FX Daily: Unorthodox Correlations

With the Yen bearing the brunt of the risk rally, the Dollar saw some delayed benefits from the re-tuning in Fed rate expectations and enjoyed a modest recovery yesterday. On Friday, all eyes will be on China PMIs, UK GDP, Europe and US CPI. Elsewhere, Oil stays supported.

USD: Dollar takes a breather as Yen takes a hit

Fridays moves in the FX market provided another confirmation that we cannot apply the traditional frameworks to the interaction between currencies and other assets. If diverging monetary policy paths (at least as perceived by the market) in the US and Europe are gradually reconstructing the link between USD/European FX and front-end rate differentials, the interactions between safe-havens, high-beta currencies and swings in the equity market continue to prove rather unorthodox.

An important point is that the Dollars safe-haven status was perhaps dented by the fact that the banking turmoil has primarily been a US story. Furthermore, another safe-haven currency, the Swiss franc, got caught up with idiosyncratic banking stress, leaving the Yen to benefit widely from the initial shock – especially considering its high inverse correlation with Federal Reserve rate expectations. This helps us understand the underperformance of JPY since the start of this week and especially yesterday. Improving sentiment asymmetrically hits the Yen given it is accompanied by an unwinding of dovish Fed bets: the USD/JPY level might rebound to the 135.00 area, even though another decline in the pair beyond the short term was favoured.

The bloc of pro-cyclical currencies remains extremely homogeneous. Markets have fallen out of love with the Aussie Dollar as lower inflation points to a stronger chance of a pause in rate hikes and the New Zealand Dollar is now looking like a more attractive option in the region. Oil-sensitive currencies may continue to enjoy decent momentum as we see more upside risks to Oil prices. The Canadian Dollar is also benefiting from the general improvement in American (North and Latam) sentiment but lacks a domestic tightening story, so its rally may start to run out of steam sooner than other peers (like MXN and NOK).

While Back to the Dollar, based on expectations the small recovery seen yesterday could be one of many along a gradual decline path, but would favour some consolidation around current levels on Friday.

EUR: First CPI readings in focus

With the European Central Bank explicitly data-dependent despite an implicit hawkish bias, this week‘s inflation figures are set to be an important driver of the market’s rate expectations. There are currently two 25bp rate hikes fully priced in by September in the OIS curve, and the bar for another hawkish repricing is set quite high. However, ECB speakers have leaned on the hawkish side of late and the EUR OIS curve is not discounting banking stress in the same way the USD OIS curve is. The EUR/USD could see it hover around those levels today, but I still favour a break above 1.0900 and ultimately a test of 1.1000 in the near term.