The Return to the Zero-bound, Dollar’s “Kingly” Status Challenged

The volatility regime shift is underway. The JP Morgan G7 Volatility Index hit a record low on February 12th with a reading of 4.91, and by the end of last week it had already rocketed up to 7.19. This isn’t viewed as a transient event. The extent of the fallout from the coronavirus is a major unknown of course, but it’s safe to say that its impact will be felt for some time to come as the global economy is stalling or worse, falling into a recession. On that, the days of extraordinarily low volatility are in the rear-view mirror, and a regime change towards elevated volatility is upon us. The long-run mean for the JPM volatility index is just over 10. We fully expect that it will be obtained, even likely overshot, then volatility will remain elevated for a period of time. Prudence points towards adjusting FX exposure polices to reflect the probability of this becoming the new reality.

How quickly things changed for the USD. The dollar’s “kingly” status is being seriously challenged right now. It was only Wednesday of last week that the market was pricing in a 0% chance of a 50-bps rate cut at the March meeting, but as of this morning odds are at 100%. The market is also pricing in another cut at the April meeting, and a 50/50 probability of yet another cut in June. The stock market remains extremely weak at this time, and another round of panic selling (this week?) could force the Fed and other CBs to panic into taking action now versus waiting for their respective meeting dates. But the question is, how much impact will rate cuts and liquidity injections have if economies are flat out paralysed by supply chain disruptions?

The timing of it all is nearly perfect for EUR/USD with it coming off a 20-year line of support. As discussed last week, it was at least expected to provide a technical bounce. However, given the rapidly changing outlook (Fed rate cuts, how much can the ECB actually do?) we could see euro seller’s faith really get put the test here. The level to watch is 1.1239. A breakout beyond this threshold will start bringing into question the subtle but persistent trend in place since the single currency topped back in 2018. A squeeze towards 1.18-1.20 could be in the works as the market is forced to reshuffle.

GBP/USD is jabbing lower on fears of UK/EU negotiation fears. Sterling has been under pressure lately, with the market pricing in hard negotiations as they begin this month. On Friday, we saw heavy selling in sterling, but late in the day when the Fed’s Powell reassured markets they would take necessary actions we saw a rebound in currencies, including sterling, versus the dollar. The long-view is that risk is still skewed positively for cable.

GBP/EUR has fallen off hard in recent sessions after attacking the top of the 3.5-yr trading range blockading it from going anywhere. There will be many more twists and turns with the UK/EU saga in the coming months as negotiations are expected to happen every two to three weeks. Eventually, though, the firmer long-term backdrop for the UK relative to the structurally challenged EU appear to favour a stronger long-term rate for sterling over the euro. We maintain that 1.2081 is the level to watch as a significant barrier to cross.

The Japanese yen is finally playing catch-up with risky assets. The risk-trade was missing a key ingredient with the yen lazily moving along while stock markets plunged at, in some cases, unprecedented speeds. The FTSE 100 shed 11% last week, the most in a week since 2008. The S&P 500 entered correction territory off a record high at a record pace. Even after stocks firm up, there is a historical tendency around extreme circumstances of financial market volatility for further buying to unfold in JPY following the equity market low.

AUD continues into 2008/09 levels, but did see some relief on the interest rate front versus the dollar. This helps stem the tides a little, but generally speaking it is hard to see Aussie rally beyond a short-term recovery with the outlook so poor. Yesterday, the Caixin China PMI for manufacturing was released, coming in at 40.3 versus the forecast of 46 and previous reading of 51.1. Rate cuts are expected in both Australia and New Zealand soon.

The Canadian dollar was hit on further weakening in oil. Less than two months ago WTI oil was trading at over $65 per barrel on the Iranian spike-and-reverse. It now trades at only $45.11, but may have further to go with the 2016 low not until all the way down around $26 per barrel. This would be a significant tailwind for USD/CAD to continue rising.

In summary, volatility is here to stay. Fed rate cut expectations have rocketed towards 3 to 4 cuts by maybe as soon as June. The euro may find itself with more fuel for higher prices. Sterling outlook near-term is uncertain, but remains bullish long-term. EU/UK trade negotiations will rev up this month. The Japanese yen finally playing catch up with the risk trade. Aussie to remain weak. The Canadian dollar could be in further trouble, oil may drop considerably further.