Dear Mr Powell…

The Fed delivered on all points in March, scaling back QT earlier than expected and much more. The now-official liquidity trajectory for EURUSD suggests upside for the pair. The size of the upside potential is though dependent on Mnuchin.

Table 1: Our current convictions

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The order of the world is always right – such is the judgment of God. For God has departed, but he has left his judgment behind, the way the Cheshire Cat left his grin. – Jean Baudrillard

Dear Mr Powell,

I have been trying (and failing) to write this letter to you for the last three months. But I keep getting stuck after the first two to three sentences. Then I sit for hours staring at the skyline outside my office window, trying to figure out how I could ever articulate the praise you deserve.

The Fed delivered on all points in March, scaling back QT earlier than expected and much more. The Fed’s dovish delivery suggests a more positive outlook for EM, because of lower US real rates – indeed, much in line with the arguments outlined in the Devil’s Advocate.

For those of a macro pessimistic bent, of which there are many, we note that even if the US enters recession in early 2020 (the risk of that is lower today than a month ago – thanks Powell!), S&P500 may still have some further juice. The average performance going into the past five recession suggests S&P500 could climb above 2950 by this summer, and if equities do what they did ahead of the 2007 recession, it could climb well above 3100(!). And if the recession hits in March next year, the average S&P500 development suggests 3100 by late summer.

Chart 1: S&P500 can still trade higher – even if a new US recession beckons

This dovish move caused a spike in EURUSD to the Fibonacci level of 1.1448 before the pair reversed. The now-official liquidity trajectory for EURUSD suggests upside for the pair. For many more charts on how US excess liquidity momentum relates to various market prices, see Global: You may not be interested in liquidity, but liquidity is interested in you.

Chart 2: EUR/USD indicated to gradually trade higher based on liquidity outlook

Our model based on US excess liquidity as well as relative liquidity suggests a move higher towards 1.18(!) already this summer. A debt ceiling standoff could push the model-implied EUR/USD-level even higher as the US Treasury may be forced to draw-down its General Cash Account (GCA) starting some time in Q3. Simply put, if debt ceiling negotiations drag on into the X-date some time this autumn, it might push ~275bn more USD liquidity into the system – how’s that for “stealth QE”?

Chart 3: Debt ceiling may push ~275bn more USD liquidity into the system in late Q3

Related to the liquidity outlook, the narrowing of Libor-OIS also suggests budding downside pressure on the USD. The widening of Libor-OIS led the turn-around in the USD in 2018 and might do so also this year. Indeed, the relationship suggests a peak in the USD as of March 18 – a date which is now behind us.

Chart 4: Libor-OIS narrowing signals a weaker dollar

The Fed’s decision to scale back QT also impacts how much US liquidity will dwindle on the good old SOMA days. We’ve earlier seen a pattern that larger declines in US excess liquidity has tended to cause greater moves higher in the USD, and the lowered monthly cap means that SOMA days will get less exciting for USD bulls already in May, not that the pattern has been that clear to start with in recent months.

Table 2: Lowered cap means that SOMA days are becoming less interesting – SAD!

Alas, EA data disappointed once more in March, with the decline in PMIs causing a larger move lower in EURUSD than the post-Fed spike (although reports that US may put car tariffs on the EA also likely played a part). While PMI services was in line with expectations, manufacturing PMI’s disappointed once more even as the EA ought to start feeling FX tailwinds right about now (the weak EUR did predict a higher ZEW, for instance). Admittedly, the FX impulse ought to either bring EA PMI higher, or drag ISM down. The disappointment in the EA raises the risk of an ISM disappointment on April 1, in our view. The mix of an überdovish FOMC and weak EA data has caused another receive-a-palooza in fixed income. With Bund yields back below zero, they face little support above the -20bp level reached after the Brexit vote in 2016.

Chart 5: EA ought to start feeling FX tailwinds right about now

Reportedly, “widespread concerns specifically focusing on heightened political uncertainty, trade wars and Brexit” dominates. Indeed, we argued in our latest Nordea View that “for the EUR to trend stronger versus the USD later in 2019, we do need to see a fading of some of the temporary factors which have allegedly held Euro area activity back”. We didn’t get that this month, but keep our fingers crossed.

Politics remain a sad wild card, as e.g. Germany’s failure to meet NATO’s defence spending targets and the country’s general cuddliness with China/Huawei, might contribute to US wrath in the forms of car tariffs. If the US administration imposes car tariffs, it would further depress EA PMI and the EURUSD. We are still looking for EURUSD upside towards this summer based on the relative liquidity outlook (Fed/ECB), but we likely need to see EA PMI data stabilise – and perhaps Brexit out of the way – before that can play out more materially.

Chart 6: Highly unusual(!) with a lower EUR/USD with USD hedging costs this lofty

One of the main counterarguments against our view that EURUSD will gradually head higher stems from interest rate differences. With the cost of hedging against USD weakness so high, market participants argue EURUSD just cannot rise. Historically however, EUR/USD has never traded below 1.12 with USD hedging costs at today’s or higher levels. We have to go back to a time before the reunification of Germany in 1990 to find the (now synthetic) EUR/USD lower than 1.10, and that is a single daily observation with EURUSD at 1.03 from June 15, 1989. This is likely a misprint in Bloomberg data, and anyhow occurred during a completely different FX regime (the EMS).

We aren’t crazy enough to argue hedging costs does not matter at all, however. For instance, high hedging costs combined with FI and FX valuations likely caused a change in USD hedging patterns in early 2018. Due to elevated costs of selling USD, market participants stopped selling as much EUR/USD forwards which likely contributed to the push higher in the USD (see here). But if FX hedge ratios were already adjusted in 2018, we find it doubtful further changes in that direction could provide much of a push.

Chart 7: EUR/USD vs implied rates-based forecasts

Another counter-argument against our EUR/USD-positive view pertains to interest rate correlations. If the Fed lobs one more hike into the mix – which looks highly unlikely for this year – surely this would widen interest rate differentials and drag EUR/USD lower? Not so fast, bucko.

If we know the correlation of EUR/USD with interest rates from the preceding year, and assume we know the exact path of interest rates the coming year, we can construct implied paths for EUR/USD.This is what is shown in the above chart. Suffice to say that interest rates are not a reliable gauge of currency trends – you can be off by 20-30 bf in EUR/USD even if you knew what relative rates were going to do down to the basis point!

SEK: There is no QE monster under the Riksbank’s bed

We’d also like to revisit the SEK and the Swedish liquidity outlook. We started banging the drum back in December on the Riksbank’s shrinking balance sheet on March 12, which we argued could be a little helpful for the SEK via “liquidity tailwinds”. This shrinking of the balance sheet did manage to coincide with a move lower in EUR/SEK, despite the recent weak inflation print. This brings us to the next point which is the Riksbank’s April decision.

Chart 8: Riksbank’s growing balance sheet may have undermined the SEK in 2018

At the end of 2020, there’s a large (~73bn) amount of maturing bonds (SGB1047, SGBi3102) on the Riksbank’s balance sheet. If the Riksbank follows in the Fed’s footsteps, it could wish to keep its balance sheet unchanged until well rates have been lifted close to 1%. If QE flows impacted the SEK negatively, the Riksbank risks being surprised once more by a weak SEK later this year if it chooses this route.

However, going back to 2015 one of the key reasons why the Riksbank started a QE program of its own was related to fears of excessive SEK strength stemming from ECB’s QE policies. Perhaps the Riksbank had to print as much money as the ECB to prevent a stronger SEK, and by extension weaker growth and inflation?

Chart 9: There is no QE monster under the Riksbank’s bed

A few years later, we must conclude that the QE monster under the Riksbank’s bed was never there to begin with – or if it was, it wasn’t never very scary. The relative money-printing pace could otherwise have dragged EUR/SEK to 8.50 – but the cross has done the complete opposite.

Looking ahead, we estimate that the ECB’s balance sheet is likely to shrink rather than expand owing to TLTRO repayments. This strongly suggests the Riksbank could cool it with its QE plans… Does the Riksbank really need to “out-print” the ECB up until December 2020? What, exactly, is it afraid for? And why? Its next decision is due on April 25.

NOK: Norge’s Bank hawkish in the front, dovish in the back

The Norwegian economy remains impressively shielded from global shivers, and Norges Bank also remains in happy-go-lucky mode, despite all other G-10 central banks throwing in the towel one at a time. Norges Bank even opted to raise the front of the rate path materially (70% hike probability in June), but cushioned it with a 25 bps downwards revision of the end-point (as we warned last week). The rate path of a central bank that basically wants to be aggressive, but still fears the consequences of signalling much higher rates further out, in particular during the ongoing receiver-palooza worldwide.

The message from Norges Bank opens the door for the 9.50-9.55 range during April/May. Anything below that range would filter directly into a less firm rate path from Norges Bank judged by the new forecast for the I-44 exchange rate (NOK: Norges Bank towards the pack).

Chart 10: Anything below 9.55 in EUR/NOK would filter into a less firm rate path in June (and limit chances of a hike)

Being hawkish in the front, but dovish in the back (as Norges Bank) is not necessarily a structural buy message to markets. Currently NOK fairs well despite a substantial flattening of the market pricing of the NIBOR path so far in 2019. If Norges Bank continues to flatten the rate path prospects, will the market then continue to buy the NOK? We doubt it.

Chart 11: Nibor path implied by markets flattens, while NOK rallies. For how long can that cocktail exist?

And just to remind you, a big test of our beloved liquidity hypothesis in Norway is coming up in 1.5-2 months from now. Structural liquidity in the Norwegian banking system will hit a record high over the summer, as the government will add 100-125 bn NOKs (via the non-oil deficit) in liquidity through June/July with commercial banks on the receiving end of the liquidity. If earlier correlations hold, then NOK could face a rough summer despite a firm central bank.

Chart 12: A risk of a new test of 10 over the summer in EUR/NOK despite a firm central bank?

We opt to keep our positive short-term NOK view alive versus CAD (and USD), but also for CAD and USD reasons. Canadian PMI momentum will most likely suffer hard over the next 3 months, judged from import PMIs from trading partners. Will Poloz have to throw in the towel completely in April? We think so.. We also keep our HUF/CAD longs alive for the same reason (even if the HUF momentum seems a little exhausted by now).

Chart 13: Canadian PMI momentum to suffer due to weakness among trade partners

Rest of G10: Early QT end a relief for risk, but…

The eagerly awaited announcement of the end-date to QT is now a reality, and hence we find it timely to look at how some of the most “sensible” G10 USD pairs price versus the new outlook for developments in USD excess liquidity.

AUD is the currency that would most obviously gain from a liquidity relief within G10, as i) positioning is super short in AUD, ii) Market pricing of RBA is very gloomy (yes, we acknowledge that the domestic Australian outlook is anything but impressive) and iii) AUD is most obviously linked to the credit cycle.

Chart 14: AUD/USD could be helped higher by the less troublesome USD liquidity outlook

We though opt to play such a potential for an AUD positive rebound against NZD still, as NZD prices higher relative to the liquidity outlook already (see chart 14 and 15)

Chart 15: NZD/USD has “front runned” positive liquidity news to a larger extent than AUD/USD

The JPY is on the other hand one of the few peers that USD could strengthen against on positive USD liquidity news (due to the potential of a steeper USD-curve), at least if equities don’t tank big time.

Chart 16: USD/JPY is, if anything, positively correlated to USD excess liquidity developments

This conclusion on USD/JPY goes hand in hand with the seasonal pattern heading into the last few trading days of the Japanese fiscal year. On average USD/JPY should already have bottomed on Friday (last trading day before 23rd of March), and the rest of the month could lead USD/JPY 1-1.5% higher.

Chart 17: USD/JPY maybe bottomed this Friday, if fiscal year-end seasonality is anything to go by