Written by George Vessey & Boris Kovacevic
Market turns bearish on euro
Investors continue to wait on the bottoming of the German economy and therefore European assets with the Ifo business climate index falling for a fifth month. Looking across all three main indices, yesterday’s release was not as bad as initially feared. Both the headline and current conditions index surprised the consensus to the upside. However, given the large negative deviation of these indicators compared to their historic averages, it seems that the German economy continues to battle 1. weak growth from China, 2. high interest rates in Europe, and 3. domestic political headwinds.
Zooming in on yesterday’s headlines shows us how bearish the news flow and positioning has become when it comes to the euro. From hedge funds turning the most negative on the common currency in 11 months or EUR/USD falling for 10 consecutive weeks. And all of this has happened against the backdrop of German 10-year yields rising to the highest levels since 2011. Investors are deciding to focus on the negative side effect of higher rates, instead of the actual level of rates.
The correlation between the euro and oil prices turning deeply negative has also not helped the common currency with brent pushing above $90 a barrel.
Pound hits fresh multi-month lows
Despite being in oversold territory according to the daily relative strength index, GBP/USD continues to slide and has printed a fresh 6-month low. The $1.22 handle has broken, meaning the pound has depreciated over 7% against the US dollar over the last nine weeks. $1.20 is a key psychological level, but we’re eying two long-term retracement levels prior to that which may offer decent support.
Surging US Treasury yields as a result of US exceptionalism is keeping dollar demand buoyant, but the pound is also being sold across the board as UK gilt yields slide with UK rate expectations. There is now less than a 50% chance of another Bank of England rate hike in this cycle, meaning markets are pricing the current 5.25% as the peak Bank Rate compared to the 6.5% peak priced in just a couple of months back when GBP/USD was trading above $1.30. The 38.2% retracement level from its all-time low of sub-$1.04 to its year-to-date high of $1.3144 is $1.2089, but ahead of that, the 76.4% retracement of this year’s low to high sits at $1.2120. Both these levels are key downside targets but should also offer much-needed support for sterling.
There are conflicting technical signals but having broken below critical daily and weekly moving averages over the past few weeks, we see these as having flipped from support to resistance levels, which makes any form of a GBP recovery a tough task in the short-term. This is especially true given speculative traders are still heavily net-long sterling.
Relentless bond selling continues
Investors are finding it hard to escape the all-encompassing impact of higher interest rates on other asset classes. The relentless selling in the fixed income space has pushed the yield on the US 10-year treasury beyond 4.50%, the highest level in 16 years. While capital continued to flow into short-dated ETFs on expectations that the Federal Reserve (Fed) would be done raising interest rates, inflows into Treasury funds investing into longer dated maturities dropped by more than 11% compared to last year. The US dollar has greatly benefited from investors pricing in a longer than expected period of high policy rates and is currently on track to rise for the eleventh week in a row.
The macro data so far this week has been less aligned with these investors’ expectations for rates to remain higher for longer. Both the Dallas and Chicago Fed manufacturing indicators disappointed the consensus forecast last month, falling more than economists had expected. Rising oil prices and financing costs, combined with the continued weakness in China, have created a toxic environment for pro-cyclical parts of the economy like the manufacturing sector.
However, Chicago Fed chair Austan Goolsbee said in a recent interview that the possibility of the US avoiding a recession remains. Still, while lagging hard economic data has held up reasonably well, leading indicators have long signaled high recession risks. Both the ISM Purchasing Manager Index and the Conference Board’s Leading Economic Index have been in contraction for 10 and 18 months, respectively. We continue to expect the largest rates shock since the 1980s to further impact the economy going forward.
Dollar at 10-month high as yields surge
Table: 7-day currency trends and trading ranges
Key global risk events
Calendar: September 25-29
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