Sive Morten
Special Consultant to the FPA
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Fundamentals
This week we do not have some extraordinary events, mostly everything was standing in expected borders - some statistics, talking around US/China agreement and UK December elections. Although we have sufficient number of events but they were not strong enough to change market balance. The directional price change that we have, say on EUR, was gradual and not too strong.
To not make this report boring, we take a look at specific topics - financial crisis and swap market. There are a lot of rumors and talks around both topics.
On Wednesday we've got US Consumer prices data. As Reuters reports - consumer prices in October rose more than expected and Federal Reserve Chair Jerome Powell offered an optimistic outlook for the economy, further solidifying the case for the central bank to pause its monetary easing cycle. U.S. consumer prices jumped by the most in seven months in October, a report from the Labor Department showed, as the cost of healthcare surged by the most in more than three years. The Fed has cut interest rates three times this year in part due to low inflation.
Expectations for an interest rate cut do not rise above 30% before July 2020, according to CME Group’s FedWatch tool. And the slim chances of a cut in the months prior became slimmer on Wednesday. In addition, Powell on Wednesday said he saw “sustained expansion” ahead for the country’s economy, with low unemployment boosting household spending and the full impact of recent rate cuts still to be felt.
Powell was “very consistent with the message from the (October) press conference, which is what we expected - that they’re on hold unless something goes unexpectedly wrong,” said Daniel Katzive, head of foreign exchange strategy for North America at BNP Paribas. “Now the burden of proof is on the data to force the Fed to do something to ease.”
Also on Wednesday, the Swiss franc rallied to a one-month high against the euro as hedge funds unwound some of their negative bets against the currency and as appetite for risky assets faltered.
Hedge funds had ramped up short bets against the franc in the last two weeks on expectations a trade pact between Washington and Beijing would fuel demand for risky assets and boost carry-trades where investors borrow in cheap currencies and invest in riskier ones.
“The main thing we seem to be doing in FX today is following a bit of a risk-off tendency,” said Katzive. “The thinking there is that the market had gotten priced for a pretty constructive outlook of reduced recession risk, reduced trade risk and (is) now paring back some of that optimism.”
The dollar generally gains towards the end of the year as investors wind down trading, and demand has been strengthened this year by higher interest rates and stronger economic growth in the United States. Optimism for an economic recovery and a rebound in global trade is not yet strong enough for other currencies to start outperforming the dollar, said Brad Bechtel, a managing director at Jefferies. “This fits well with the narrative that seasonality, carry and a benign macro backdrop should keep the dollar stabilised,” Bechtel said.
China’s factory output growth slowed more than expected in October, Japan’s economy ground to a standstill in the third quarter and the German economy only narrowly avoided a recession in the third quarter.
U.S.-China negotiations continued on Friday as both sides sought to hammer out a “phase one” trade pact. U.S. Commerce Secretary Wilbur Ross said progress was being made on the agreement’s details, which helped lift trade-exposed currencies at the expense of safe-haven assets such as the Japanese yen.
Ross, in an interview on Fox Business Network, said there was a very high probability the United States would reach a final agreement on a phase one trade deal with China, but would not say whether he expected a deal to be reached before U.S. tariffs on Chinese goods are set to go into effect on Dec. 15.
Bleak Chinese data earlier in the week was still bolstering hopes for a deal, some analysts argued.
“The belief is that perhaps, even though the numbers in the United States are barely expansionary ... the fact that China is slowing down means that there is perhaps economic leverage on the U.S. side and that China will sign on to whatever,” said Juan Perez, senior foreign exchange trader and strategist at Tempus Inc.
On Friday, the Commerce Department reported that U.S. retail sales rebounded in October, but consumers cut back on purchases of big-ticket household items and clothing, raising questions about the consumer strength currently underpinning the U.S. economy. That may have also contributed to the rise in the euro and the pound.
“When we were looking at second-quarter numbers for Europe and the United Kingdom, those numbers were very worrisome, but now that we’re looking at the third-quarter numbers, their progress has been a little bit better and their pace has been at expectation or beyond, whereas the United States has actually slowed down,” said Perez. “The dollar is finally today reacting to those numbers and saying the economic pace of the United States is not that great.”
Now let's take a look at UK news.
On Tuesday, in a significant boost for Prime Minister Boris Johnson ahead of the Dec. 12 election, Brexit Party leader Nigel Farage said his party was standing down candidates in seats won by the Conservatives in 2017 and would instead focus on challenging anti-Brexit politicians. The pound rallied to as high as $1.2896 on the news, which the market had interpreted as reducing the probability of a hung- or Labour led- government that would further complicate Britain’s exit from the European Union.
Sterling had already risen above $1.28 before Farage’s announcement, after data showed the UK economy had narrowly missed a recession in the third quarter of 2019, expanding 0.3%.
Currency analysts said the Brexit Party standing down candidates could clear the way for the Conservatives to pass their Brexit withdrawal deal. “The sterling’s move was notable while other currencies were quiet, mainly because the U.S. market was closed,” said Ayako Sera, market strategist at Sumitomo Mitsui Trust Bank.
“It certainly is positive that the Conservatives got greater support. But with a month to go ahead of the Dec. 12 election, I’m not all that optimistic because I think anything can still happen,” Sera said.
Next day average weekly earnings rose at a weaker pace in the three months to September in the UK. On top of that, inflation fell in October to its lowest level in nearly three years, official data showed on Wednesday, adding to expectations that the Bank of England’s next move might be an interest rate cut. Money markets are still pricing in a very low probability of BoE action next month.
But it was not enough to disrupt positive sentiment on background of political factors. Sentiment was also buoyed by a YouGov poll released on Tuesday showing Johnson’s Conservatives had a 14-point lead over the opposition Labour Party. Another poll by Survation put the Conservatives six points ahead.
Johnson’s office said he would promise later on Wednesday to get Britain out of its Brexit “rut” if he wins next month’s vote, saying the world is baffled by why the country is so “hesitant about its future”.
“If you start to see the Labour (party) making gains in the polls it will be interesting to see what the impact on sterling will be. I think sterling is priced too much for a Boris win,” said Justin Onuekwusi, fund manager at Legal & General Investment Management.
The pound is likely to remain well supported as long as the political news-flow pointing to a Tory majority continues,” said Derek Halpenny, head of research at MUFG, but he added, “The upside is limited.” “There is a price to pay for these gains – a promised short transition period (after Brexit) that will weigh on sentiment, and with the economy set to weaken further as household spending weakens, pound gains will be contained.”
On Friday the Brexit party has stood down from 43 non-Conservative seats, 11 of which are held by the main opposition Labour Party and 17 of which saw the Conservative Party finish in second place in the 2017, according to a Telegraph reporter.
“It’s a combination of dollar weakness and the political backdrop playing out,” said CIBC Capital Markets head of G10 FX strategy Jeremy Stretch.
Meanwhile, Labour said it would nationalise parts of telecoms provider BT’s network if it won power in the Dec. 12 election to provide free full-fibre broadband for all. BT shares fell to the bottom of the FTSE 100 index.
“At present, sterling benefits from anything that lowers Labour’s chances of winning the election,” Commerzbank’s head of FX and commodity research, Ulrich Leuchtmann, wrote in a client note. But election news may be distracting from broader market pessimism about sterling’s long-term outlook. The UK will have just 11 months to negotiate a trade deal with the EU next year before a transition period comes to an end. Data this week has also been weak, with UK retail sales falling unexpectedly in October.
“My concern is - and this is something possibly the market has thought about - that we’ve got preoccupied with the election but there is still a lot of uncertainty post-election,” said Neil Mellor, senior currency strategist at BNY Mellon.
So, this is brief observe of fundamental news this week. Mostly they do not contradict to our view. On US/China relationships - we told the whole time that US controls situation and dominates over China in this question. So, after some rebelling, they will be forced to do what US wants. And now we see the same comments on the market. EU/US balance differs in short-term and long-term perspective. While we see some deteriorating in US economy now - this fact supports EUR, but it doesn't mean that it will have long-lasting effect. Investors view on Fed policy tells that situation is more or less stabilized right now, but poor EU data and hazard of US tariffs on car makers makes longer-term perspective not as cloudless as we would like it to be.
Finally, speaking on Brexit we also have different short term and long-term view. In short term everybody are excited that Brexit saga is coming to an end. Thus, everything that supports this direction will be treated as positive fact and support GBP in short term. But, longer term view brings less optimism as UK data is also far from desirable levels, and break with closest neighbour hardly will disappear utterly. So, we follow to short-term upside momentum on the wave of political euphoria but do not treat it as a breaking of major downside trend yet.
Fathom consulting also supports this view. They releases update on UK economy activity, showing that it is not too positive.
The UK economy has avoided a technical recession, with output expanding by 0.3% in Q3 following a contraction of 0.2% in Q2. Nevertheless, the Q3 data were below both our own forecast (+0.5%), and the median forecast among private sector economists as surveyed by the Reuters Poll (+0.4%).
The relatively new monthly measure of GDP is erratic. However, it suggests that UK economic output has been broadly flat for much of this year. Positive growth contributions from the household sector have, by and large, been offset by negative growth contributions from investment as firms await greater clarity over the timing and the nature of the UK’s departure from the EU.
Now let's turn to some specific technical issues. And one of them that could significantly impact on USD value by the end of the year is FX swaps. As dollars dry up, global finance is growing increasingly dependent on opaque currency trading to keep cash flowing. Unlike regular ‘spot’ currency transactions, swaps involve two parties swapping one currency for another. Repayment is after a set period and fixed at a forward exchange rate determined by the gap in interest rates on the two currencies.
Many central bankers say bank borrowing and funding via swaps, which are typically used for hedging, day-to-day liquidity management or even speculation, is driving the increase in FX swaps as they are “off-balance sheet”. This is favorable for banks and companies because the lower their debt, the higher their credit rating. It is also cheaper to hold a smaller amount of debt on the balance sheet.
One central bank official said that authorities were keeping an eye on the end-2019 period but they are also concerned about borrowers’ ability to refinance. “A lot of FX trading activity is very short term. That could expose banks to significant rollover risks,” the official added. Borrowing via swaps could amount to $14 trillion or more, Claudio Borio, head of the BIS monetary and economic department estimated.
And the dollar funding gap, the difference between non-U.S.-banks’ dollar assets and liabilities, may be up to $1.5 trillion, said Tobias Adrian, director of monetary and capital markets department at the IMF. “Much of that has to be funded in FX swap markets, and those markets can be fragile,” Adrian told Reuters.
These data tells that any lack of US liquidity could trigger domino effect on currency market. Everybody still remember the spike of short-term interest rate in October. Now swap traders tell that background for possible rise in USD demand exists. The central bank official said stress tests implied some banks use swaps for more than 10% of their funding, while the BIS says dollars are on one side of 90% of all currency trades. Because dollar demand is so high, lenders ask for a price premium known as the cross-currency basis, which tends to become more negative as dollar shortages deepen. This is increasingly costly for non-U.S. banks without dollar deposits and dollar-denominated collateral and these must turn to swaps to finance trade and hedge investments.
Money market traders and regulators do not expect a re-run of the 2008 and 2011 crises, when dollar borrowing dried up outside the United States as U.S. banks hoarded it at home. Nonetheless, as year-end nears, traders are on edge because big U.S. banks often reduce cash on deposit at the Fed to comply with rules requiring them to show sufficient cash buffers, meaning they lend out fewer dollars.
This causes periodic spikes in dollar funding premia “in FX swaps and repo”, said Olek Gajowniczek, a trader at Japanese bank Nomura, adding that regulation had made it harder for the market “to absorb unlimited quantities of FX swaps”.
Before the 2008 financial crisis, the basis swap between the dollar and major currencies was negligible but has since ranged between minus 20-50 basis points, while in some countries it has moved beyond minus 100 bps, Adrian said.
The three-month euro-dollar basis swap for instance is at around minus 22 bps but spiked beyond minus 300 bps in October 2008. It touched minus 42 bps a month ago when a money market squeeze sent overnight repo rates to 10% in New York.
“We estimate that when the basis widens by 50 bps, then financial stability risks in the home country of the institutions are increasing and they’re cutting down lending,” Adrian added.
“It seems that dollar liquidity is still there, but is obviously close to a level where small things can cause big price changes,” he said. “We’ve kinda learnt that in September.Some now fear that swaps could be that catalyst, possibly as soon as the end of 2019, if U.S. banks, the main conduit for dollars, cut back lending to meet cash reserve rules. “Around year-end ... the normal supply dynamics will be thrown out,” said Topham.
Tighter regulations stipulating lenders must hold at least 8% of capital as reserves, rising U.S. protectionism and corporate cash repatriation are all shrinking dollar supply.
Reflecting the increased reliance on currency markets to borrow dollars, FX swap volumes have grown to represent 49% of total currency trading, from 42% in 2013, Bank for International Settlements (BIS) figures from August show.
Technicals
Monthly
This week price action was gradual and long term situation stands in the same borders as week ago. As we said, we've got reversal month by October's close. November stands inside one by far, showing retracement back in October's body. In general this is not something uncommon and absolutely natural process. At the same time, taking broader view - forming of reversal bar doesn't make any impact on major tendency by far, as EUR still keeps LH-LL trend. Reversal bar will be valid if it will lead to breaking of this tendency.
In general recent changes were in favor of EUR due poor US statistics and more dovish Fed policy, at least in short-term. But this week data has improved (ISM, NFP) and new achievement of US/China negotiations stands on horizon. It stops for awhile EUR appreciation. Now we need to keep close eye on key technical levels that are vital for longer-term tendency. Market should not erase October rally as it was in June. Otherwise EUR continues to drift lower to 1.03 area.
Now we come closer to the end of the year and second issue that might be interesting on EUR is YPS1. If EUR, by the end of the year will be able to hold above YPS1 - 2019 action could be treated as retracement of 2016 - 2017 rally. And EUR will keep chances on extension in 2020.
That's being said the major intrigue stands around fundamental background now - it is changing. It is interesting whether its change will be strong enough to make impact on monthly chart and long lasting tendency here. As economy in EU hardly will improve soon - the major driving factor depends on US - how better/worse situation will be there.
Weekly
Weekly reversal candle still stands in focus here. If nothing outstanding will happen, it seems that we should forget about bullish tendency, at least for a few weeks. Weekly chart brings worrying picture. It stands out of long-term price shape inside the channel. Never before we see the same price action. Downside reversal is sharp and engulfs three previous weeks (almost month), so I mark it with "R" letter.
This let's call it reversal, happens in the middle of the range and not at some resistance area, which looks even more bearish.
Thus, currently we have to be extra careful with any long positions on daily/intraday charts. This miserable plunge on weekly chart has solid chances on continuation. And our bullish trade that we've taken this week should be considered as retracement, so we have to care on risk and constant position management.
Daily
Taking in consideration weekly setup, we should be careful to daily resistance levels, because EUR could turn down again. On daily chart EUR has completed our setup - minimal target of "222" Buy pattern has been reached. This is 3/8 upside bounce from Agreement support area right to 1.1060 level. This area creates multiple setups and forces you to make a decision. If you keep long position still - tight your stop and think about at least 50% profit taking.
Market probably will show downside reaction on this level next week. Despite that thrust down looks a bit small, but here we have 7 candles down, and it could take the feature of B&B "Sell" setup. But in context of weekly situation, this B&B easily could trigger downside continuation instead of retracement. This is major risk factor on next week.
Intraday
Upside action takes the shape of AB=CD pattern, which creates Agreement resistance with daily major 3/8 level. By adding 5/8 level from minor reaction point we have K-resistance area. For scalp traders this is the scenario to consider, if somebody has an intention to go short. B&B idea suggests drop to 1.1014 support, but as we do not have perfect B&B, market could drop just to K-support area @ 1.1030.
Both levels, especially K-area is a great indicator, which should tell us about sentiment on the market. If price will be able to hold above major 5/8 area, and especially above K-support - bullish tendency is still intact and market could proceed higher. Drop below 5/8 level significantly increase chances on downside drop below 1.08 level.
Conclusion:
Currently fundamental background stands stable and lets market to be driven by its own factors. Major events should happen in December and this keeps long-term charts intact. Thus, we keep up with our trading plan and continue trading setups that we have on daily/intraday frames.
This week we do not have some extraordinary events, mostly everything was standing in expected borders - some statistics, talking around US/China agreement and UK December elections. Although we have sufficient number of events but they were not strong enough to change market balance. The directional price change that we have, say on EUR, was gradual and not too strong.
To not make this report boring, we take a look at specific topics - financial crisis and swap market. There are a lot of rumors and talks around both topics.
On Wednesday we've got US Consumer prices data. As Reuters reports - consumer prices in October rose more than expected and Federal Reserve Chair Jerome Powell offered an optimistic outlook for the economy, further solidifying the case for the central bank to pause its monetary easing cycle. U.S. consumer prices jumped by the most in seven months in October, a report from the Labor Department showed, as the cost of healthcare surged by the most in more than three years. The Fed has cut interest rates three times this year in part due to low inflation.
Expectations for an interest rate cut do not rise above 30% before July 2020, according to CME Group’s FedWatch tool. And the slim chances of a cut in the months prior became slimmer on Wednesday. In addition, Powell on Wednesday said he saw “sustained expansion” ahead for the country’s economy, with low unemployment boosting household spending and the full impact of recent rate cuts still to be felt.
Powell was “very consistent with the message from the (October) press conference, which is what we expected - that they’re on hold unless something goes unexpectedly wrong,” said Daniel Katzive, head of foreign exchange strategy for North America at BNP Paribas. “Now the burden of proof is on the data to force the Fed to do something to ease.”
Also on Wednesday, the Swiss franc rallied to a one-month high against the euro as hedge funds unwound some of their negative bets against the currency and as appetite for risky assets faltered.
Hedge funds had ramped up short bets against the franc in the last two weeks on expectations a trade pact between Washington and Beijing would fuel demand for risky assets and boost carry-trades where investors borrow in cheap currencies and invest in riskier ones.
“The main thing we seem to be doing in FX today is following a bit of a risk-off tendency,” said Katzive. “The thinking there is that the market had gotten priced for a pretty constructive outlook of reduced recession risk, reduced trade risk and (is) now paring back some of that optimism.”
The dollar generally gains towards the end of the year as investors wind down trading, and demand has been strengthened this year by higher interest rates and stronger economic growth in the United States. Optimism for an economic recovery and a rebound in global trade is not yet strong enough for other currencies to start outperforming the dollar, said Brad Bechtel, a managing director at Jefferies. “This fits well with the narrative that seasonality, carry and a benign macro backdrop should keep the dollar stabilised,” Bechtel said.
China’s factory output growth slowed more than expected in October, Japan’s economy ground to a standstill in the third quarter and the German economy only narrowly avoided a recession in the third quarter.
U.S.-China negotiations continued on Friday as both sides sought to hammer out a “phase one” trade pact. U.S. Commerce Secretary Wilbur Ross said progress was being made on the agreement’s details, which helped lift trade-exposed currencies at the expense of safe-haven assets such as the Japanese yen.
Ross, in an interview on Fox Business Network, said there was a very high probability the United States would reach a final agreement on a phase one trade deal with China, but would not say whether he expected a deal to be reached before U.S. tariffs on Chinese goods are set to go into effect on Dec. 15.
Bleak Chinese data earlier in the week was still bolstering hopes for a deal, some analysts argued.
“The belief is that perhaps, even though the numbers in the United States are barely expansionary ... the fact that China is slowing down means that there is perhaps economic leverage on the U.S. side and that China will sign on to whatever,” said Juan Perez, senior foreign exchange trader and strategist at Tempus Inc.
On Friday, the Commerce Department reported that U.S. retail sales rebounded in October, but consumers cut back on purchases of big-ticket household items and clothing, raising questions about the consumer strength currently underpinning the U.S. economy. That may have also contributed to the rise in the euro and the pound.
“When we were looking at second-quarter numbers for Europe and the United Kingdom, those numbers were very worrisome, but now that we’re looking at the third-quarter numbers, their progress has been a little bit better and their pace has been at expectation or beyond, whereas the United States has actually slowed down,” said Perez. “The dollar is finally today reacting to those numbers and saying the economic pace of the United States is not that great.”
Now let's take a look at UK news.
On Tuesday, in a significant boost for Prime Minister Boris Johnson ahead of the Dec. 12 election, Brexit Party leader Nigel Farage said his party was standing down candidates in seats won by the Conservatives in 2017 and would instead focus on challenging anti-Brexit politicians. The pound rallied to as high as $1.2896 on the news, which the market had interpreted as reducing the probability of a hung- or Labour led- government that would further complicate Britain’s exit from the European Union.
Sterling had already risen above $1.28 before Farage’s announcement, after data showed the UK economy had narrowly missed a recession in the third quarter of 2019, expanding 0.3%.
Currency analysts said the Brexit Party standing down candidates could clear the way for the Conservatives to pass their Brexit withdrawal deal. “The sterling’s move was notable while other currencies were quiet, mainly because the U.S. market was closed,” said Ayako Sera, market strategist at Sumitomo Mitsui Trust Bank.
“It certainly is positive that the Conservatives got greater support. But with a month to go ahead of the Dec. 12 election, I’m not all that optimistic because I think anything can still happen,” Sera said.
Next day average weekly earnings rose at a weaker pace in the three months to September in the UK. On top of that, inflation fell in October to its lowest level in nearly three years, official data showed on Wednesday, adding to expectations that the Bank of England’s next move might be an interest rate cut. Money markets are still pricing in a very low probability of BoE action next month.
But it was not enough to disrupt positive sentiment on background of political factors. Sentiment was also buoyed by a YouGov poll released on Tuesday showing Johnson’s Conservatives had a 14-point lead over the opposition Labour Party. Another poll by Survation put the Conservatives six points ahead.
Johnson’s office said he would promise later on Wednesday to get Britain out of its Brexit “rut” if he wins next month’s vote, saying the world is baffled by why the country is so “hesitant about its future”.
“If you start to see the Labour (party) making gains in the polls it will be interesting to see what the impact on sterling will be. I think sterling is priced too much for a Boris win,” said Justin Onuekwusi, fund manager at Legal & General Investment Management.
The pound is likely to remain well supported as long as the political news-flow pointing to a Tory majority continues,” said Derek Halpenny, head of research at MUFG, but he added, “The upside is limited.” “There is a price to pay for these gains – a promised short transition period (after Brexit) that will weigh on sentiment, and with the economy set to weaken further as household spending weakens, pound gains will be contained.”
On Friday the Brexit party has stood down from 43 non-Conservative seats, 11 of which are held by the main opposition Labour Party and 17 of which saw the Conservative Party finish in second place in the 2017, according to a Telegraph reporter.
“It’s a combination of dollar weakness and the political backdrop playing out,” said CIBC Capital Markets head of G10 FX strategy Jeremy Stretch.
Meanwhile, Labour said it would nationalise parts of telecoms provider BT’s network if it won power in the Dec. 12 election to provide free full-fibre broadband for all. BT shares fell to the bottom of the FTSE 100 index.
“At present, sterling benefits from anything that lowers Labour’s chances of winning the election,” Commerzbank’s head of FX and commodity research, Ulrich Leuchtmann, wrote in a client note. But election news may be distracting from broader market pessimism about sterling’s long-term outlook. The UK will have just 11 months to negotiate a trade deal with the EU next year before a transition period comes to an end. Data this week has also been weak, with UK retail sales falling unexpectedly in October.
“My concern is - and this is something possibly the market has thought about - that we’ve got preoccupied with the election but there is still a lot of uncertainty post-election,” said Neil Mellor, senior currency strategist at BNY Mellon.
So, this is brief observe of fundamental news this week. Mostly they do not contradict to our view. On US/China relationships - we told the whole time that US controls situation and dominates over China in this question. So, after some rebelling, they will be forced to do what US wants. And now we see the same comments on the market. EU/US balance differs in short-term and long-term perspective. While we see some deteriorating in US economy now - this fact supports EUR, but it doesn't mean that it will have long-lasting effect. Investors view on Fed policy tells that situation is more or less stabilized right now, but poor EU data and hazard of US tariffs on car makers makes longer-term perspective not as cloudless as we would like it to be.
Finally, speaking on Brexit we also have different short term and long-term view. In short term everybody are excited that Brexit saga is coming to an end. Thus, everything that supports this direction will be treated as positive fact and support GBP in short term. But, longer term view brings less optimism as UK data is also far from desirable levels, and break with closest neighbour hardly will disappear utterly. So, we follow to short-term upside momentum on the wave of political euphoria but do not treat it as a breaking of major downside trend yet.
Fathom consulting also supports this view. They releases update on UK economy activity, showing that it is not too positive.
The UK economy has avoided a technical recession, with output expanding by 0.3% in Q3 following a contraction of 0.2% in Q2. Nevertheless, the Q3 data were below both our own forecast (+0.5%), and the median forecast among private sector economists as surveyed by the Reuters Poll (+0.4%).
The relatively new monthly measure of GDP is erratic. However, it suggests that UK economic output has been broadly flat for much of this year. Positive growth contributions from the household sector have, by and large, been offset by negative growth contributions from investment as firms await greater clarity over the timing and the nature of the UK’s departure from the EU.
Now let's turn to some specific technical issues. And one of them that could significantly impact on USD value by the end of the year is FX swaps. As dollars dry up, global finance is growing increasingly dependent on opaque currency trading to keep cash flowing. Unlike regular ‘spot’ currency transactions, swaps involve two parties swapping one currency for another. Repayment is after a set period and fixed at a forward exchange rate determined by the gap in interest rates on the two currencies.
Many central bankers say bank borrowing and funding via swaps, which are typically used for hedging, day-to-day liquidity management or even speculation, is driving the increase in FX swaps as they are “off-balance sheet”. This is favorable for banks and companies because the lower their debt, the higher their credit rating. It is also cheaper to hold a smaller amount of debt on the balance sheet.
One central bank official said that authorities were keeping an eye on the end-2019 period but they are also concerned about borrowers’ ability to refinance. “A lot of FX trading activity is very short term. That could expose banks to significant rollover risks,” the official added. Borrowing via swaps could amount to $14 trillion or more, Claudio Borio, head of the BIS monetary and economic department estimated.
And the dollar funding gap, the difference between non-U.S.-banks’ dollar assets and liabilities, may be up to $1.5 trillion, said Tobias Adrian, director of monetary and capital markets department at the IMF. “Much of that has to be funded in FX swap markets, and those markets can be fragile,” Adrian told Reuters.
These data tells that any lack of US liquidity could trigger domino effect on currency market. Everybody still remember the spike of short-term interest rate in October. Now swap traders tell that background for possible rise in USD demand exists. The central bank official said stress tests implied some banks use swaps for more than 10% of their funding, while the BIS says dollars are on one side of 90% of all currency trades. Because dollar demand is so high, lenders ask for a price premium known as the cross-currency basis, which tends to become more negative as dollar shortages deepen. This is increasingly costly for non-U.S. banks without dollar deposits and dollar-denominated collateral and these must turn to swaps to finance trade and hedge investments.
Money market traders and regulators do not expect a re-run of the 2008 and 2011 crises, when dollar borrowing dried up outside the United States as U.S. banks hoarded it at home. Nonetheless, as year-end nears, traders are on edge because big U.S. banks often reduce cash on deposit at the Fed to comply with rules requiring them to show sufficient cash buffers, meaning they lend out fewer dollars.
This causes periodic spikes in dollar funding premia “in FX swaps and repo”, said Olek Gajowniczek, a trader at Japanese bank Nomura, adding that regulation had made it harder for the market “to absorb unlimited quantities of FX swaps”.
Before the 2008 financial crisis, the basis swap between the dollar and major currencies was negligible but has since ranged between minus 20-50 basis points, while in some countries it has moved beyond minus 100 bps, Adrian said.
The three-month euro-dollar basis swap for instance is at around minus 22 bps but spiked beyond minus 300 bps in October 2008. It touched minus 42 bps a month ago when a money market squeeze sent overnight repo rates to 10% in New York.
“We estimate that when the basis widens by 50 bps, then financial stability risks in the home country of the institutions are increasing and they’re cutting down lending,” Adrian added.
“It seems that dollar liquidity is still there, but is obviously close to a level where small things can cause big price changes,” he said. “We’ve kinda learnt that in September.Some now fear that swaps could be that catalyst, possibly as soon as the end of 2019, if U.S. banks, the main conduit for dollars, cut back lending to meet cash reserve rules. “Around year-end ... the normal supply dynamics will be thrown out,” said Topham.
Tighter regulations stipulating lenders must hold at least 8% of capital as reserves, rising U.S. protectionism and corporate cash repatriation are all shrinking dollar supply.
Reflecting the increased reliance on currency markets to borrow dollars, FX swap volumes have grown to represent 49% of total currency trading, from 42% in 2013, Bank for International Settlements (BIS) figures from August show.
Technicals
Monthly
This week price action was gradual and long term situation stands in the same borders as week ago. As we said, we've got reversal month by October's close. November stands inside one by far, showing retracement back in October's body. In general this is not something uncommon and absolutely natural process. At the same time, taking broader view - forming of reversal bar doesn't make any impact on major tendency by far, as EUR still keeps LH-LL trend. Reversal bar will be valid if it will lead to breaking of this tendency.
In general recent changes were in favor of EUR due poor US statistics and more dovish Fed policy, at least in short-term. But this week data has improved (ISM, NFP) and new achievement of US/China negotiations stands on horizon. It stops for awhile EUR appreciation. Now we need to keep close eye on key technical levels that are vital for longer-term tendency. Market should not erase October rally as it was in June. Otherwise EUR continues to drift lower to 1.03 area.
Now we come closer to the end of the year and second issue that might be interesting on EUR is YPS1. If EUR, by the end of the year will be able to hold above YPS1 - 2019 action could be treated as retracement of 2016 - 2017 rally. And EUR will keep chances on extension in 2020.
That's being said the major intrigue stands around fundamental background now - it is changing. It is interesting whether its change will be strong enough to make impact on monthly chart and long lasting tendency here. As economy in EU hardly will improve soon - the major driving factor depends on US - how better/worse situation will be there.
Weekly
Weekly reversal candle still stands in focus here. If nothing outstanding will happen, it seems that we should forget about bullish tendency, at least for a few weeks. Weekly chart brings worrying picture. It stands out of long-term price shape inside the channel. Never before we see the same price action. Downside reversal is sharp and engulfs three previous weeks (almost month), so I mark it with "R" letter.
This let's call it reversal, happens in the middle of the range and not at some resistance area, which looks even more bearish.
Thus, currently we have to be extra careful with any long positions on daily/intraday charts. This miserable plunge on weekly chart has solid chances on continuation. And our bullish trade that we've taken this week should be considered as retracement, so we have to care on risk and constant position management.
Daily
Taking in consideration weekly setup, we should be careful to daily resistance levels, because EUR could turn down again. On daily chart EUR has completed our setup - minimal target of "222" Buy pattern has been reached. This is 3/8 upside bounce from Agreement support area right to 1.1060 level. This area creates multiple setups and forces you to make a decision. If you keep long position still - tight your stop and think about at least 50% profit taking.
Market probably will show downside reaction on this level next week. Despite that thrust down looks a bit small, but here we have 7 candles down, and it could take the feature of B&B "Sell" setup. But in context of weekly situation, this B&B easily could trigger downside continuation instead of retracement. This is major risk factor on next week.
Intraday
Upside action takes the shape of AB=CD pattern, which creates Agreement resistance with daily major 3/8 level. By adding 5/8 level from minor reaction point we have K-resistance area. For scalp traders this is the scenario to consider, if somebody has an intention to go short. B&B idea suggests drop to 1.1014 support, but as we do not have perfect B&B, market could drop just to K-support area @ 1.1030.
Both levels, especially K-area is a great indicator, which should tell us about sentiment on the market. If price will be able to hold above major 5/8 area, and especially above K-support - bullish tendency is still intact and market could proceed higher. Drop below 5/8 level significantly increase chances on downside drop below 1.08 level.
Conclusion:
Currently fundamental background stands stable and lets market to be driven by its own factors. Major events should happen in December and this keeps long-term charts intact. Thus, we keep up with our trading plan and continue trading setups that we have on daily/intraday frames.