e-markets.nordea.com/article/45386/fx-weekly-how-to-trade-a-ceasefire

29 July 2018

FX weekly: How totrade a ceasefire

Andreas Steno Larsen | Martin Enlund

While a ceasefire between Trump and Juncker and the solid reporting seasonare reasons to be short-term positive on risk, we continue to consider this ashort-term bet only. Relative GDP expectations will be an important driver ofEUR/USD from here.

Table 1: Our current list of convictions

Lots of positive surprises, but a contained market reaction

While the week has been full of positive surprises and conciliatory trade developments, risk appetite hasn’tperformed as well as one could have expected.

Outside of a few “tech-misses” the Q2 reporting season in the US continues to deliver positive earningssurprises on average. Our surprise indicator on the earnings component of S&P 500 hasn’t been this strongfor years. Something that would have catapulted S&P500 substantially higher, if other factors had allowedit. We see two major reasons for the only moderate positive market response. I) The market was alreadypositioned towards strong US corporate fundamentals, II) Forward looking indicators are hinting achange of momentum around the corner. This leaves a market ahead where it will take fewer negativesurprises to create a correction, compared to the amount of positive surprises needed to lift the risk appetitefurther.

As a consequence, we only see short-term reasons to be positive on risk, but a short-term bet only.

e-markets.nordea.com/article/45386/fx-weekly-how-to-trade-a-ceasefire

Chart 1: Positive earnings surprises all-over, but only a moderate reaction upwards in S&P 500

Despite the strong Q2 reporting season so far, the ratio between cyclicals and defensives on S&P 500continues to hover below the peaks seen earlier in 2018. This is one reason why the 10yr treasury yield isstuck below 3% for the time being. It is likely a third variable that keeps both of these variables at bay, namelythe loss of momentum in Global Manufacturing PMIs . It is increasingly dicult to see how the globalmanufacturing momentum should gather renewed pace in this part of the business cycle, why it is notfrom the PMI front that one should expect an upwards pressure on longer bond yields.

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Chart 2: Weaker Global Manufacturing PMI momentum keeps both cyclicals and treasury yields at bay

On top of the weakening PMI momentum (and the cap eect on long bond yields), it is also highly debatablewhether Feds QT increases or decreases the flattening pressure on the USD yield curve. There is no doubtthat a smaller bond portfolio and the accordingly shrinking excess liquidity increases the upwardspressure on yields in the short-end of the curve. The question is whether the demand eect (as Fedwithdraws increasingly from the market) pushes the long-end of the curve up also.

Judged solely by empirical evidence, we consider it most likely that QT increases the flattening pressureon the yield curve. From a theoretical perspective, this is also supported by the link between the monetarybase and inflation expectations. A lasting increase of the money supply (QE) should increase inflationexpectations, as the money supply will ceteris paribus increase relative to the amount of goods (money willbe more ample compared to goods –> inflation). If this holds, a lasting reduction of the monetary base (QT)should have the opposite eect (deflationary).

The bottom-line is that we tend to think that QT is curve-flattening and deflationary in its nature. While thereare other reasons to expect inflation (and long bond yields) to pick up, QT is not amongst them.

The curve-flattening could be the main theme to watch ahead of the FOMC meeting on Wednesday,as several FOMC members have started to voice their concerns. Powell (and the FOMC majority) thoughremains unconcerned, also on the QT eects.

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Chart 3: Money-un printing has coincided with a flatter, not steeper, yield curve

In terms of the alleged ceasefire agreed between Juncker and Trump, let us just remind you that Reuters hadthis headline on May 20th “US, China putting trade war on hold, Treasury’s Mnuchin says”. Here we are afew months later with taris implemented and USD/CNY substantially higher (Read more in our Week ahead:Ceasefire Déjá Vu)

From a momentum perspective, there are still reasons to believe that China will continue to counter theadverse eects from the trade war. Judging by both the copper price development and the plungingShanghai Composite, there are reasons to expect the Chinese PMI to lose steam next week.

e-markets.nordea.com/article/45386/fx-weekly-how-to-trade-a-ceasefire

Chart 4: If you ask copper or Shanghai Composite, Chinese PMIs are set to weaken

Where does this leave EUR/USD? The very solid 4.1% (annualised) Q2 GDP print from US was most likelyalready priced in to EUR/USD. Diverging growth outlooks have been a key driver of lower EUR/USD sinceearlier this year. 12 months forward looking growth estimates have moved in favour of the USD at least sinceFebruary and we still see most reasons to expect that trend to continue over the next quarter or so.

e-markets.nordea.com/article/45386/fx-weekly-how-to-trade-a-ceasefire

Chart 5: If US outperforms the Euro area on growth expectations, expect EUR/USD to head lower

Swedish PMI figures are leading the way for Euro area dittos (as the Swedish economy feels the heat earlierthan the Euro area), and based on the most recent Swedish manufacturing PMI, there is still a scope forthe Euro area manufacturing PMI to drop towards 51-52. We will get a new indication of whether theSwedish canary will start to fly again this week.

e-markets.nordea.com/article/45386/fx-weekly-how-to-trade-a-ceasefire

Chart 6: Wherever you go, I will follow

JPY: A twist to help the banks

Bank of Japan has been rumoured to consider a reverse operation twist already at the meeting on Tuesday,implying that eorts to keep the 10yr point at the yield-curve zero-bound will be tapered in return for a largerpurchase tempo in shorter-dated JGBs.

It is worth noting that BoJ has already started this process to a certain extent, though further out on the curve.The tapered purchase tempo from BoJ over the past quarters has primarily resulted in fewer purchases oflong-end bonds (+20yrs), while the 10yr point on the curve has been under strict protection still.

Should BoJ opt for a more clearly communicated reverse operation twist (against our baseline) with thepurpose of allowing also 10yr yields to rise, we don’t consider it a hawkish signal from BoJ – and certainlynot a signal that BoJ will “accept” a non-neglectable rise in the trade-weighted JPY. A reverseoperation twist is designed to be a helping hand to banks and nothing else.

If the trade weighted JPY and the oil price stay at current levels for the remainder of the year, the inflationpressure (ex. fresh food) will continue to abate towards the zero-mark on our models.

In other words, if the JPY is to strengthen, it should not be welcomed by BoJ. We though continue tostick to our short NZD/JPY bet, as a late cycle and US curve flattening play. (FX weekly: What’s that curve?)

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Chart 7: If JPY and Oil stays put, inflation will disappear in Japan

GBP: Even a dovish hike will not be GBP positive

Most analysts agree that Bank of England will hike the bank rate on Thursday and the market isaccordingly pricing above 80-90% implied probability of a hike. We are, however, less certain that BoEopts for a hike, a i) The unemployment rate remains glued to the latest NAIRU-assessment around 4.25%,while wage growth has decelerated compared to latest inflation report from May (from 2.9% to 2.7%), ii) Coreinflation has surprised on the downside compared to the May inflation report, while headline has developedmore or less in line with the May-projections from BoE.

In sum, it is hard to see any reason for increased optimism on wage growth and core inflation in UKcompared to the inflation report from May.

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Chart 8: The UK unemployment rate remains glued to the latest NAIRU-assessment

Also, the most recent voting indications given by MPC members haven’t convinced us that the >90% impliedprobability of a hike is a fair reflection of the probability of such an outcome. Jon Cunli asked for stodginessfrom the MPC in a speech on the 13th of July. Cunli will surely vote against a hike, but he is also the mostdovish MPC member.

More importantly, the potential median-vote in the MPC, Ben Broadbent, indicated last week that he is yet todecide on whether to vote for a hike or not. Should the sta projections on inflation and wage growth be lessoptimistic than in May (as we see a scope for), we are not convinced that Broadbent will ultimately vote for ahike.

Ultimately, we think the MPC will vote to keep rates unchanged by a 5-4 margin, but the view hingeson a dovish revision of projections by the BoE sta. The bottom-line is that we favour a short GBP position into the meeting from a risk/reward perspective. Even a dovish hike could end up as a GBP negative event,given the current pricing of BoE.

If the MPC set aside credibility considerations, there are no reasons to hike in UK. Core inflation will droptowards 1% over the next quarters.

e-markets.nordea.com/article/45386/fx-weekly-how-to-trade-a-ceasefire

Chart 9: No reason to expect UK core inflation to remain high

On top of the potential dovish surprise from BoE, the option market is again increasingly indicating thatmarket participants are willing to pay up for GBP downside protection. The closer we get to March 2019 (Theocial brexit-date) without any substantial progress in the Brexit negotiations, the bigger a risk premium is tobe expected in EUR/GBP risk reversals. Time works as a magnet and no news is bad news.

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Chart 10: The market is starting to pay up for GBP downside protection again. Expect more of the same

NOK: The summer liquidity puzzle

The summer can be a hard time for NOK as market liquidity dries up. This has been the case this year asNOK has weakened around 20 øre towards the EUR at the most.

The lack of market liquidity over the summer is not the only explanation for the weak NOK. The loyal readersof this publication series will know that we consider excess bank liquidity an underappreciated driver ofcurrencies. In Norway, the excess liquidity in the banking system is highly cyclical as Norges Bank sterilisesthe liquidity eects from the highly seasonal budget deficit on the government account almost linearly overthe year.

As a consequence the liquidity withdrawal from the banking system (liquidity sterilisation > budgetdeficit) peaked in late June and the tide is now turning on the banking excess liquidity until late August/early September. We went short NOK on this story earlier in the summer (with success).

e-markets.nordea.com/article/45386/fx-weekly-how-to-trade-a-ceasefire

Chart 11: Running development in excess banking liquidity in Norway is an underappreciated NOK driver

Late August and into September I) market liquidity will return, II) we will get close to the first rate hike fromNorges Bank and III) excess liquidity developments will turn NOK positive. With those three things movingin favour of NOK at the same time, 9.20-9.30 should be within reach in EUR/NOK, but for the time being, wefavour a side-lined or even a slightly NOK negative approach (NOK: Surviving the summer)

e-markets.nordea.com/article/45386/fx-weekly-how-to-trade-a-ceasefire

Chart 12: Norges Bank have paved the way for stronger NOK down the road

SEK: What if the Riksbank buys more foreign held SGBs?

We continue to hold on to our long EUR/SEK position in our tactical convictions (despite a mediocrestart), despite the already elevated levels in EUR/SEK. We have had several questions on the potentialdrivers of higher EUR/SEK, given the already high levels in a historical context.

We see several reasons for short-term to medium-term SEK weakness, but the “stealth QE” from theRiksbank is amongst the more important of them. Remember that the Riksbank is pre-reinvesting bondsmaturing in 2019, why the Riksbanks balance will continue to increase in size until early 2019 (further thanthe ECBs QE program). If the Riksbank buys the SGBs from foreigners, it could create more SEK weakness.

The upcoming Swedish general election (September 9th) is another potential SEK negative catalyst.(SEK: political scientists will have a field day).

e-markets.nordea.com/article/45386/fx-weekly-how-to-trade-a-ceasefire

Chart 13: The Riksbank have killed foreign holdings of SGBs

Previous FX weeklies:

·FX weekly: What's that curve? (22 Jul)

·FX weekly: The China Factor (15 Jul)

·FX weekly: Take a short trade war breather (08 Jul)

·FX weekly: Trump will never #238 (01 Jul)

·FX weekly: The USD is the best carry currency in the world (24 Jun)

·FX weekly: Dollar to provide headwinds for earning estimates (17 Jun)

·FX weekly: Fire and fury risks for the USD (10 Jun)

·FX weekly:  It's not only Italy.. (03 Jun)

·FX weekly:  The Sumo SOMA days (27 May)

·FX weekly: EM won't be sprinting, if the Fed is unprinting (20 May)

·FX weekly: The two final nails in the dovish FOMC-con (13 May)

·FX weekly: Is there anything left in the USD bull-run? (06 May)

e-markets.nordea.com/article/45386/fx-weekly-how-to-trade-a-ceasefire

·FX weekly: Dragon Energy (29 Apr)

·FX weekly: Relative curvature is the new king of FX (22 Apr)

·FX weekly: Why is EUR/USD not trading lower? (15 Apr)

·FX weekly: Like watching paint dry, they said (08 Apr)

·FX weekly: The list of potential USD-positives is getting longer (01 Apr)

·FX weekly: 2 reasons why EUR/USD has decoupled from rates spreads (25 Mar)

·FX weekly: Time to buy a USD lottery ticket? (18 Mar)

·FX weekly: Taxation mirror on the wall, who is the fairest of them all? (11 Mar)

·FX weekly: Trump's game of chicken (04 Mar)

·FX weekly: Will the market neglect the clutch of canaries? (25 Feb)

·FX weekly: Is the correlation break-down driven by FX hedges? (18 Feb)

·FX weekly: The liquidity tide is ebbing (11 Feb)

·FX weekly: Hawkish spectacles (04 Feb)

·FX weekly: Who will stop EUR/USD from moving higher? (28 Jan)

·FX weekly: Did the Democrats dent the Dollar? (21 Jan)

·FX weekly: Is 1.25 the new 1.20? (14 Jan)

·FX weekly: The euphoria rises (07 Jan)

·FX weekly: Paging Dr. Pangloss (01 Jan)

·FX weekly: The R-star of Bethlehem (24 Dec)

·FX weekly: A numbers game (17 Dec)

·FX weekly: The year-end liquidty shrink (10 Dec)

·FX weekly: Three reasons why EUR/USD isn't trading lower (03 Dec)

·FX weekly: Which currencies to sell if the housing downturn continues? (26 Nov)

·FX weekly:  The global industrial cycle is set to weaken (19 Nov)

·FX weekly: Is high-yield a canary in the global coal mine? (12 Nov)

·FX weekly: Is this the end of the inflation convergence trade in EUR/USD? (5 Nov)

·FX weekly: Was that it for the EUR bulls? (29 Oct)

e-markets.nordea.com/article/45386/fx-weekly-how-to-trade-a-ceasefire

·FX weekly: Hawks in opposition, doves in charge (22 Oct)

· FX weekly:Continued convergence or re-divergence?(15 Oct)

·FX weekly: Thingsdon't matter until they do(08 Oct)

·FX weekly:"October seasonality is strong" (01 Oct)

·FX weekly:“Is 1.20 the new 1.15?”(24 Sep)

· FX weekly:Honey, I shrunk the balance sheet(17 Sep)

· FX weekly: “USD liquidity will turn scarcer, but when?” (10 Sep)

· FX weekly:“Strong currencies and inflation”(3 Sep)

· FX weekly:“USD in the (Jackson) hole” (27 Aug)

· FX weekly:“Q4 is the USD quarter”(20 Aug)

· FX weekly:“In the year 2525”(13 Aug)

· FX weekly:“EUR/USD ceiling or debt ceiling?”(6 Aug)

· FX weekly:“Elevator up, stairs down “(30 Jul)

· FX weekly:Trump “spices” up EUR/USD(23 Jul)

· FX weekly:Flip-flop?(16 Jul)

· FX weekly:Consolidation time?(9 Jul)

· FX weekly:Hawks R Us(2 Jul)

· FX weekly:Another lowflation week?(25 Jun)

· FX weekly:No Fed put?(18 Jun)

· FX weekly:A bouncy dollar?(11 Jun)

· FX weekly:Heating up(4 Jun)

· FX weekly:Summertime sadness(28 May)

· FX weekly:Special counsel lessens Trumpbulence, while OPEC looms(21 May)

· FX weekly:Are China worries old hat?(14 May)

· FX weekly:Inflation week…(7 May)

e-markets.nordea.com/article/45386/fx-weekly-how-to-trade-a-ceasefire

Andreas Steno LarsenGlobal FX/FI Strategistandreas.steno.larsen@nordea.com+45 55 46 72 29

Martin EnlundChief AnalystMartin.Enlund@nordea.com

28.9.2017

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Nordea Bank AB Hamngatan 10 SE-105 71 Stockholm

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