Fundamental FX Factors To Watch Focus:
- A parallel move in the US yield curve may be upon us as inflation fears are heating up
- WTI Crude oil has recently broken toward $70/bbl and its taking inflation breakevens along for the ride
- Haven currencies are on the defensive as the carry trade gets revived
- The Fed and yield curve disagree, but who will win?
Focusing on the Federal Reserve as the key determinant of where markets were heading was so two years ago. Now it seems that forces beyond their control (gasp at the thought) are dictating the market’s focus. The force is in a word, inflation.
The IEA Chief Economist, Fatih Birol said it best earlier this week on a Bloomberg Interview when he said that those who wanted inflation and higher prices should be careful what they wish for because they just might get it. It is referring to inflation as Birol was referring to the sharp drop in Venezuelan output, which has turned the economically strained company to a net-importer as a key concern for the market that could in turn only add to the supply shocks that are driving up crude oil prices.
As a key proponent of intermarket analysis, I often preach that no market can be seen as an island. What shocks happen in one market will often have spill-over effects and crude oil’s spillover effect to fixed income, a key proxy for inflation expectations is ground zero.
Chart: Inflation Expectations Are Rising Alongside Crude Oil
Data source: Bloomberg
As you can see on the chart above, inflation expectations per the US 10Yr Breakevens are pushing higher alongside crude oil. However, crude oil is not the only inflation factor in town that’s on a tear. The massive Aluminum squeeze that has recently seen prices rise by the most since 2012 as a global downstream user of the non-ferrous metal contest with supply shocks due to US sanctions on Russian giant, United Co. Rusal, the biggest non-Chinese supplier.
The inflationary developments were met with NY Fed President, Bill Dudley who said that there was no real need for the Fed to be more aggressive given inflation remains below target. However, inflation has a habit of getting out of hand fast and a quick look at the front-end of the US yield curve shows us that once again, bond have it figured out, and it’s not good. The Fed is in a pickle of their own making with a little help from OPEC-Russia.
WTI Crude Oil Nears $70 despite OPEC Saying Mission Nearly Accomplished
At a meeting in Jeddah between the Joint Technical Committee of OPEC and non-OPEC nations, reports came that the producers’ target of reducing global oil stocks back to the 5-year average was nearly accomplished. However, crude traders appear to be looking beyond as the backwardation in the energy market is showing a Brent curve with a bullish skew that is the highest in four years.
Brent Oil Backed By Tightening Physical Market
The rise in the blue area on the chart shows a premium being paid for the front-month contract of December 2018 relative to the back-dated contract of December 2019. The premium was the highest ever for this particular contract and the highest spread in four-years when Crude was trading above $100 on the Dec.-Dec. spread.
Given the broad-based gains of the commodity sector and that futures traders continue to pay a premium as the benefit to buying and carrying now are expected to exceed the costs through December 2019 this warrants our attention. Commodity markets are by nature, fractious meaning that multiple forces like sanctions, supply cuts, tariffs and more can cause these markets and inflation expectations to push higher, which could weaken low-yielding haven currencies like the Japanese Yen further.
Haven Currencies Sell Off as the Franc Drops past 1.2000 per EUR
The trading day that will live in infamy was January 15, 2015 when the SNB put their collective hands up to tell the market, we’re done. In a moment, EUR/CHF dropped by ~19% from 1.2000 to ~0.98. Mind you this happened the same week that they said the peg of 1.2000 CHF to EUR was a cornerstone of their monetary policy.
Regardless of the blunder, the CHF by market forces and a few nudged by the SNB is back above 1.2000 per EUR to trade at the weakest level since the cap was removed on that fateful day.
Naturally, as you’ll notice in the factors to watch articles, these headlines tend to be inter-related. Due to commodities rising alongside inflation expectations, the view of a 3% yield on the US 10-year Treasury yield is back on the table, though an inversion may still be at hand in a few month’s or years’ time.
EUR/CHF Retraces Entire Move From January 2015
Chart Source: Pro Real-time®, an IG Charting Package, IG UK Price Feed. Created by Tyler Yell, CMT
What’s Your Plan, Powell?
Over the last 48-hours, the relentless flattening of the US 2/10 yield curve has taken a breather after touching the flattest level (yields and prices closest) since 2007 on Wednesday. As I covered on FX Closing Bell webinar, the true concern of the market is likely not so much the 2-year yield, which is marching ever-higher, but rather the Federal Reserve’s terminal rate on their DOT plot.
Fed's DOT Plot Released At March FOMC
Article source: US Dollar Whipsaws Around March FOMC Decision - No Direction
Looking at the Dot Plot, you can see that the Fed now sees their last rate hike at a median of 3.375% as of 2020. What’s surprising is that the US Treasury 2-year yield is ~95bps below the terminal rate and the US 10 year yield is ~46 bps below the rate at which the Fed expects will be their last hike.
Either, the Fed is expecting to invert the yield curve intentionally, or they will need to bring down their median dot plot, which would likely wreak havoc on the US Dollar and cause the US Dollar bears to awaken from their hibernation that started on January 25.
Either way, the market appears to be calling the Fed’s hand, and hoping they don’t have a bluff as inflation emerges aggressively for the first time in a post-QE world.
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---Written by Tyler Yell, CMT
Tyler Yell is a Chartered Market Technician. Tyler provides Technical analysis that is powered by fundamental factors on key markets as well as t1rading educational resources. Read more of Tyler’s Technical reports via his bio page.
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