FX

US$ – DXY has been rudderless within 105.50 and 107 for a good month now, but with both 2 and 10yr yield spreads still forging ahead in the USD’s favour the immediate direction of DXY travel should be towards recent range highs at 107.35. Data and event risk should generally break in the USD’s favour this week. Chair Powell likely points to geopolitical risks, the back up in long term rates and encouraging disinflation trends, and at the same time he will likely craft a hawkish pause, underscoring that they are attentive and wary about persist above trend growth. Most of the partial October data released so far suggest Oct ISM and payrolls could print at least as strong as consensus too, altogether making a case for more aggressive 13 Dec FOMC pricing, currently just +5bp - a meeting that will likely see further notable GDP upgrades, albeit no changes to PCE projections. The Treasury’s quarterly refunding announcement likely skews the risks for yields higher too, while any BoJ YCC tweaks probably won’t be sufficiently material to trigger a sustained reversal in USD/JPY, certainly not while the US 10yr leg of the US-JGB spread continues to push in the USD’s favour. DXY looks like it will be supported into the 106.20 region today.
Macro FX Trades Ideas update for the majors: Short EUR/JPY from 158.00, opened 6 Oct, stop 160.20, target 152. Rationale: BoJ YCC policy tweaks running high this week, Eurozone growth expectations cooling. Long DXY at 105.55, opened 23 Oct, targeting 108.00, stop 106.00. Rationale: Dec FOMC hike risk underpriced (+5bp) and US resilience to extend into Q4.

AU$ - - Australia’s elevated Q3 CPI remains a positive for the Aussie but it is not very visible in the current global environment. Money markets are more than fully priced for another RBA hike by Q1, eye-catching in the G10. So the Aussie has a degree of support from RBA expectations that it has rarely had since the pandemic. Westpac believes a November hike is more likely than not.
But the initial AUD/USD bounce post-CPI reversed at 0.6400 and it has not retested this since, struggling against the USD's appeal of high yields backed by a resilient economy, insulation from global energy price pressures due to local supply and safe haven status.
In Richard’s FX model weekly, he estimates that commodities and yield spreads have had only a modest role in the AUD decline of recent weeks. Proxies for investor sentiment towards China and the US appear to be the heaviest weight on the A$. Given the ongoing war in the Middle East, AUD/USD seems likely to target 0.6250, then 0.6200. Any A$ benefit from RBA pricing may only be evident against fellow risk-sensitive currencies such as NZD, which we see extending its rally to 1.10 multi-day/week.

NZ$ – NZD/USD continued to probe lower last week, reaching 0.5774 – a low since November 2022 – although it has not followed through. The 0.5800 area remains supportive, but vulnerable, a break then targeting 0.5650 multi-week. The main drivers of the decline have been receding expectations the RBNZ will hike again, and global risk aversion emanating from the war in the Middle East. On the latter, we note that Israel has started a ground offensive, which could weigh on markets today. This week’s Q3 NZ labour data, particularly wage inflation, will be closely watched, as will the signals from the FOMC. Multi-week/month, our bullish USD outlook remains intact, implying a bearish NZD/USD bias.

Rates

US rates – The FOMC is widely expected to leave rates unchanged this week, for the 2nd consecutive meeting. We expect the messaging to be slightly hawkish, albeit cautious, as the FOMC assesses the impact of tighter financial conditions and the lagged effects of past tightening. So, we expect Fed Chair Powell to maintain an explicit tightening bias, which will not shift pricing for the December meeting too much. If anything, depending on how hawkish Powell’s message is. there might be scope for the market to pare back some 2024 rate cut pricing. Unusually, however, the FOMC might not be the main market driver this week. There is plenty of focus on the Treasury’s quarterly refunding announcement on November 1. Last quarter’s issuance was the largest outside of the pandemic period and there is scope for an even larger programme of UST coupon issuance in the November-February quarter. While most of the issuance will be in the 2y to 5yr maturities, this heavy supply load is likely to add to term premia across the term structure as the market assesses who the marginal buyer will be and at what clearing price. While other important data, including Payrolls, will influence directional price action, the supply story alone biases us to expect rallies to be short-lived and for US 10yr yields to end the week closer to 5% than where they open.
Beyond that near term influence, how to we assess medium term risk rewards for US 10yr bonds? Certainly the recent volatility is set to continue as the market consolidates the recent rapid yield rise and deals with competing economic, geo-political and other market risks. Beyond that, we would eventually expect a further push toward, and above, 5%. As to how high 10yr yields could rise, we are also conscious of the ongoing heaviness in equities, which have now corrected around 10% since July under the weight of higher yields. That brings into sharp focus the nexus between equities and bonds. One which will be a headwind to a sustained and material sell-off beyond the 5% level.

AU rates – The market has pared back some of its hike expectation for next week’s RBA policy decision to just over 50%. It had been as high as 75% chance in the period post the CPI. Beyond that, forward cash rate expectations remain upward sloping, with a terminal rate of around 4.49% by mid-2024. In our view, that appropriately reflects the current risks around the RBA’s policy reaction function. If they do deliver a hike in November, as Westpac expects, then the market shouldn’t see it as “one and done”, but nor should the forward guidance shift significantly from the message they have maintained since they paused their hikes in June – that they will remain vigilant on the inflation front and will act appropriately as the data evolves. So in our view that would make February the next “live” Board meeting beyond November.
At around 50bp, the 3-10yr future spread is currently at the middle of its recent 46-57bp range. Clearly if the RBA does resume its hike cycle, there would be momentum for the curve to flatten further, perhaps to the 40bp level and even lower if the rhetoric was more hawkish than we expect. We would also expect swap spreads to continue to move wider under a hike scenario, as it would likely confirm some of the recent push in swap tenors and encourage payside flows on any dips. Any widening in swap spreads will negatively impact semi-bond, however given wide semi-swap spreads are, underperformance will likely be limited. There has been significant issuance in the sector this month, and similar volumes could be expected in November ahead of year end. However we expect solid demand to continue for now. Perhaps the most interesting aspect of the market is the underperformance of AU rates and bonds on a cross market basis. The benchmark 10yr AU-US bond spread has widened by as much as 16bps over the week and is now only slightly inverse (-1bp at the time of writing). While that is completely rational given the re-pricing of relative cash rate expectations, we think we are moving toward a good entry level to reverse the recent trend and enter narrowers. It is too early right now, however a lot of the recent re-evaluation of policy risks is now done and there is an ongoing relative supply story, a relatively steep curve and a still-low currency that should encourage global investor flows. Looking at other relativities there is an apparent role reversal underway between market expectations regarding the RBA vs RBNZ, in which the RBA is playing the more hawkish hand. That has not been the case for most of this year and last. So, there is now in our view a greater risk to price action if the RBA DON’T hike in November. Then the market would get very concerned about them falling behind the inflation curve, BEIs will widen, curves will steepen and that might add extra risk premia to cross market spreads as well.

NZ rates - NZ swap rates for shorter maturities continued to decline last week, the slightly softer Q3 CPI data two weeks ago still weighing on market expectations of the RBNZ. A November hike has been completely priced out, while February is priced as a 25% chance. Longer term swap rates, though, have remained elevated in sympathy with offshore counterparts (e.g. Australian rates rose following stronger CPI data last week). As a result, the yield curve steepened (or disinverted) further, and is looking overdue for a correction.
This week’s event calendars in NZ and offshore contain significant market-moving potential. In NZ, labour data will be important for the stance of RBNZ monetary policy. Offshore, the main event will be the policy rate decision from the Federal Reserve (expected to remain on hold with a conditional hiking bias), followed by the monthly jobs data and quarterly Treasury borrowing update. There are also policy decisions from the Bank of England and Bank of Japan, both also expected to remain on hold.
The 2yr swap is likely to remain below the cycle peak of 5.85% during the weeks ahead, given the more informative Q4 CPI and labour data won’t be available until January. The NZ-AU 10yr bond yield spread has continued to narrow as expectations of an RBA hike this week build.

Funding, basis and liability management

NZD/USD continued to probe lower last week, reaching 0.5774 – a low since November 2022 – although it has not followed through. The 0.5800 area remains supportive, but vulnerable, a break then targeting 0.5650 multi-week. The main drivers of the decline have been receding expectations the RBNZ will hike again, and global risk aversion emanating from the war in the Middle East. On the latter, we note that Israel has started a ground offensive, which could weigh on markets today. This week’s Q3 NZ labour data, particularly wage inflation, will be closely watched, as will the signals from the FOMC. Multi-week/month, our bullish USD outlook remains intact, implying a bearish NZD/USD bias.

Commodities

No real change in our views here. We are sticking to the mantra that crude markets need more bad news to fuel gains, and while there has been plenty of shocking news over the weekend, it just doesn’t seem to be enough to spike prices above recent highs. We tend to see this situation remaining in place as long as the Israel/ Hamas war continues. Price remain well supported in the early $80s for WTI and $85+ for Brent on the obvious risks that Iran proxies in the region widen out the conflict, drawing in the huge US presence in the region. However, the topside appears capped by two important forces.
Firstly as we noted last week, our measure of OPEC+ production has dropped by 2.7mb over the last year with Saudi accounting for 2mb (Russia only 300k) suggesting that there is a lot of Saudi spare capacity that could quickly be brought to market if required. The IEA estimates that OPEC has 4.9mb of spare capacity that can be reached within 90 days and sustained for an extended period. A year ago that number was just 2.4mb suggesting roughly 2.5mb could be very quickly pumped into the market if required, with another 2.5mb being brough online if/ as required.
Secondly, we suspect our proxy for global crude plus liquids inventory is set to rise from multi year lows in coming weeks, given waning demand for liquids on retail higher prices, plus the sharp rise in tanker rates hitting crude trade around the world. Reflecting the sharp rise in war risk premium, tanker rates for medium sized ships have jumped to more than $100,000 a day in Europe, the highest since December. And right on cue physical markets have showed signs of softening with Bloomberg noting that prices of WTI delivered into Europe have fallen by almost $2 per barrel in a little more than a week, hitting lows back to the end of last year and Western Canada Select hitting the softest since late August. The spread between the prompt and next WTI contract hit a fresh 5 week low of 66c last week, down from a peak of $2.38 just a month ago. Citi last week noted that the US has overtaken Russia as the world’s largest gross exporter of middle distillates and that domestic product demand is “surprisingly weak amid signs of economic strength” – indeed US liquids inventory is running well above seasonal average levels as we head into refinery re-tooling season.
As long as the current situation continues, the risks of spikes towards the $95+ highs seen late September remain. But we find it really telling that we have not even been able to approach those bar the spikes seen in the first week of the war. And the fact that prices are lower this morning despite Israel embarking on the “next stage” of the ground war adds to our case. So it feels as if we should be capped/ headed lower assuming the current situation dies down without material escalation. Though as ever, if we did see Iran proxies for instance hit facilities in the Straits of Hormuz which carries circa 80mt (20% of global LNG per year) and 20.5mbpd of crude plus liquids (circa 20% of global trade) then the situation could change very quickly. Hence the call that we need more bad news to sustain current prices/ create spikes; but without a fresh deterioration, we are headed lower near term.

Richard Franulovich

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Australia and NZ weekly 11 December 2023

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