After terrible French PMIs last week, the Composite Euro area PMI is now clearly in “easing territory”. Meanwhile, financial conditions have continued to tighten in the US, despite Powell’s softening. This limits the risk of a hawkish Fed surprise.

Table 1: Our current list of convictions

Before we move on to more esoteric stuff here are some FX quickies for those of tactical persuasion;

EUR/USD: Terrible French PMIs outlines the issue for the EUR. There are simply too many political obstacles in front of a strong EUR-performance currently. 1.13 is at odds again in EUR/USD and it looks like the wedge has broken on the low side. We still think that EUR/USD could be headed higher in Q1 but are not willing to bet on it yet. Stay long EUR/AUD (or go short AUD/USD for carry reasons).

EUR/GBP: We still consider Theresa May a “walking dead” politically, but opt to take profit on our long EUR/GBP anyway, as much negativity is already priced in. May’s deal looks stone-dead, despite her win in the confidence vote. How is a 200-117 margin in an internal vote of confidence seen as a real victory? Maybe it is still too cheap to buy the wings in EUR/GBP (no-deal or no-exit)?

EUR/SEK: A choppy week is behind us. Above 10.36 there is thin air technically in EUR/SEK, while a break of 10.1640 on the downside opens for another leg lower. Risk/rewards favours a bet on a dovish take-away of the Riksbank meeting this week.

EUR/NOK: Uptrend since the 4th of December remains solid, while the big test for the uptrend is whether the momentum is strong enough to break 9.76 on the topside. We look for the range of 9.80-9.85 before New Year.

ECB: Lets add the “yellow vests” to the list of excuses for the bad growth momentum

The ECB has identified 13 different reasons why EA growth has been weaker than expected this year and will surely add a yellow garment to their list after the December collapse in French PMI. Referring to the economic recovery, Draghi in his presser had to admit that “[e]verything, all this when we look at all these drivers of the recovery, yes, it’s true, it’s just weaker”. The last time PMI were at similar levels as today, in the winter of 2014-15, the Eonia rate was falling.

Who does not move forward, recedes (Qui n’avance pas, recule). The ECB may have to face a substantial headache in 2019 (will they even have to ease?).

Chart 1: EA PMI composite clearly in easing territory after French collapse

Central banks (ECB, SNB & Norges Bank) are indeed not in a hurry to tighten policy, being surprised not only by recent growth weakness but also by the associated pickup in financial market volatility and especially the tightening of financial conditions which has taken place following Powell’s hawkish remarks in early October. While Powell backtracked at the end of November, this has not yet prevented financial conditions from tightening further. This suggests that a hawkish Fed surprise next week should be quite unlikely.

Chart 2: Financial conditions has tightened somewhat further since Powell’s backtrack

In retrospect it looks as if Fed Powell’s October remarks was the nail in the coffin for US asset outperformance. The Fed’s hawkish stance throughout 2018, and the accelerated shrinking of its balance sheet, had long been a problem of sorts – but mostly for the rest of the world – not for the US. This changed after Powell’s hawkish remarks in October.

Chart 3: US asset market outperformance ended in October

While the Fed may opt to hike dovishly in December, it is unlikely to alter its balance sheet policies. The liquidity tide (QE), which lifted all boats, has turned to ebb (QT), and this ebb has started to sink all boats. It has decidedly not been like “watching paint dry” as the Fed predicted in 2017.

It is not nature given that a softening of the tone on the Fed Funds path is enough to change the broader trend of tighter financial conditions. Maybe concessions are also needed on QT for that trend to reverse? M1 growth is still slowing fast and QT is probably one of the main culprits. By the way, slowing M1-growth usually coincides with a flattening pressure on the yield-curve as well.

Chart 4: M1 growth is still slowing fast and QT may be the culprit

FX: What happens after US curve inversions?

In September we looked at what usually happens ahead of US curve inversions. Recently we instead looked at what happened after US curve inversions, since the inversion point has been getting closer and closer in time given recent trends (a soft Fed will hopefully delay that time for some point, but further data weakness, which is likely in our view, could point in the other direction).

To answer this question, we analysed how more than one thousand FX crosses behaved in the six months after these US curve inversions: 1978-08-17, 1989-01-05, 1998-05-26, 2000-02-11 and 2005-12-27. These dates were chosen because the curve had been steep for quite some time running into these inversions, and as the curve often becomes volatile after an inversion.

Table 2: Top 12 G10 crosses after an US curve inversion

Table 3: Top 12 EM crosses after an US curve inversion

While we do not have that many observations to go by, if history repeats or rhymes, we should stay away from AUD & NZD in particular. We remain long EUR/AUD.

SEK: Damned if you do, and (less?) damned if you don’t

It’s not easy being the oldest central bank in town. Maybe Riksbank Governor Ingves still seeks to lift the repo rate by 25bp on 20 December, maybe to celebrate the bank’s 350th anniversary? It’s far from a slam dunk though, given yet another disinflationary cold shower in November (core inflation has undershot the Riksbank’s expectations by an average 0.15pp/month this year, for a cumulative disappointment of 1.6%!). Global money market rates have been significantly repriced in a dovish direction, with end-2020 rates down by more than 20bp. The Riksbank’s SEK forecast is based in part on relative rates, why lower rates abroad tend to trigger a lower repo rate path. Moreover, political risks are prevalent (Brexit, Italy, Trump, trade war, yellow vests). And Ingves could, or should, also ask himself that maybe Fed Chair Powell might know something he doesn’t.

Chart 5: Riksbank will need to cope with a big dovish repricing abroad – end-2020 rates down by ~20bps

The Riksbank has said it hasn’t changed reaction function, and that it’s data-dependent. Hence if it lifts rates, as is our forecast, Ingves et al will be criticised not only for being behind the curve but also for having changed reaction function despite insisting otherwise. How else could they hike despite two massive misses on the inflation front? On the other hand, if the Riksbank does not hike, it will face criticism for not hiking in December despite “promising” to do so. Of these two, we think option one, hiking, ought to be costlier.

Chart 6: EURNOK intraday when Norges Bank hiked while flattening its rate path

While one can still envisage a hawkish rate path and a hawkish message from the Riksbank in December, this looks mostly like a tail risk. The likelihood of a Norges Bank-style dovish hike, or no hike at all, is surely much greater. When Norges Bank hiked and flattened the curve in September, EUR/NOK rose 1% on the day..

SEK: Not all hope is lost for 2019

There are some potential game-changers for the SEK in 2019 though. We have earlier highlighted that perhaps Riksbank’s QE program has been the chief driver of the SEK weakness in 2018, for instance as the Riksbank may have bought so much bonds so that the domestic supply of said bonds has diminished (perhaps for regulatory reasons). And if domestic accounts are no longer as ready to sell SGBs, that leaves foreign accounts – and such flows are more likely to be SEK-negative.

Chart 7: Riksbank’s SGB holdings vs EUR/SEK – note reversed scale

The Riksbank’s expansion of its balance sheet throughout 2018 was decided already a year ago and aimed to pre-reinvest the large maturity (of the SGB1052 on 12 March 2019. The Riksbank owns ~47bn of this bond and when it matures, excess liquidity will decrease by the same amount. Given that we love excess liquidity measures, we have figured this might be SEK-positive to some extent. At least the Riksbank will no longer undermine the SEK via QE flows when the balance sheet stops growing. The ~23bn maturity of the SGB1051 in the summer of 2017 was preceded by a move lower in EUR/SEK. This could be good news for the SEK. But as the 2017 move lower in EUR/SEK coincided with a soaring Swedish surprise index, maybe we shouldn’t get that excited…

Chart 8: Cost for hedging 12m FX risk in EURUSD

More interesting still is the dollar cycle. At the start of this year market participants were asking themselves who was going to fund the US’ ballooning twin deficits (the budget deficit and the current account deficit). At the time, yields soared and the dollar weakened. These twin deficit fears ran out of steam in February, when a large fixed income investor made media headlines by saying they now judged that unhedged purchases of US FI were making sense again as a result of e.g. higher yields and a weaker USD. The mix of US economic and political outperformance may also have been key drivers of “haven demand” of USD. The EA has seen growth expectations being lowered while the EUR has also needed to cope with plenty political worries, and the trade war has intensified (this has been broadly dollar-supportive).

Chart 9: USD cycle a potential game-changer for the SEK

What does this have to do with the SEK? The cost of hedging USD assets had soared on the back of Fed’s rate hikes (and ECB/Riksbank NIRP) to more than 3%/annum level. which caused some market participants to reassess their hedge ratios to some extent (hence less USD selling).

If e.g. Swedish investors reduce their selling of USDSEK forwards, it won’t affect EURUSD much because of the pairs liquidity but it may affect EURSEK positively (a purchase of USDSEK equals one purchase of EURSEK and sales of EURUSD). We have also seen in recent years that changes in USD positioning on IMM data often roughly coincides with movements in EUR/SEK. As the global market collective turned more positive on the USD, it has coincided with a weaker SEK even vs the EUR.

If the dollar is ripe for a large weakening move, so as to compensate for the 3%+ hedging cost, the market could find itself massively underhedged. A wave of USD selling might result, which would spill over to a positive flow environment for the SEK (a sale of USDSEK equals one purchase of EURUSD and one sale of EURSEK). In our view, this is the game-changer to look for if one wants to be a big SEK bull (and to a certain extent NOK bull as well).

We though find it harder (compared to 3-4 months ago) to see the end of the USD cycle around the corner.

NOK: It will be hard for housing to outperform Norges Banks view

Norge’s Bank did as we expected. They kept the plan of a hike in March intact, while cushioning that message with another substantial flattening of the rate path. Not a big deal for markets. In the current global environment, the market will likely continue to be reluctant to price in the hike in March from Norges Bank for another while.

Usually we would expect January-April to be a NOK positive period, due to the tightening structural NOK liquidity. This will probably also be the case in 2019, but there are downside risks to the view of Norge’s Bank on at least a couple of parameters.

In the December monetary policy report, Norge’s Bank keeps looking for a 2% annual increase in house prices in 2019. Given the signals send from the inventory-to-sales ratios this will be a difficult threshold for Norwegian house prices to beat in 2019 (see chart).

Chart 10: It will be difficult for Norwegian house prices to outpace Norge’s Banks forecast

We have been looking for higher EUR/NOK into year-end over the past weeks and it seems like EUR/NOK is slowly getting there. 9.80-9.85 is within reach before we “close our books” for the year and one should watch out for the F-Loan auction the 31st of December – last year the year-end F-loan auction caused a temporary dip in the NIBOR of 10 bps. Again, we tend to think that the combo of i) The tighter market liquidity, ii) The abundancy of structural liquidity (excess liquidity) will weaken NOK just before and after Christmas.

JPY: Why are the Japanese buying US equity like crazy again?

It is always interesting to follow the portfolio data in Japan and strikingly the October data reveals that Japanese accounts on a net basis bought the most US equity since late 2015. It seems like substantial Japanese purchases of US equities always show up in data when it is “hurtful” (they did so in 2000-2001 also). Are Japanese investors more contrarian or just late on the ball?

If the October-data constitutes a level-shift in the Japanese purchases (as in 2014-2015), it could be viewed a JPY negative signal, as most of these purchases are likely undertaken without FX hedges.

Chart 11: Japanese investors bought a lot of US equities in October

Now we are discussing safe-haven currencies, we don’t think that the SNB will be in any hurry to re-start interventions in EUR/CHF yet, despite the very “scared” rhetoric used by Jordan and Zürbrugge at the meeting last week. 1.10 is probably the intervention-threshold they look at in EUR/CHF.

Chart 12: Don’t expect SNB to intervene unless the 1.10 mark is breached on the downside in EUR/CHF

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