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Parity Party Postponement and Other Asundry Issues - Global Exchanges

FICC Podcasts 26 juillet 2022
FICC Podcasts 26 juillet 2022


Disponible en anglais seulement

In this week's episode, we discuss some of the key issues for the FX market during the dog days of summer, including the persistence of above-average volatility, the softening of oil prices, and the modest relief rally in the euro.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

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Greg Anderson:

Hi, welcome to episode 47 of Global Exchanges, a podcast about foreign exchange markets and related issues. In this week's episode, my co-host Stephen Gallo and I discussed some of the key issues for FX markets during the dog days of summer, including the persistence of above average volatility, the softening of oil prices, and the modest relief rally we've seen over the past two weeks in the euro. The title of this episode is Parity Party Postponement and Other Asundry Issues.

Stephen Gallo:

Hi, I'm Steven Gallo, a London-based FX strategist. Welcome to Global Exchanges, presented by BMO Capital Markets.

Greg Anderson:

Hi, I'm Greg Anderson, a New York-based FX strategist. I'm Steven's co-host.

Stephen Gallo:

In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets, like commodities.

Greg Anderson:

We strive to make this show as interactive as possible, so don't hesitate to reach out by going to bmocm.com/globalexchanges. Thanks for joining us.

Stephen Gallo:

Okay, let's get things rolling, Greg. It's the 26th of July 2022. Thanks for listening to Global Exchanges for those tuning in. In view of the title of this episode 47, Greg, let's mark where we are on the broad dollar month to date. We see the dollar up about, call it 1.5 To 2%, but we are off the high for the cycle. For the euro portion of the dollar basket, the single currency has recorded around a 3.5% decline for the month so far.

Stephen Gallo:

The major European currencies have been the laggards overall, particularly the net energy importers. But in euro, as mentioned or noted in the title, we've seen a bit of a rebound in the currency versus the dollar from the test of levels below parity in mid-July. In terms of the percentage move in euro-dollar from the low we're a little over 1% above the low for the cycle.

Greg Anderson:

So Stephen, if I could interject with an explanation of our title, the last time that euro-dollar broke below parity was in December of 1999. And I'll just say the global situation, it was much different then. We were in the height of the .com boom. And the NASDAQ had gained something ridiculous, like 70% on the year. So with equity returns like that, it was really hard for those of us in foreign exchange to get investors to pay any attention at all to FX.

Greg Anderson:

The employer that I worked for decided to throw a parity party, just to be able to retain engagement with euphoric investors and point out to them that not only were amazing things happening in equities, but also that there were noteworthy things going on in the FX market, too. So at any rate, it's obviously a different world now. And this year's move below parity in euro-dollar comes alongside a major correction in stocks and bonds this year. So with that intro, Stephen, my question back to you is this. Was the move below parity on July 14th in euro-dollar this year, something that the ECB would want to celebrate with a party? Or did that break of parity motivate the ECB to implement the 50 basis point rate hike we saw last week as a defense of the common currency?

Stephen Gallo:

I like this theme a lot, which is that the world has changed a great deal since the launch of the euro in '98, '99, particularly when we look at the global trade picture amongst other factors. I guess we shouldn't be surprised by the fact that there has been a significant amount of change and upheaval in a little over 20 years or so, but in the last three to five years, the pace of change appears to have accelerated Greg. If we go back to '98, '99, and I pick up on your thoughts about the US equity market surging, the reasons for the break below par in '99 I think were much more benign. And if I look back at the euros, for instance, the balance of payments data from around that period, I can see heavy net outflows of capital on the equity side. Also reasonably large on the FDI side.

Stephen Gallo:

And it's almost as if European investors were using their new currency to soak up foreign assets. But this time around Greg, we're looking at, I think, a more pernicious move lower in the euro. So yes, I think there are a number of ECB officials that have been perturbed by the move lower in the euro, but equally, I don't think there is a resounding view within the ECB that the institution is able to stop it. For instance, on that point, what can the ECB really do about a negative flows picture, particularly since a lot of those flows have been in the current account? The ECBs kind of stuck, Greg. On the one hand, some officials would probably prefer the euro to be stronger. But on the other hand, if they attract too much attention to a single level in euro-dollar, the FX market may test the ECBs resolve when the ECB doesn't really have the ammo to stop the move anyway. It's a bad situation to be in.

Greg Anderson:

In last week's post, ECB Relief Rally, euro-dollars spiked up to as high as 1.0278, but that didn't last long. Now, less than a week later, we're back below 1.0150 and seem to be drifting lower. So, Stephen, my next question. What do you think about the rest of the summer? Say through the end of August. Do you think we will go back below one quadruple zero in euro-dollar and maybe stay longer than a few hours this time?

Stephen Gallo:

I think that is pretty much where the balance of risks is tilted, Greg, to another test below parity in euro-dollar. And that's basically what we've been publishing in our outlook profiles for that pair. I also think it's worth pointing out that there are a number of issues which are up in the air here. Firstly, the next move of Putin's regime. Uncertainty about the pace and flow of LNG shipments into the European Union to offset these Russian supply cuts, which are now happening in reality and not just a risk.

Stephen Gallo:

And of course, another thing that's up in the air or uncertain is the weather. Looking ahead as we get into the autumn/winter period, I think we will be faced with potentially supply rationing of natural gas in parts of the European Union, although, I would expect the FX market to price that risk in long before we actually get to the autumn/winter season. So in terms of outright levels in euro-dollar, Greg, we've been putting the 98 figure into our euro-dollar profiles along the one to three month part of the curve. And I would say for the time being, most of the factors point to us sticking to that view.

Greg Anderson:

Before we switch channels and put me on the hot seat, Stephen, I just wanted to ask you about euro crosses. Is there anything that has happened in intra-Europe euro crosses, alongside the euro-dollar parity test, that you think is particularly noteworthy for investors?

Stephen Gallo:

Yeah, Greg. I'm glad you brought that up, but I have to admit defeat on a couple of my near term euro cross calls. Firstly, in euro Swiss, the pair is deeper below parity than I had expected at the time of the June FX quarterly when we published. And that's partly due to the fact that the SMB, the Swiss National Bank, has been particularly hawkish. And this is a recurring theme in Europe, which is that central banks around the ECB, including the Swiss National Bank and central banks in the CEE region, they've demonstrated that they have fewer constraints on them when it comes to tightening policy than the ECB. The other pair is euro-sterling, which is trading heavier than I have been anticipating. And in recent days, I think that heaviness is certainly related to the Russian energy supply cuts.

Stephen Gallo:

The UK is notably less exposed than countries like Germany, but it's also been due to Italian political risk. Near term I would certainly look for the heavy tone in euro-sterling to persist, but I still like it higher the six to nine month part of the curve given sterling's weak balance of payments fundamental. So my anticipation is that the 83, 84 range looking further out the curve is where the pair should base. Greg, why don't we flip over to the dollar side of the equation now and to you. So I mentioned the level of 98 in euro-dollar. Can you explain how you see things progressing here for the dollar and talk about where or when the dollar peak might occur for the cycle?

Greg Anderson:

So with this year's call it 10% rally in the broad US dollar. I think there are three main catalysts. One is the aggressive Fed rate hikes. The second is rising risk aversion and recession fears, as encapsulated by strongly negative equity returns and inverted twos versus tens US Treasury curve. The last catalyst of US dollar strength has been high oil prices. With the US' balance of payments, being much better insulated against that then key trading partners like Europe, China, and Japan.

Greg Anderson:

So I think we're already passed peak pricing of Fed rate hikes. And in fact, if you look at FFZ3, which is the December 2023 Fed Funds futures contract, it was pricing in an end of 2023 Fed Funds rate as high as 3.75 back in June. But now it's pricing an end of 2023 Fed Funds rate of 2.80%. So this pricing in of rate cuts for next year that we've seen over the past two weeks, this has taken away some of the US dollar upside pressure.

Greg Anderson:

And then oil has also backed off in a big way in July. We're down about $10, call it from 105 a barrel to 95 in WTI. That has taken away some of the upside pressure on the USD as well. Lastly, the third pillar of dollar strength, the recession fears. That is what has kept the dollar somewhat bid in July. But it has been a mixed bag because while we've had the Treasury curve inverting, at the same time equities are recovering a bit. So the S&P 500 is up 3.7% month to date, for example. So back to the question, you asked me about where and when the US dollar peak might get put in. My response is that I think that the Fed rate hikes pillar of dollar strength is past peak already and I'm fairly high conviction on that view.

Greg Anderson:

I think the recession fears theme is also probably past peak, but I'm more like low conviction on that. And then that brings us to the last pillar, oil. With W2I at 95 , as I mentioned, I'm still pretty bullish on oil there, and I admit to being somewhat wrong. So I talked quite a bit in Q2 about high risks of a summer oil price spike that hasn't realized yet. But I still think W2I goes back to somewhere around $110 a barrel over the next couple months. So I think that factor is out there and it, and it still gives the US dollar some upside. So kind of bottom line putting all three factors together, right now, my best guess for the broad dollar index is that, I now say it's going to put in a double top with a second peak that roughly matches the July 14th peak. So that's, let's call it one to 3% higher for the dollar index, and I give you timeframe over the next one to three months. And then it's probably over.

Stephen Gallo:

Right, Greg. And let's say that I'm still looking to play the dollar from the long side in an environment where we have the broad dollar peaking on the one to three month part of the curve. Outside of the European space, what's your preferred pair in that case?

Greg Anderson:

So with the broad US dollar index pullback, we've seen a pullback in dollar-yen from the high of 139.39 on July 14th to about, well, let's call it 136 and a half now. It's not a huge pullback, just 2%, but I think it's a gift. I think dollar-yen still has a rally above 140 in it. And all it would take is oil back above $100 a barrel, and then recession fears abating just a little bit as would be evidenced by a few percent higher in inequities. So that's where I would put my biggest US dollar long and also I'd, alongside the dollar, I'd also be looking to build longs in CAD and in Aussie against yen.

Stephen Gallo:

Greg, we've got to wind this down soon, but one thing we have not discussed yet is implied volatility in FX, or just volatility in general. And it's relatively high at the moment. So for example, if I look at three month implied vol in euro-dollar comfortably above its five year average. With so many moving parts in FX and at the global level, I guess this high volatility environment is not surprising. My take, Greg, before I pass it over to you shortly, is whereas prior vault spikes that we've seen over the last decade or so have been abrupt and short-lived, my instinct on this one is that the current high volatility environment probably in both implied and realized terms, it's got a greater chance of sticking. Any thoughts on that, Greg, before we wrap up?

Greg Anderson:

So FX volatility isn't a variable that if you put it into a distribution or density chart that it looks anything like the classic normal bell curve. Basically, in FX there's a high vol regime that we're in about 30% of the time, and then a low vol regime that we're in about 70% of the time. We're presently in the high vol regime. And although we've seen implied vols in both euro-dollar and dollar-yen back off a little bit since July 14th's peak for the US dollar. And I guess I could see them fading a little bit lower if we get in August doldrums period of market news, which is pretty typical. But anyway, I don't think there's much chance at all that we transition all the way back to the low vol regime anytime in calendar 2022. There's just too much going on in the global landscape that needs to be resolved before we go back to the low vol world.

Stephen Gallo:

I think this is a great point to end on, Greg. To our listeners, thank you again for joining in. As always your thoughts and feedback are welcomed. Bye for now.

Greg Anderson:

Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts at bmocm.com/globalexchanges.

Stephen Gallo:

We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:

This show and resources are supported by our team here at BMO, including the thick macro strategy group and BMO's marketing team. This show is produced and edited by Puddle Creative.

Speaker 3:

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Greg Anderson Chef mondial, Stratégie de change
Stephen Gallo Chef de la stratégie de change pour l’Europe

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