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The impact of quarter-end flows has diminished, and the markets are now firmly set on a path favouring short bonds and a strong dollar. This shift has been aided by positive developments in US ISM manufacturing data and the hawkish comments from the Federal Reserve. In this context, both EUR/USD and GBP/USD appear poised to challenge the support levels of 1.0400 and 1.2000, respectively.
Furthermore, the newly appointed governor of the Reserve Bank of Australia (RBA) has conveyed a message of continuity while also increasing pressure on the AUD.
USD: Reclaiming the crown.
I had previously attributed the recent weakness of the dollar to quarter-end flows, but recent market movements have shifted sentiment back towards a pattern favouring short bonds and a stronger USD. This trend, which has been predominant since mid-July, has been reinforced by two key factors: an improving ISM manufacturing index and hawkish remarks from Federal Reserve officials.
The ISM manufacturing index for September surpassed expectations, rising from 47.6 to 49.0. Additionally, S&P Global Manufacturing PMIs for September were revised upwards to 49.8. It's worth noting that this marks the 11th consecutive reading below the 50 thresholds, indicating contraction in the manufacturing sector. However, the improvement to 49.0 and its close correlation with GDP suggest the possibility of a robust 4.0% annualized growth rate for the third quarter, which would support the Federal Reserve's view of a soft landing for the economy.
In recent days, several FOMC hawks have become more vocal about the prospect of additional rate hikes. Loretta Mester called for another hike this year, following Michelle Bowman's suggestion that multiple hikes are still necessary. Michael Barr struck a more moderate tone but did not rule out another hike.
The USD 2-year swap rate has risen above 5.0%, potentially serving as a floor, especially if the Federal Reserve continues to signal a hawkish stance and unless there is a significant deterioration in US economic data in the short term. The disparity between the dot plot projections and market expectations for 2023 and 2024 also suggests that short-term USD interest rates may find some support.
Today's focus in the US data calendar will be primarily on the Sep ADP NFP Change.
The direction of FX movements is likely to be determined by volatility in back-end yields. Should US 10-year bond yields continue to rise above 4.75%, it could keep the US Dollar Index (DXY) on track to reach 108.00 soon.
EUR: Back-end yield premium weighing on the euro.
On Friday, we witnessed a 10-basis-point tightening in the EUR/USD 2-year swap rate differential. However, this gain was completely wiped out on Monday, leaving the spread once again at a -120-basis point level. This wide gap has only been seen twice in 2023, firstly at the beginning of January and then throughout February and March.
What's intriguing is that during those periods when the spread was similarly wide, EUR/USD never traded below the 1.0500 level. This underscores the influence of the back-end US-yields premium, which is currently exerting pressure on the currency pair. The spread between Bund and UST 10-year yields has expanded by nearly 60 basis points since mid-June, now standing at a -177-basis point low, as observed in November 2022.
The most recent data from the Commodity Futures Trading Commission (CFTC) regarding speculative positioning indicates that EUR/USD still has some residual net-long positions, amounting to 14% of open interest, that need to be unwound. Given the continuously deteriorating rate gap with the dollar, there is a strong likelihood that the pair could test the 1.0400 level this week. However, as mentioned earlier, the timing of this move will largely depend on the swings in the volatile bond market. In a recent analysis, I estimated that EUR/USD could decline to the 1.02 area if 10-year yields were to reach 5.0%.
On the domestic front, the eurozone's data calendar is devoid of significant releases today. Nevertheless, we will be hearing from President Lagarde from European Central Bank, as well Eurozone Services PMI and Composted PMI, which could provide insights into the central bank's stance and influence currency movements.
GBP: 1.2000 in sight
The sterling market is currently preparing for the 1.2000 level to come under scrutiny in the GBP/USD currency pair, often referred to as Cable. Unlike the euro, the British pound is not grappling with a significant interest rate disadvantage against the US dollar. However, the GBP/USD 2-year swap rate gap has narrowed substantially, standing at just 17 basis points. This decline is noteworthy, considering it was at a peak of 135 basis points back in July. The narrowing of this gap is primarily the result of a combination of a hawkish Federal Reserve and a dovish Bank of England, leading to a repricing of expectations.
Given the current state of the swap rate gap, it aligns with the idea that GBP/USD is trading around its present levels. If the support at 1.2000 were to falter, it would not be an unusual occurrence in recent trading history. In the event of a breach, the next support level to keep an eye on would be the 1.1830 level, which corresponds to the low point reached in March.
AUD: New RBA governor fails to surprise.
The Reserve Bank of Australia (RBA) has opted to maintain interest rates at their current level as Michele Bullock takes the reins as Governor. Her debut appearance has conveyed a sense of continuity with the policy stance of her predecessor. The RBA's perspective on inflation remains relatively subdued, reinforcing the prevailing consensus that the tightening phase of monetary policy has ended.
It's worth noting that the expectation of further tightening was already widespread, underscoring the RBA's commitment to a data-dependent approach that has been a driving factor in recent policy decisions. Market expectations currently reflect approximately a 10-basis-point rate hike by December. I maintain a more hawkish stance compared to the consensus, believing that there are significant chances that an unexpected Consumer Price Index (CPI) surprise could compel one final rate increase to the peak.
Nevertheless, even the possibility of another rate hike is unlikely to have a transformative impact on the Australian dollar (AUD). The substantial increase in US yields and the prevailing risk-averse market environment are likely to exert downward pressure on AUD/USD for the time being. Consequently, there is a heightened risk that the correction in the AUD/USD exchange rate may extend to the range of 0.62 to 0.6250.
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