front-runs the Fed’s decision, which he speculates could happen as early as July.
There are different thematics currently playing out, including a rallying Euro, due to the massive inflow into Italian debt, the ECB current account surplus, and the contraction of its balance sheet. However, Weston questions if these factors will still support if the ECB eases policy substantially. “With the Fed effectively pushing back on rate expectations, it’s fairly hard to be overweight in the USD at the moment. But if the Fed becomes hawkish then the USD will become a stronger currency,” says Weston. “We are already seeing signs of this playing out now.”
So assuming the market does front-run the Fed’s exit, the next question traders need to ask, says Weston, is which currencies should they pair it against? “The USD is the logical place to play this outcome and I would suggest USD/JPY and USD/Swiss due to the fact that both the SNB and BoJ still favour a much weaker currency,” advises Weston.
With equity movements acting as some sort of proxy, he says any deterioration in the S&P500 could lead to moves in fixed income, while the corporate credit default swap is yet another indicator to watch. A spike here will cause movement within other asset classes, and so he says it’s worth keeping an eye on bonds, although the reason behind the sell-off will always be a key determinant.
If you look at the nine prior cyclical bull markets since 1949 and you take the mean length (in days) that they have run, there’s a suggestion that the currency bull market could end in July. This could, adds Weston coincide with the trend break in the S&P and the ECB cutting its deposit rate into negative hence pushing EUR/USD lower.
“As you will see in the attached chart, the end of both QE1 and QE2 defines the trend line. At the bottom right you can see the divergence which creates lower highs, this sends a powerful signal that we could be in for a reversal,” says Weston.
With the value of US corporates in a healthy state, it’s difficult to determine how much of a pull-back we might see. But Weston says a pull-back to 1708-1710 would be a nice place for the market to come back to.
Simpson expects – what appears to be – a 6.4 year cycle to form a major trough sometime between July and August this year. “So I expect to become USD bullish around this time and pair it against weaker currencies – technically and fundamentally – such as the EUR, JPY and CAD.’
Beyond October, what the market wants to see, adds Weston is enough earnings growth to replace QE stimulus, and that means sufficient organic growth resulting in higher corporate profitability.
While a 10% pull back on the S&P500 to 1710 would mark a correction, Weston says it won’t be sufficient to signal bear market territory. Hedge funds are expected to be much more prevalent in the market once QE3 is over, and he also expects funds that like shorting to increase activity within this environment.
“The first step in the pullback is to recognise that QE3 is going to be over, secondly they’ll be a rotation into value plays, followed by a more pronounced risk-off in all sectors.”
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