US Dollar Forecast Sours as Fed Rate Cut Odds Rise, US Yields Sink
US Dollar Forecast Overview:
- Based on the Eurodollar contract spreads, there is a 60% chance of a 25-bps rate cut by the end of the year – much less aggressive than Fed fund’s implied probability of 92%.
- The area where the DXY Index found resistance this week was the trendline helping constitute resistance in the longer-term bearish rising wedge – an ominous topping pattern that persists.
- Retail trader positioning suggests that the combination of current sentiment and recent changes gives us a stronger USDJPY-bearish contrarian trading bias.
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Even though the US-China trade war in a short-term truce, there is concern that it may only be a temporary reprieve, and that the damage may already be done: PMI readings from around the world suggested that the global economy is in the worst shape in a decade. Or, the global economy hasn’t been on this kind of weak footing since the Global Financial Crisis.
US Treasury Yield Curve Flashing Warning Signs
With global growth fears dominating investor sentiment this week, there has been a steady demand for lower yielding currencies and safe haven assets. To no surprise, US Treasury yields have dropped quickly as investors shift funds into ‘safer’ assets. After some of the worst stretch of US economic data in recent memory – a ten year low in US ISM Manufacturing, three-year lows in US ISM Services, CEO & CFO confidence, and a six-month low in US retail sales -- concerns over aUS recession are rising again.
US Treasury Yield Curve: 1-month to 30-years (October 4, 2019) (Chart 1)
The drop in both short-end and long-end rates suggest that investors’ expectations for the Fed’s rate cut cycle have been pulled forward over the past week, and perhaps importantly, that the Fed rate cycle will cut deeper than previously envisioned.
Fed Rate Cut Cycle Becoming More Aggressive
There is now a 77% chance of a 25-bps interest rate cut at the October Fed meeting, according to Fed funds futures. If not, there is a 92% chance of the rate cut coming at the December Fed meeting. But if the Fed does indeed cut rates in October, then rates markets are pricing in a 50% chance of another 25-bps rate cut by the end of the year.
Federal Reserve Interest Rate Expectations (October 4, 2019) (Table 1)
Yesterday, there was an 85% chance of a 25-bps rate cut at the October Fed meeting; one week ago, those odds were 43%; and one month ago, those odds were 55%. While the trajectory has been for a more dovish Fed, it is worth noting that one month ago, there was a 15% chance of a 50-bps rate cut at the October Fed meeting; those odds are now down to 0%.
Eurodollar Contracts Concur with Fed Funds About Cut Cycle
We can measure whether a rate cut is being priced-in using Eurodollar contracts by examining the difference in borrowing costs for commercial banks over a specific time horizon in the future. Eurodollar contracts continue to be closely aligned with Fed funds regarding the scope and scale of the Fed rate cut cycle.
The chart below showcases the difference in borrowing costs – the spreads – for the continuous front month/January 20 (orange) and the continuous front month/June 20 (blue), in order to gauge where interest rates are headed in the December 2019 Fed meeting and the June 2020 Fed meeting.
Eurodollar Contract Spreads – Continuous Front Month/January 20 (Orange), Continuous Front Month/June 20 (Blue) (April to October 2019) (Chart 2)
Based on the Eurodollar contract spreads, there is a 60% chance of a 25-bps rate cut by the end of the year – much less aggressive than Fed fund’s implied probability of 92%. Through June 2020, Eurodollar contracts are pricing in a 98% chance of 50-bps of rate cuts; curiously, Fed funds are pricing in an 84% chance of two 25-bps by that point in time. Typically, divergences in rate expectations between Eurodollars and Fed funds breeds volatility.
DXY PRICE INDEX TECHNICAL ANALYSIS: DAILY CHART (October 2018 to October 2019) (CHART 3)
In our last DXY Index technical forecast update, it was noted that “above 99.04, there will be a fresh closing high in place for the DXY Index with little standing in the way of a run to the yearly high at 99.37.”
Earlier this week, on October 1, the DXY Index pierced 99.37 on its way to a fresh yearly high of 99.67. But like on the first full trading days of August and September, the run to fresh yearly highs was marked by a bearish shooting star candle. To this end, the area where the DXY Index found resistance this week was the trendline helping constitute resistance in the longer-term bearish rising wedge – an ominous topping pattern that persists.
At present time, the DXY Index’s bullish momentum profile has weakened in recent days. Price is below the daily 8- and 13-EMAs – but is still holding above the daily 21-EMA. Daily MACD is readying to turn lower (albeit in bearish territory), while Slow Stochastics have already started to drop back towards their median line. are quickly advancing to overbought territory. Further development is needed before a directional call can be made.
USDJPY RATE TECHNICAL ANALYSIS: DAILY CHART (October 2018 to October 2019) (CHART 4)
In our last USDJPY rate technical forecast update, it was noted that “a move through 108.42/50 would increase the likelihood that USDJPY rates would return to a 30-pip area around the May 10 swing low and August 1 bearish outside engulfing bar high near 109.02/32. A move below the weekly low at 107.45 would suggest a false breakout has transpired in USDJPY.”
It appears that the latter scenario – a false bullish breakout – has started to play out. USDJPY rates have broken back below the late-September swing low and 76.4% retracement of the 2018 to 2019 high/low range near 106.78/97 as well as the descending trendline from the April 24 and July 10 swing highs. The daily 8-, 13-, and 21-EMA envelope is in bearish sequential order. Momentum indicators such as daily MACD has turned lower (albeit in bullish territory), while Slow Stochastics have nearly fallen intooversold territory. The path of least resistance for USDJPY appears to be to the downside.
IG Client Sentiment Index: USDJPY RATE Forecast (October 4, 2019) (Chart 5)
USDJPY: Retail trader data shows 60.5% of traders are net-long with the ratio of traders long to short at 1.53 to 1. The number of traders net-long is 2.4% higher than yesterday and 9.1% higher from last week, while the number of traders net-short is 14.2% lower than yesterday and 12.3% lower from last week.
We typically take a contrarian view to crowd sentiment, and the fact traders are net-long suggests USDJPY prices may continue to fall. Traders are further net-long than yesterday and last week, and the combination of current sentiment and recent changes gives us a stronger USDJPY-bearish contrarian trading bias.
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--- Written by Christopher Vecchio, CFA, Senior Currency Strategist
To contact Christopher Vecchio, e-mail at firstname.lastname@example.org
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