Markets are opening with a small wobble on the risk axis this morning as investors are perhaps reaching a near term inflexion point. However, it's probably too early to say as investors have their feet firmly planted and continue to roar like lions, supported by a lengthy vaccine runway paved with US stimulus.
Dramatic moves over the past days following the Georgia elections have been triggered by a larger fiscal stimulus and a stable monetary policy. But the word "taper" has increasingly featured in Fed rhetoric, so the street is already keeping an eye on the Fed as they start to shift on this front.
And despite the analogue to the 2013 taper tantrum that saw equity market climb when US 10- years backed up 130 basis points, this glorious 10-month rally has been unilaterally supported by stimulus and Fed policy air balloons. Even the slightest hint at letting air out of one or the other will unquestionably turn investors a bit fidgety and less gleeful to take risk higher.
Also, the omnipresent Covid concerns continue to hang like a nasty cloud over the market and, given a great deal of optimism in stocks and oil is linked to the rollout of Covid-19 vaccines, investors are sitting with fingers and legs crossed that there won't be any negative news flows on this front, which would prompt a sharp negative market reaction.
Meanwhile, US-China friction continues to build as the Trump administration removed US-Taiwan restrictions in a move likely to enrage China. That will likely propel the first week of the Biden administration into a standoff with China and the Democrats; backpedalling Republicans will happily portray the new White House administration as soft on China.
Friday was a good day to stay long as oil futures were in big demand at commodity index rebalancing on Friday. But with that demand now in the rear mirror, it's likely back to physical demand concerns with Covid hot spots flaring again in Asia’s colossal oil importers, with 11 million people lockdown in China Hebei province alone. Indeed, this along with a touch of Fed policy uncertainly has likely triggered some profit taking out of the gates this morning. Unquestionably one of the biggest risks to the view is the spread of Covid in China.
But oil traders have done an excellent job sidestepping lockdown threats, suggesting that unless the vaccine doesn't work against the new variant, oil prices will remain supported.
It's been a great start to the year with both Brent and WTI at levels not seen since Feb-20 and the pandemic's initial impact in western economies. There was very little new material news impacting the oil market, other than commodity rebalancing demand, as the complex continues to reprice and bask in the afterglow of the Saudi production cut, the implications of the Democrats being in control of the Senate and the limited impact on broader markets of some of the political turmoil seen in the US.
The Democrat sweep of Georgia’s run-off elections helps to address one of the key medium-term risks for oil: the potential supply response from US E&Ps. The Biden administration, now with support from a Democrat-controlled Senate, may be more likely to impose restrictions on US oil companies, for example limiting drilling activity on Federal land, which limits the medium-term production upside from the US and therefore diminishes one of the key downside risk factors for oil.
Oil is still pricing in a great deal of optimism linked to the rollout of Covid-19 vaccines and any negative news flow on this front would prompt a sharp negative reaction. Demand will always improve as the vaccines roll out, and the supply side is under control thanks to OPEC+ and Saudi Arabia's continued efforts. Risks remain, but there appears to be a clearer path to oil upside with downside risks diminished.
How will USD perform in the face of higher equities and increased prospect of more US stimulus?
One would assume lower. However, any time you get a quick fixed-income move in either direction – especially one that challenges a one-sided Forex view – the market narrative takes a pause. It appears this time is no different as investors now struggle to iron out whether the triggered inflationary rise in nominal rise yields could be a precursor to a shift in Fed policy, which is the primary key for the US dollar.
Right now FX dollar shorts are fidgeting about both higher UST yield differentials that favour the US dollar and the pivoting view on growth differentials that could see the US economy recover quicker than Europe, particularly as Joe Biden aggressively pushes vaccination efforts and will achieve herd immunity relatively early.
For the dollar, it might be a case of push and pull where risk-on sentiment and dollar-negative as capital is allocated elsewhere, versus the attraction of higher US yields over the short term.
The majority of the street expects the broad US dollar momentum to extend, even though the rising 10-year yield differential is leaning in US dollars favour. The logic here is that FX markets are far more sensitive to front end rates, which are still pinned down by the 0% Fed funds that are not expected to lift off until 2023. And while taking the Fed at their word – which might prove to be a calculated error if inflation explodes higher in Q2 – Vice Chair Clarida said Friday; he did not expect any QE "tapering" until 2022 suggesting a turn around for the US dollar is still a ways off.
However, I think what you’ll see is a tightening of short dollar stop-loss levels and a greater reluctancy to sell the dollar with the reckless abandon that most of the big shops on the street were calling. The street’s views might go from selling the dollar across the board to tactically cautious short on less owned USD shorts until shorts reduce.
The real yield move after the Pfizer vaccine announcement in November is probably instructive, where the dollar rally in G10 was short-lived because fundamental flows were still dollar negative. Still, the dollar rally in gold was more significant given a reliance on real yields rallying.
There’s a bit of a sleeping beauty trade unfolding in USDJPY. The US reflation trade gains traction due to the 'Blue Wave' effect, and US yields have soared. USDJPY is catching up with Treasuries, and there's room for a move to 106 in the short term. With the USD bounce again as Treasuries yields continue to march higher, USDJPY is approaching the crucial technical level of 104.30-35. This is the bottom line of the daily Ichimoku cloud and a downtrend going back to February/March 2020. With the market not properly positioned for this trade, it could be a good way to bank 200 pips quickly.
USDASIA continues to retrace higher on higher US yields as are G-5 currencies. The Ringgit is falling on broader USD strength despite higher oil prices as higher UST yields appear to drive underperformance.
Also, Asia FX has lost a primary support anchor after the PBoC set several macro-prudential measures in succession last week to stem the risking yuan tide.
The US dollar's recent gains, higher yields and the equities rally is keeping gold on the defensive.
The gold market spent most of Friday aggressively trimming longs with little support down until $1,825. Naturally, there was stop-loss selling on the way down as buying interest from the real money community has lacked in any meaning full way this year which runs counter to seasonal norms.
The sell set up from technical and fundamental perspective hit gold like a ton of bricks on Friday when the yellow metal sliced like a hot knife through butter at $1,900, with one million ounces loaded and stopped within one second at that critical level.
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US stocks appear to have reached a mini cyclical fatigue point, but the pace of vaccinations remains the key driver for risk markets