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Article / 09 September 2016 at 14:30 GMT

FX 4 Next Week: ECB letdown sparks seismic shift

Head of FX Strategy / Saxo Bank
  • Carry trades could be set to unwind as ECB signals limits of policy easing
  • High-yield weakness could send NZD sharply lower versus Aussie
  • Negative-yield SEK could turn around with sentiment, particularly versus EUR
  • BoJ, FOMC meetings could result in a substantial USDJPY spike

At the edge
World's end: This week's ECB stalemate was a signal that policy easing may be nearing its limit, and the reaction could see carry trades unwind around the globe. Photo: iStock

By John J Hardy

This week’s first key development was a very weak US ISM non-manufacturing survey that pushed the USD sharply lower and encouraged a further rally in carry trades. Then, the European Central Bank meeting impressed as president Draghi delivered far less than expected – essentially nothing – while at the same time providing very little guidance that the ECB sees scope for further easing. 

This has engineered a sudden turn in broad market sentiment that could spill over into next week as the market reconsiders its stance on the validity and power of the central bank put that has been driving carry trades since February of this year.

EUR higher versus AUD and NZD

The signaling from the ECB meeting appears to be an admission that the central bank is doing all it can and doesn’t expect to do any more for now, hoping that governments will pick up the policy impetus and launch structural reforms and fiscal stimulus. 

This is far more “hawkish” than the market has been positioned for in light of the longstanding reach-for-yield trade that has prevailed since the comeback from the ugly start to 2016 for global asset markets. So carry trades could look to unwind until we have a look at the September 21 Federal Open Market Committee meetings and the euro may adjust significantly higher versus the higher-yielders.

Trading stance: Trading ranges are quite large in EURAUD and EURNZD pairs, but traders may look to buy dips for a move considerably higher and buy breakouts out of recent ranges (especially EURAUD) for an extension higher – for example, 1.5150-plus in EURAUD.


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Source: Saxo Bank

AUD higher versus NZD if divergent momentum confirmed

AUDNZD broke below the 1.0313 low from the summer this week, but has so far failed to follow through lower. Next week, we’ll likely either see a continuation lower setting the pair on the path for a test of parity (the 2015 and all-time modern low was 1.0021) or we will see a rejection of these new local lows. 

One reason to expect that the kiwi will underperform is the reaction to the ECB meeting and the possible rejection of carry trades resulting that is already quite pronounced in the wake of the meeting. This could see NZD switching from notable outperformance to decided underperformance.

Trading stance: We have a momentum divergence setup on the chart (lower prices this week but at a higher MACD reading than at the previous low) that has yet to be confirmed as of this writing. Confirmation would be a rise back above the 1.0375/1.0400 area next week and a crossing of the MACD indicator, which could have traders focusing on a return to the 1.0750 area in the weeks to come.

Source: Saxo Bank

EURSEK lower

EURSEK reversed this week after a test of the massive 9.60 level that has contained the pair, if with slippage at times, since the global financial crisis. 

As a negative-yielder, SEK has performed somewhat inversely to the carry trade, and as our chief theme this week is the potential unwinding of carry trades after the ECB refused to signal more easing this week, SEK could outperform even a relatively strong euro. 

As well, the technical setup and risk/reward look compelling for bears.

Trading stance: Traders looking for EURSEK lower may trade around 9.50 with stops well above 9.5500 for a try toward 9.40 or lower over the next couple of weeks. Note the relatively busy Swedish economic calendar next week, with CPI on Tuesday, GDP on Wednesday, and Unemployment Rate on Thursday.

Source: Saxo Bank 

USDJPY upside via optionality

There should be plenty of energy in USDJPY on the other side of the September 21 BoJ and FOMC meetings. The most dramatic outcome for USDJPY around these two meetings might be a surprise hike from the Fed while the Bank of Japan announces a further rate cut into negative territory, possibly along with other measures or guidance on helicopter money-like considerations. 

On the other hand, even if the BoJ disappoints with an empty-handed meeting similar to this week’s ECB meeting, the USD may yet strengthen if we continue to see global bond yields higher on the theme that central banks are pulling away from QE due to its ineffectiveness. (USDJPY very likely extremely volatile both ways if we get both nothing new from the BoJ, but higher bond yields). 

USDJPY upside is a trade we have mentioned in previous weeks, and given reasonable volatility levels for one-month volatility around such an important date, the risk/reward for buying optionality for a large move in USDJPY after the two central bank meetings remains appealing.

Trading stance: Traders looking for USDJPY upside may consider options structures for one-month expiry, or at least a week after the BoJ and FOMC meetings to allow some time for the trade to develop. 

Examples are long USDJPY calls with a 104.00 strike or long a 104/107 call spread (with USDJPY trading 102.75, this costs about 74 pips, offering about 3x1 reward-to-risk if USDJPY trades 107.00 or higher at expiry).

Longer-dated call options with higher strikes are another approach, for example three month 106/110 call spreads etc.

Investors setting high targets for USDJPY post- the BoJ/FOMC meetings 
may consider trading the events via options. Photo: iStock

— Edited by Michael McKenna

John J Hardy is head of FX strategy at Saxo Bank


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