A few days away from markets and the financial backdrop has evolved and thrown up some interesting dynamics which should be explored.
I won’t dwell on reports around Rod Rosenstein and the Mueller investigation, although some have suggested reports the deputy attorney has offered his resignation was an influence on sentiment and could explain some of the variability behind the 0.4% fall in the S&P 500. Personally, I see this as a sideshow, for now, on what are the more dominant issues at hand.
Firstly, moves in global fixed income and rates markets, both on a nominal and ‘real’ (inflation-adjusted) have to be on the radar, as they scream of policy normalisation and a view that central banks are on the move here. Many have been intently focused on the US markets here, with the likes of 10-year Treasury pushing above and holding 3%, but we can also see 10-year ‘real’ Treasury sitting at 92 basis points, and the highest since March 2011.
This is not a good look for emerging markets, and while there are other factors in play, the idea that investors can get a better ‘real’ return in US assets only incentives capital to head towards the US. We can also see that interest rate markets are rich ahead of this weeks FOMC meeting, with a full 25bp hike priced for this meeting and 19bp for the December meeting (a 76% probability of a hike). It seems the algo’s will be most intently reacting to the wording around the Fed’s current ‘accommodative’ stance on monetary policy. One strongly suspects that if this is wording in the statement is left unchanged, it would be the trigger to suggest the market is still under-pricing rate hikes and USD upside should be easy to come by versus the JPY and CHF.
We should also be focused on Europe, where two-year German bunds have moved from -65bp on 13 August to currently sit at -50bp. We can also see this reflected in Euribor (euro interest rates), where traders have moved its pricing structure, with the market effectively pricing 19bp of hikes by the end-2019, with 59bp of hikes priced between December 2018 to December 2020, with this spread the widest since June. We can also see the 10-year German bund at 51bp and breaking out too. The market is responding, not just to moves in oil, which is a strong influence on European inflation expectations, but also the recent dialogue from ECB members Coeure, Praet, Nowotny and overnight Mario Draghi, who suggested that a stable inflation profile conceals a relatively vigorous pickup in underlying inflation.
(Euribor Dec2018 – Dec2020 – interest rate normalisation on the move)

So, without going into depth on each speech, the bottom line is the ECB is preparing the world for an end of QE, but also, if economics continue on their current path, for higher interest rates and a normalisation of policy. This makes the EUR a pretty attractive currency to own, especially against the AUD and NZD. I am warming to EURUSD longs, but the pair really needs to clear 1.1800, upon which we could be looking at a move into the 1.20 handle. Perhaps this could be on the cards this week if the Fed drop its ‘accommodative’ stance on monetary policy, which again is a big ‘if’, but it is not out of the realms of possibility.
The Brexit negotiation is a theme close to my heart, and a thematic that undoubtedly has the potential to create sizeable volatility in GBP and gilts. On the session, we can see GBPUSD found buyers easier to come, with GBPUSD hitting a session high of 1.3167 and holding the figure with comments from UK negotiator Dominic Raab helping reverse some of the building negative GBP sentiment. For me, GBP is almost untradeable on any chart over a four-hour timeframe, given flows have been premised purely on political headlines and we see all roads leading to a turbulent October and November. A lot of the institutional money is merely steering clear of GBP until we get clarity, and that ain’t coming anytime soon, and that increases the prospect of a more significant move as liquidity is less abundant.
Oil prices are another huge talking point too, with both Brent and US crude pushing to new highs in the recent bullish run. The flow-through into higher inflation expectations is one thing that needs to be monitored, but it’s interesting that we hear a number of bullish calls from oil research houses, with calls for $100 by year-end. We’ve heard that record before in mid-2008, and that proved to be a super contrarian call. That said when we hear OPEC raising its forecasts for consumption in 2020 while refraining to heed Trump’s calls to increase production and naturally the tailwind for an appreciating oil price are prevalent. It’s just as well there are no sanctions Trump can place on this organisation.
Published by Chris Weston, Head of Research, Pepperstone