Five key themes in FX to persist into Q3, says BMO Stephen Gallo

Stephen Gallo, European head of FX Strategy at BMO Financial Group, has picked out five key themes he believes will typify the FX market into the third quarter of 2013.

Markets in general and including FX were far less choppy overnight than they had been at the very start of the week, but overall fluctuations in the FX space were mixed, with no clear direction. We suspect that month-end/quarter-end flows are beginning to set in, hence the lack of any clear tone within FX this morning.

Moreover, the mixed tone facing the USD may have, in part, been a result of the weakness in precious metals prices but without any bid in US yields to correspond.

It is not clear therefore that FX markets were expressing a view on US monetary policy this morning by selling EUR/USD, although we do suspect that concerns regarding financial sector stability in Europe are beginning to gradually show up in the EUR cross rates. As month-end and quarter-end approach, we view the current environment as likely to be more supportive of “risk-on”, although, to one degree or another, a second or third leg higher in core sovereign rates and European or Chinese financial instability could be offsetting factors, and ones that we cannot completely rule out.

Nevertheless, we are basing our view around five key themes which we think may persist into the very early portion of Q3:

   1. We think policy makers, particularly from within the Fed, are more likely to continue jawboning than not when it comes to encouraging anti-volatility in markets – for now, this means less of a focus on QE tapering and more of a focus on the easing that is still left on tap. Moreover, we suspect that a start to QE tapering before year-end may already be reflected in the current value of the USD and the vast majority of asset prices

   2. Our forward traders are looking for a potential retracement in front-end rates following the latest spike higher, and on balance we think that this will be net-negative for the USD, particularly versus the high-yield space

   3. Non-Fed policy makers, particularly in Europe, are attempting to talk down the likelihood of a near-term exit from accommodative policies

   4. The Chinese so far appear to be succeeding in managing financial stability risks

   5. Based on positioning and a potential gradual move lower in Chinese money markets rates, the AUD appears somewhat oversold

Although the CNY is probably likely to witness a bit more weakness from here, we view the lack of aggressive downside in the currency as quite astounding particularly in view of the instability in Chinese money markets. All in all, the PBoC’s move to limit hot money inflows over the preceding 12 months by allowing the CNY to strengthen has probably greatly reduced the risks of a sharp fall today. If so, that would strike us as some pretty fantastic management of the exchange rate in China.

In terms of our aforementioned themes, we prefer to express a possible back-up in high-yield currencies through short EUR/AUD, targeting a move back into the 1.3750-1.3850 range into early July as a means of expressing a view on European financial instability – particularly over the course of Q3/Q4. Although on the surface it would appear to contradict this view, as long as equity markets remain bid we prefer to buy EUR/CHF on dips above 1.2200 on possible CHF underperformance.

At this point we still don’t feel overly confident in expressing a negative view on Europe or the euro area through aggressively shorting EUR/USD just yet.


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