The Federal Reserve meets tomorrow, a meeting that we think will largely be a non-event in the immediate term. In our view, the most important signals we think we can get from the Fed are clarifying the conditions necessary for balance sheet tapering. As of right now, we see no signs of slowing in the Fed’s balance sheet expansion. Reserve creation continues to be abundant, creating huge amounts of USD liquidity:

While this reserve creation is indeed immense in a domestic setting, it is being outpaced in an international setting by the EU, which needs monetary aid to keep its economy running:
Overall, we expect the value of this meeting to be in helping understand the future path of the Fed and its monetary programs. While markets may move intraday, the fundamental outlook is unlikely to shift.

This week will be an important one for USDJPY and the US outlook in general. We think it makes sense to take stock of what is happening in various markets relative to the dollar at this junction. In this post, we look at Euro, Yen, Pound, and Gold relative to the US dollar, using our trading tools to get a comprehensive sense of what’s going on. As a refresher:

• Trading Range: These ranges represent a trading bank within which a currency should trade based on multiple market factors. If we are long- prices above the upside range indicate the asset is expensive, and prices below the downside range suggest that they are cheap and vice versa if we are short.
• Year-to-Date Returns: This is the price performance of a given currency over the course of the current calendar year, in percentage terms. We also compare the current price to the 52-week high and low for reference.
• Price Momentum: This looks at cumulative rolling returns for a selected lookback period.  Positive momentum is good if we are long and bad if we are short. 
• Implied Volatility Discount/Premium: This tells us what the market expects in terms of volatility relative to the history of volatility. If we are long a currency, we typically want market implied volatility to be higher than historical volatility and vice versa if we are short.

Let us look at our currency pairs through these lenses:

1. EURUSD: No Clear Signal 

After a weakening significantly this year, the Euro has made back some losses. From a trading perspective, momentum has now turned positive once again but remains mixed on a multi-duration basis.

Further, our volatility signal doesn’t indicate this is a good entry point for long positions. Additionally, our fundamental view is that EURUSD will remain weak this year.

2. USDJPY: Short-Term Momentum Dragging

USDJPY was a fantastic buy until a few weeks ago. Over the course of 2021, USDJPY has seen a significant rally as part of the generally strong dollar environment. This move has tempered in the recent past, making short-term momentum a detractor for further long positions:

Nonetheless, this is the second-best looking set-up from a long-dollar standpoint. Volatility premiums and upside/downside ratios are indeed supportive.

3. GBPUSD: Momentum, Volatility, and Risk/Reward Supportive

GBPUSD has been one of our favored dollar shorts this year, largely due to the fundamental mismatch in relative central bank balance sheet capacity. Indeed this has been good exposure, albeit having returned some gains over the last two months.

As we can see above, all our signals are pointing to a good entry point for GBPUSD. Implied vol premiums could be a little higher in our opinion, but the set-up is nonetheless favorable.

4. Gold: Short-Term Bounce, But Not Fundamentally Supported

The US and the world still remain in a global economic expansion. During this environment, gold is typically not a favorable asset to own. As such, gold still remains down on a year-to-date basis but has seen a consolidation since March. Indeed, Gold’s potential to rally in the second half of this year if the inflation environment remains elevated and economic growth rates moderate. However, we don’t think we’re there yet.

Hence, we continue to think gold is a favorable short position, but our trading signals aren’t supportive, as we can see above. We will have to wait for the next moves in gold.

Hence, the most currency pair with the most support from our trading tools analysis is GBPUSD, in line with our fundamental views.

Beginning 2021, we were among the few in the FX industry calling for a higher dollar, particularly relative to the Euro (and less so the Yen). Our reasoning for this was that the US monetary and fiscal response was so strong, immediate and efficacious, that the credit creation machine in the US would outperform those of other countries. Indeed, this is what we have seen across asset markets, with a stronger dollar the general theme:

Above, we show that the dollar has indeed rallied year-to-date. The notable exception above is the Pound (GBPUSD). Indeed this too was in line with our expectations. While these moves aren’t over yet, the fundamental environment looks to be shifting. Our expectation is that US growth and inflation will be solid in the first half of this year, exhibiting continued growth outperformance. If fundamentals play out this way, it is most likely that the US will develop conditions conducive to a Federal Reserve balance sheet taper. While the taper may not be instituted by the end of the year, we expect the narrative to become strong around then, i.e., markets will begin to reflect that. Below, we show the performance of major country currencies during the last taper:

There are two things we need to note from the above. The first is that tapering puts significant pressure on currencies, especially currencies engaged in their quantitative easing (BOJ and ECB). Given the US will likely be out of the recession faster and stronger than the Euro and Japan, we expected the same dynamic to repeat itself. However, the is a considerable amount of time before this narrative plays out. Until then, we think the global risk will remain well-supported, especially in the next few months. Nonetheless, we think setting up for the next big moves will create the most opportunities for us to trade, and we should start thinking about these moves well in advance.

The timing of balance sheet reduction is important because any reduction in the balance sheet reduces liquidity, which bodes ill for risk assets. At the same time, this would be a strong boost to the US dollar, as it will effectively reduce the supply of dollars. Given the current dynamics of the dollar selling off as risk rallies, understanding the taper’s timing is extremely important. We show the effects of a taper using our “All-Asset Return” framework:

In our view, a taper would effectively drag up expected returns in the United States, making dollars more attractive to hold relative to global risk assets. Hence, we need to understand what will trigger the Fed to consider tapering. In our view, it will be a combination of the following conditions:

Inflation >2% + Unemployment =4% + Vaccinations >75%

Looking at vaccination rates, inflation, and unemployment, we expect that all three will be conducive to a taper at the earliest around December 2021. There is a chance for this to get preponed, especially given that our outlook is dynamic. However, for now, we think that the December 2021 date offers a balanced target date. When taper becomes a more extensive conversation in markets, we expect a risk-off environment with a stronger dollar. However, there is a lot of time from now until December, during which time we expect risk-on to continue. However, the eventual pricing of a Fed taper would mean a dollar big against almost all major currency pairs.

USDJPY has been on a tear upwards this year. However, over the last month, we have seen a fair amount of downside. The question is whether this is a short-term pullback or the start of a larger move lower. We think that this largely depends on the future path of US 10 year yields, as we think JPY yields are anchored at zero by the BOJ. Hence, the next moves in USDJPY will like come from changes in the US yield curve:

Above, we show our yield curve forecast, in which we expect yield curve to turn lower after their significant steepening earlier this year. This will likely come from a significantly lower 10 year-yield in H2 2020. Hence, while USDJPY might have some room left to appreciate, it looks like US yields are headed lower. However, this outlook could change completely if we begin to see tapering expectations in the US. Nonetheless, USDJPY looks like an attractive short term trade, even though the fundamental support is weakening:

As a general note, we prefer trades that have both an accommodative fundamental outlook and strong risk-return profile. Wile the risk-return profile looks good on USDJPY, the fundamental support for this move is waning. There may be room for USDJPY to rally further until July, but with US yield likely peaking the trade is less attractive as a few months ago.

Yesterday, US CPI came in stronger than expected, coming in at 2.6% year-over-year. We think this move is unambiguously reflationary. We see this inflation was already priced-in recently in the bond market:

Hence, we think of the current CPI print to confirm our views mentioned before the print. To reiterate, we are likely in a rising inflation environment:

This CPI print also puts the US in the lead in terms of global reflation, with the highest inflation rate amongst the major currencies:

This is just confirmation of what asset markets have been telling us. We are still in a global reflation, led by the US economy. However, signs are emerging that we are at peak reflationary impulse, and we need to be vigilant.

Tomorrow, we get US CPI, which is likely headed into strong territory based on our cyclical model. Our cyclical model does a good job of getting the medium-term trend right more than the exact print:

Indeed, this expectation is in line with what a range of market-based indicators is pointing to:

We see further evidence of this from the recent acceleration in ISM prices paid, which gives us an indication of the coming CPI print:

Overall, we are likely in an accelerating inflation environment, a move which we think is priced in across many markets. A strong CPI print will just confirm the reflation story. However, as we’ve written about recently, we need to start thinking more about fading reflation trades. Our preferred gauge of US reflation- the US stock market- remains elevated relative to our trading ranges:

At this junction, either our trading range will shift upwards to accommodate recent strength, or the S&P will correct. We’re definitely waiting and watching to see how this evolves. Markets are at an important junction.

Increasingly, we find ourselves thinking about the limits of the reflation trade. Admittedly, our research team has been aggressively bullish on global reflation, especially beginning 2021. However, we think it is time to start orienting towards a regime shift. Now, this doesn’t mean that we abandon our reflation positioning across investments. Rather, it means we start looking for the tell-tale signs of a regime change from reflation to a moderate expansion. We think the context below is important, particularly for EURUSD, JPYUSD, and DXY:

Above, we show our model-driven estimates of future Industrial Production for the UK, US, and Japan. We use industrial production to measure global business activity, and our models are pointing to peaking YoY numbers in June-July of 2021. Markets are forward-looking, and as we would expect, they have already priced in the numbers, which can be seen in our global risk appetite measures (defined as total equity allocation):

As we can see above, our risk appetite measures have started to come down after posting record-highs earlier this year. We think this is largely a function of markets beginning to price the next phase of the global economic recovery, i.e., one where growth will continue, but its pace will likely decelerate. This is consistent with the currently elevated levels of global growth expectations, making it hard for growth expectations to increase further:

As we can see, the consensus forecast shown above is already pricing in a high rate of recovery for major economies. Hence, we see little room for these to continue to climb substantially. As such, we need to start monitoring the situation carefully to assess when we are definitively in regime change. Particularly, we think that the best information to gauge reflation narratives is embedded in major economies’ equity markets. We will be watching price action, implied earnings growth, asset allocation, and momentum carefully. For the time being, reflation looks like it continues. However, we need to start looking for the next regime shift.

Gold has gone through considerable pain this year- down almost 9% year-to-date. After being aggressively bullish gold for the majority of last year, we pivoted to bearish this year. Our rationale, while multi-factorial, can be boiled down to us expecting risk assets to rally as reflation continued. This move indeed played out as we expected, and gold is now down significantly from its all-time highs from last year. The question we find we’re asking ourselves today is how long this environment can continue? To answer this question, we offer our cyclical model for gold, a reliable signal for future gold trends over a long time. While gold will eventually turn upwards, there looks to be some downside left:

As we can see, our cyclical model has indeed been a strong predictor of gold trends, and we don’t expect this to continue. According to our estimates, gold will likely continue to fall as long as the US equity market continues to rally. We think that focusing on this fact, rather than a specific date as a turning point, is a superior approach. To get a better sense of market timing, we look at gold through our risk measures:

Recall:

• Trading Range: These ranges represent a trading bank within which a currency should trade based on multiple market factors. If we are long- prices above the upside range indicate the asset is expensive, and prices below the downside range suggest that they are cheap and vice versa if we are short.
• Year-to-Date Returns: This is the price performance of a given currency over the course of the current calendar year, in percentage terms. We also compare the current price to the 52-week high and low for reference.
• Price Momentum: This looks at cumulative rolling returns for a selected lookback period.  Positive momentum is good if we are long and bad if we are short. 
• Implied Volatility Discount/Premium: This tells us what the market expects in terms of volatility relative to the history of volatility. If we are long a currency, we typically want market implied volatility to be higher than historical volatility and vice versa if we are short.

Longer-term indicators are pointing to lower gold. Further, the recent spike in gold prices has compressed volatility to a level that looks inconsistent with recent history. However, we do need to be careful as price momentum over the last momentum has turned positive. Overall, there seems to be further downside left until the reflation narrative tops out.

One of the few things that EURUSD typically has going for it to the upside is the strong deflationary forces that pervade its economy. However, today’s HICP inflation print for the Eurozone tells us otherwise. Below, we show US and EUR inflation rates, respectively:

As we can see, the most recent print puts EUR HICP quite close to USD CPI, making its real rate of return even more unattractive. Of course, these inflationary pressures could be transitory, but they are not additive to EURUSD strength for the time being. Since the start of 2021, we have been bearish on EURUSD based on our fundamental outlook that the US would outperform Europe, resulting in inflows to the dollar. Our execution of this view has been augmented by our trading ranges, which we show updated for EURUSD below:

As a reminder:

• Trading Range: These ranges represent a trading bank within which a currency should trade based on multiple market factors. If we are long- prices above the upside range indicate the asset is expensive, and prices below the downside range suggest that they are cheap and vice versa if we are short.
• Year-to-Date Returns: This is the price performance of a given currency over the course of the current calendar year, in percentage terms. We also compare the current price to the 52-week high and low for reference.
• Price Momentum: This looks at cumulative rolling returns for a selected lookback period.  Positive momentum is good if we are long and bad if we are short. 
• Implied Volatility Discount/Premium: This tells us what the market expects in terms of volatility relative to the history of volatility. If we are long a currency, we typically want market implied volatility to be higher than historical volatility and vice versa if we are short.

Our current read of these technical tools tells us that EURUSD is still attractive to short. Implied volatility continues to paint a picture of complacency, and momentum is definitely in favor of more downside. As the market begins to look past weak European data, EURUSD can bounce. However, our judgment is we are not at that point yet. US data’s relative outperformance has likely only just begun, so there are likely legs left for EURUSD to slide.