QT cannot run forever

An end to QT by Q4 2019 will probably not be a big game changer for EUR/USD by now. We will need a premature end to QT to lead EUR/USD higher. The Fed might though decide to indirectly let excess liquidity shrink further, even after the end of QT.

Table 1: Our current convictions

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Fed: QT had nothing to do with turmoil

Fed admitted to the discussion of an end-date for QT in the meeting minutes this week but refrained from accommodating market speculation that QT had been a co-driver of the turmoil before New Year. “While respondents assessed that the reduction of securities held in the SOMA would put upwards pressure on rates, they generally placed little weight on balance sheet reduction as a prime factor spurring the deterioration in risk sentiment over the period..“ QT will hence merely end due to technicalities, and not because Powell and co. suddenly think that QT is “part of the problem”, to use Powell’s own words from January.

We are and have always been pragmatists on the structural liquidity question. If the market thinks that it matters, then it matters. No matter what central bank economists try to explain to each other.

A plan on how to phase out QT will most likely be published in either March or May, as “almost all participants thought that it would be desirable to announce before too long a plan to stop reducing the Federal Reserve’s asset holdings later this year.”

This leaves us with a baseline scenario including a new normal of $1000bn in USD excess liquidity (roughly the current consensus), alternatively $500bn in case the Fed indirectly would allow excess liquidity to dwindle even after the end of QT. If $1000bn is the new normal, then QT will have rolled back QE-2 and QE-3, but not QE-1.

Chart 1: QE2 and QE3 will be rolled back, while the new excess liquidity normal is equal to the QE1 liquidity.

If we assume that $1000bn USD is the new normal for excess liquidity (suggested by the primary dealer survey and by consensus), then the Fed will reach the mark in a little more than eight months from now at the current monthly tightening pace of $50bn (plus roughly $10bn from the monthly increase in currency in circulation). If the Fed wants to withhold a “liquidity buffer” of a $1000bn, then it would have to buy bonds on aggregate again already from early 2020.

The Fed could though continue to allow excess reserves to dwindle lower than the $1000bn mark even without QT, as an increasing amount currency in circulation would slowly erode excess liquidity, if the asset side is kept constant. It seems as if at least parts of FOMC still expect to be able to shrink excess liquidity below a $1000bn via this channel. This scenario is probably the most USD positive scenario in play currently.

Chart 2: QT will have to end due to shrinking excess reserves. Is $1000bn the new normal for excess reserves?

In terms of the EUR/USD repercussions, we need a “premature” end to QT, such as in April, to really underpin the EUR/USD outlook this year. If the Fed allows QT to run all the way until Q4, then the EUR/USD is kind of capped around 1.16-1.18 from a liquidity perspective.

Should the Fed allow the excess liquidity in USDs to dwindle below $1000bn (towards $500bn in the passive scenario described above), it could keep EUR/USD lower for longer (in the 1.10-1.15 range). In any case, it is a tough sell to be a long-term EUR bull currently.

Chart 3: Unless we get a premature end to QT, the EUR/USD outlook is kind of capped from a liquidity perspective

Currently, we put our money on a weakening USD over the upcoming debt ceiling deadline 1st of March (via a basket of short USD versus NOK, CHF and JPY). The Treasury Cash Balance currently stands at $331bn, but we expect it to go as low as $200bn over the next 7-10 days (the level of the GCA, when the last debt ceiling deal was signed). The commercial banking system will be on the receiving end of that liquidity.

This development should tighten Libor/OIS further, while also work to put a lid on the USD over the next 60-90 trading days. Remember that excess USD liquidity leads EUR/USD (and DXY) by roughly 60 trading days.

Chart 4: It’s time to empty the cash balance Mnuchin

The debt ceiling deal is obviously not the only important political deal with an early March deadline. Most, if not almost all, market participants expect a prolongation of the US/Chinese trade negotiations and neither tariffs nor a signed deal by early March.

We warn that the trade war risks could be about to take a turn for the worse as China is flexing its muscles towards the US. China has “turned on the heat”, as imports from the US have absolutely plummeted. Is China trying to trigger a meltdown in US manufacturing, as part of the negotiations? (Week ahead: Death by China).

This risk is part of the reason why we have opted for a defensive basket to short USD against (CHF, JPY and NOK).

Chart 5: Is China trying to trigger a meltdown in US manufacturing?

Revisiting SOMA and REBA

We, however, have a SOMA-day coming up before we get to the debt ceiling and trade war deadlines. Even if the Fed is discussing the timing of the end of QT, we still have several SOMA-days left. On some SOMA days, excess liquidity shrinks a lot, on other SOMA days, not by much. The SOMA-day on Thursday the 28th of February is one of the smaller ones with an estimated negative liquidity effect of $6.7bn USD.

The bulk of the positive USD move on these days is usually seen between 14:30-17:15 Central European Time, but the last SOMA-day was spoiled partly by Benoît Cœuré, as his remarks fell just before 14:30.

Table 2: USD/EUR, USD/SEK and USD/NOK on SOMA-days, numbers in bn USD

The SOMA-day coincides with month-end rebalancing flows (REBA-days), and according to our monthly market cap tracker, SEK, NOK and GBP should see a modest selling pressure into month-end due to portfolio rebalancing. Both SOMA and REBA, therefore, speak in favour of lower cable and higher USD versus Scandies into month end.

Chart 6: Relative selling pressure on NOK, SEK and GBP to be expected from portfolio rebalancing flows

SEK: The Krona is starting to chase the Riksbank

The Riksbank has been chasing the SEK for years, but now the SEK is chasing the Riksbank. The 10-day old KIX forecast (trade-weighted SEK) is already almost 2.5% off, as the sad key figure news flow from Sweden just continues.

Given how openly the Riksbank has chased a weaker SEK in recent years, it seems extraordinarily difficult for them to re-install credibility in the Swedish krona, and frankly no-one believes the Riksbank, when they tell markets that they expect a stronger SEK.

Chart 7: SEK is already almost 2.5% weaker than anticipated by the Riksbank just 10 days ago

The weak SEK could though become the most obvious hawkish argument for the Riksbank by the April meeting. The meeting minutes in general supported the idea that a weak SEK will limit the risk of downwards revisions to the rate path in April. Board member Flodén even went as far as warning of a risk of a hike in April, should the “bananafication” of the SEK continue until then.

This is what Flodén said in the meeting minutes: “An increase in April could possibly be justified if the krona continues to be weak, if the three forthcoming inflation outcomes indicate higher inflationary pressures and if, at the same time, the economy develops well.” A hike if,

i) SEK weakening trend continues. Check. 2) Inflation pressures intensify. Not really. Iii) The economy develops well. Unlikely given the PMI details.

The Riksbank will never hike in April, and Flodén also still supports the rate path from February.

Next week is the official winter break school holiday in Stockholm. We silently highlight that the SEK suffered during two out of three public holidays in 2018. A SEK risk to consider ahead of next week?

Table 3: SEK often suffered on public holidays in 2018

On top of the “holiday seasonality” in SEK, we would not be surprised to see another very weak PMI print from Sweden on Friday. If the Swedish PMI drops another index point, while the Norwegian stays unchanged, then the PMI spread will be larger than in 2012, when NOK/SEK traded at 1.20.

Chart 8: PMI divergence points at NOK/SEK in +1.20 territory

In Norway, everything still points toward a hike from Norges Bank in March, but ahead of that meeting a tighter $Libor-OIS (due to the debt ceiling story) could pull Nibor lower, as Nibor-OIS is mostly explained by $Libor-OIS. It is, however, a tricky case whether to receive the front of the NOK curve, as a March hike from Norges Bank is not fully priced in.

We would though not be surprised if some market participants confused this as a NOK negative signal, if Nibor dropped due to USD liquidity developments.

We remain short CAD/NOK and AUD/SEK in our tactical portfolio.

Chart 9: More USD liquidity -> Tighter LIBOR/OIS -> Lower NIBOR

AUD & NZD: Compelling to go long AUD/NZD

We have disliked the AUD for a while, as we expect China spill-overs to continue for longer than most people anticipate. The recent negative developments in the mutual relationship between Australia and China have only worked to strengthen that negative tilt on Australia in general.

First, Huang Xiangmo, a Chinese top lobbyist, was denied re-entry into Australia. Since, stories of a ban on Australian coal imports in the Chinese port of Dalian have followed. Is it just Huawei related, or is this an early signal of an imminent Australian/Chinese trade war?

Judged from Chinese auto sales, we could see another leg lower in both AUD/USD and NZD/USD even without discounting for the trade risks mentioned above, but admittedly such a view has required a little patience recently.

Chart 10: Chinese auto sales point at a risk of further downside for AUD and NZD

We though opt to add an intra-regional bet to our tactical portfolio instead. We have warned of an imminent sell-off in NZD for a couple of weeks, as the New Zealand surprise index is super depressed.

Usually, when the difference between the Australian and New Zealand surprise index gathers pace as currently, you would expect AUD/NZD to follow suit higher.

Chart 11: The spread between data surprises in Australia – New Zealand points at higher AUD/NZD

Despite the string of negative surprises from New Zealand, the market still remains relatively less downbeat on the RBNZ outlook compared to the RBA outlook.

The difference between the pricing measured by 9×12 FRAs suggests that RBNZ will outpace RBA by 20 basis points. Is it all feasible to expect the RBA to cut, without expectations of a cut from RBNZ gathering momentum as well?

In sum, we think this leaves a decent risk/reward in being long AUD/NZD. We target 1.0650 initially.

Chart 12: Markets are relatively less downbeat on RBNZ than RBA

GBP: Will the ERG pull the rug from under May?

The European Research Group (ERG) seems ready to try and block a prolongation of the Brexit deadline next week. Whether the ERG will succeed in that is doubtful, but will they then pull the rug from under the Mays administration, if she opts for a prolongation? At least they will try to send this signal to Theresa May ahead of the action on Wednesday.

According to our own small Vox Populi, a big majority of market participants expect a prolongation of the Brexit deadline (+75%). Maybe this is the exact reason why EUR/GBP trades below 0.87, despite a renewed pick up in the focus on no deal risks among journalists. We continue to see best risk reward in a long EUR/GBP position, but remain side-lined in our tactical portfolio.

Chart 13: Long EUR/GBP should have traded higher, judged from the no-deal story tracker