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As we roll into a new for financial markets it is worth reflecting on Friday’s session, as the moves we have seen have set a strong foundation for the week ahead.
Perhaps the most noticeable factor for me, which was largely overshadowed by Fed Chair Powell’s Jackson Hole speech, was the strength in the Chinese yuan. While I am sure many will disagree, a simple sense check and overlap of USDCNH (and USDCNY) with EURUSD and AUDUSD portrays that the yuan is central to G10 FX markets. So, the move lower in USDCNH from the start of European trade resonated through G10 FX markets, and while the market took Powell’s narrative as less hawkish than anticipated, we had already seen the USD sold going into his speech. Although it did provide the USD sell-off with further fuel.
(white – USDCNH, blue – USDEUR, orange – USDAUD)
(source: Bloomberg)
Keep an eye, therefore, on USDCNH through trade today, with a break below 6.8000 likely to receive attention, especially given the magnitude of the selling on Friday, with USDCNH having its biggest fall since January 2017 (-1.3%). For context, the PBoC has confirmed that it has altered the methodology by which it formulates its daily RMB ‘fixing’ rate. Reverting back to hedge or neutralise the pro-cyclicality in the FX market. In layman’s talk, this is another factor designed to keep the currency stable, with the Chinese authorities targeting capital outflows, which will materialise when there is a perception that the CNY is only going to weaken further. Capital flight acts as a tightening of financial conditions and negatively impacts economics if sustained.
One could make an argument that EURUSD should have fell on the session, given we have seen Italian 10-year bond yields widen six basis points against German 10-year bunds, with this premium now at 2.80% and threatening a test of the May highs of 2.90%. Italian press (Source: Corriere della Sera) have suggested that we could see Italy and the wider European Union facing a stand-off on budget laws, and on any given day this widening of sovereign spreads would have been seen as an EUR negative.
The weekend press has explored this issue of rising tensions further, where both Premier Conte and Deputy Di Maio have spoken out about EU migration demands. That said, EUR has seen limited moves on the FX open today and is feeding of the gains seen on Friday against all G10 currencies except the AUD. AUD was always going to be most sensitive to moves in the USDCNH cross. As a Segway, I am still bullish EURAUD but would look to roll some of this exposure into EURJPY, with the daily chart looking quite compelling, although as we head into September and the budget negotiations and reviews from rating agencies S&P and Moody’s, there will be a heightened risk to those calls.
There has been some focus on reports Donald Trump had offered to buy Italian bonds, which in itself opens up a can of worms given the growing tensions between the EU and the Italian Premier. Trump has made it clear he would welcome Italy leaving the EU and offering to buy their bonds would be encouraging to any Italians who embrace that idea. That said, Italy isn’t leaving the EU or EMU (European Monetary Union) anytime soon, if at all, and Trump needs to understand that if markets had Italy leaving the EU/EMU if their sights then the S&P 500 would see a sizeable drawdown and the US economy would head towards a fairly protracted recession. And, unless the Fed were going to buy unlimited amounts of BTPs and ‘do whatever it takes’ with increased coordination from the ECB, then it would be wholly unsuccessful.
The question then arises what to do with EURUSD. With the cross-currents of a move lower in USDCNH (and USDCNY), rising yield differentials between Italian and German bonds and a flatter yield curve in the US in play. The technicals, as always, aggregate this news flow and give us a roadmap and at this juncture, I wouldn’t be fighting the fairly positive tape. That said, the bottom of the i-cloud (on the daily chart) may act as near-term resistance at $1.1660 through trade today. However, with price holding above an upward sloping five-day EMA (exponential moving average) there is scope for a push into $1.1750 to $1.1780, where I would expect greater downside risks to emerge.
I touch on the US Treasury yield curve, and this remains a definite talking point among market participants, with both Fed members Bostic, Bullard and Kaplan all giving insights on this issue in speeches on Friday. We certainly haven’t seen any real concerns in either credit or equity prices on Friday, with high yield credit spreads narrowing three basis points and the S&P 500 closing at the new all-time high and setting the Asian equity open nicely with a 0.6% gain. However, the outperformance of long-end of the US Treasury curve is a consideration for USD bulls, and it’s hard to have firm conviction if the curve continues to flatten, while the upcoming US mid-term elections suggest the balance of risk here is tilted to a weaker USD.
It seems likely that at some stage in the next few weeks we will see the US 2s5s curve invert, and this will then bring the 2s7s curve towards inversion, and given I see scope for the 10-year to test the 2.64% to 2.62% area then we will be talking about an inverted US 2s10s Treasury curve and here the screams of recession risk will be deafening. US data will then be heavily digested this week, with consumer confidence, Q2 GDP (revision) and core PCE (personal consumption expenditure) in play.
AUDUSD should get good attention from local traders today and, as mentioned, the moves into $0.7330 have predominantly been driven by USDCNH. The Australian political situation has given traders some inspiration, but I would be fading that hope as the betting markets still have Labor winning the election fairly comfortably and the risk remains that we get gridlock in the Senate and concerns re-surfacing around Australia AAA-rating. We should see the rally capped and personally I would be looking at $0.7380 as a more attractive area to sell rallies into. Locally, we get Q2 private Capex expenditure, building approvals and private sector credit in play, while China manufacturing and service PMI data, released Friday, could also be a consideration.  
(Source: Bloomberg)
Published by Chris Weston, Head of Research, Pepperstone