Article / 05 October 2016 at 10:00 GMT

Quarterly Outlook: Queasy and uneasy

Head of FX Strategy / Saxo Bank


  • The reach-for-yield theme has been overplayed as QE nears end-game
  • Markets yet to take on board significance of BoJ's de facto QE taper
  • Trump victory in November not necessarily a dollar negative
  • Dollar remains best safe haven of choice in potentially rough-ride Q4
  • Ongoing Brexit uncertainty likely to send sterling ever lower into Q1 2017

By John J Hardy

In many ways, Q3 felt like a collective holding-of-the breath in markets as asset markets and currency volatility largely died down during the quarter, even after the Brexit vote rocked the financial world near the end of Q2.

The lion’s share of the reaction to the Brexit vote was absorbed in the initial 24 hours and volatility faded for much of the quarter, even if we did see a steep devaluation in sterling. Elsewhere, the eerie quiet that asserted itself in Q3 was actually an extension of the massive return of risk appetite and the 'reach-for-yield' regime that developed in the wake of the crisis at the beginning of this year.

To recap, the meltdown in financial markets in January forced the Federal Reserve to retreat from its rate-hike intentions and veered China away from its yuan devaluation that had been the chief driver of market volatility, but had also been brought about by the yuan’s linkage to a painfully strong US dollar (based again on Fed hawkishness). In Q3, the Brexit vote and subsequent Bank of England easing underlined the idea that central banks will never do anything to upset the market and encouraged a fresh extension of risk taking.

But the market has overplayed the reach-for-yield theme as we head into Q4 and has not sufficiently appreciated the implications of September’s key central bank meetings. At the September 8 European Central Bank meeting, for example, the ECB, amid expectations for a policy overhaul, was loudly silent and didn’t even extend the horizon of its purchase programme.

The reasons are that its asset purchases are too large for the European bond market to absorb beyond the established horizon out to March of next year and clearly aren’t boosting economic growth or inflation meaningfully in the first place.

Then, on September 21, the Bank of Japan delivered a bombshell that wasn’t fully appreciated for what it was: a de facto QE taper. The BoJ policy announcement abandoned a set asset purchase target and instead announced a focus on managing the yield curve. g

The Bank of Japan hit a crossroads effectively going for a QE taper and
that is something markets might only begin to assimilate in Q4. Photo: iStock

The BoJ was clearly running out of bonds to buy and didn’t like that it was brutally flattening the yield curve and therefore crushing Japanese bank’s ability to eke out profits in a traditional borrow-short, lend-long banking model. The new focus was a very clever one-two, however, as the bank prevented an avalanche of yen buying as the move also had longer-term implications.

Yes, for the short term it allows the BoJ to taper purchases if necessary when the BoJ has trouble finding bonds to buy at reasonable yields while hiding under the cover of a yield focus. But for the longer term, it also leaves the door open to massive future expansion in QE without having to declare a new purchase target. That buying might be needed the day the Shinzo Abe government commits to a larger fiscal stimulus than we have seen thus far.

This new framework could keep a floor under USDJPY in Q4 eventually.

QE to infinity yields to unease

So the ECB and BoJ have stepped off the QE train, showing not only evidence of losing faith that QE acts as intended, but also quite simply bumping up against practical limits because of the overwhelming size of their programmes, which vastly outstrip government’s net issuance needs. Market observers might counter that the Fed could head back into a QE regime if markets destabilize or the US economy shows signs of slipping into recession.

After all, Janet Yellen weakly proclaimed at her damp squib of a Jackson Hole, Wyoming speech this August that fresh easing would take the form of more QE, if aimed at an expanded palette of assets, and forceful forward guidance.

But the game is up: monetary policy acting alone simply does not work – and the Fed’s lack of recognition in the complete loss of its credibility in the market place is disquieting, to say the least. The policy impetus from here is switching to fiscal, if with various leads and lags, just as central banks were remarkably out of synch in implementing QE in the 2009-15 timeframe.

But as of this writing, it doesn’t appear that markets fully share our impression of what is going on or appreciate the implications if we are headed into a long period of uncertainty in which markets both lose faith in QE and risk a long wait until fiscal stimulus comes in sufficient size to move the needle. Our expectation, therefore, is a rise in volatility in Q4 that we thought would be well under way already in Q3.

Our chief trading theme for Q4, therefore, is that with the waning faith in and impact of QE, we expect the large QE currencies will perform well against most other currencies, especially those that benefitted the most this year from the reach for yield theme, like commodity and emerging market currencies.

Chart: Carry adjusted performance of G3 versus commodity dollars (Source: Bloomberg)

Indexed to 100 on January 1, 2007, the chart shows the carry-adjusted return of a long basket of USD, EUR and JPY versus a basket of AUD, CAD and NZD. If markets are losing faith in QE pushing currencies from here, the traditional QE currencies, the G3 of USD, EUR and JPY could rise sharply against the commodity dollars, where structural headwinds from large private debt bubbles could finally start to come into play in Q4 and have the market actually predicting further rate cuts and even the eventual arrival of bailouts, QE and so on.


Source: Bloomberg, Saxo Bank

Questions for currencies in Q4

Trump or Clinton? Alone, the uncertainty of whether Donald Trump or Hillary Clinton will be the next president will occupy considerable bandwidth in Q4. The supposed no brainer is that a Trump victory would mean greater uncertainty and a greater risk of an asset market correction with supposed lack of faith in the US dollar and liquidation of US treasuries. A focus on the fiscal implications of some of his spending and tax cut proposals is also cited as a USD negative.

But the USD might just as well strengthen under Trump as well. Two reasons: markets might position for a massive corporate profit repatriation down the road and fewer risks to the US economy than elsewhere. As well, new Trump fiscal outlays will only arrive with a long lag, and the Fed may be reluctant to play ball with Trump, who would inevitably politicize Fed policymaking.

We’ve not seen political antagonism around the Fed policy in a generation, not since Reagan-Volcker. The only 100% guarantee with a Trump presidency will be that Yellen is no longer Fed Chair when her term runs out in early February 2018. Any replacement is hardly likely to be of the Yellen/Bernanke mold and what use is forward guidance from a Fed with an unknown leader in just over a year?


The US election on November 8 could see a Donald Trump win but that
does not necessarily equate to a dollar-negative scenario. Photo: iStock

USD, EUR or JPY? The USD is our still our favourite safe haven in times of volatility, though Q4 could be a rough ride. The yen is a difficult call, as the near-term implications of what was a de facto BoJ taper this September are JPY positive, but Japan will likely be the first major currency to look at fiscal stimulus, which will drive real rates lower. The euro may prove relatively resilient as well on the ECB’s stepping away from QE, but a new political crisis over the future of the EU and the ongoing challenges to Europe’s banks could force Europe more quickly towards a massive new easing with fiscal support that could see the euro sharply weaker versus the US dollar.

How low can sterling go? We would expect sterling to find a low point some time in Q4, though there could be a risk of weakness stretching into Q1, until the maximum moment of uncertainty when Article 50 is invoked. Sterling is getting very cheap, but we may need to see signs of the developed world’s largest current account deficit turning before the currency can stabilize and possibly rally. Sterling could turn the corner first against a likely troubled euro in 2017.

Can any of the G10 smalls stand tall?  The lay of the land among the G10 smalls (the three commodity dollars AUD, CAD and NZD plus the Scandies SEK and NOK) is actually quite varied, though they do mostly share the structural risk from having inflated remarkable private debt bubbles. In Q4, the cracks may begin to show in some of these bubbles, particularly in housing in Australia and Canada. Longer term, the inevitable response will be enormous bailouts that leverage up the public balance sheet to bail out the private sector. QE comes to the small economies, in other words, even as it is largely losing steam in the G3. We’ve played this scene before – this will mean lower real rates and weaker currencies.

As a basket, the G10 smalls may perform weakly against the G3 in Q4. Among these five currencies, the kiwi stands out as the most egregiously overvalued, SEK is rapidly becoming the cheapest, and the others sit somewhere in the middle. We would expect AUD to outperform NZD.

CAD is a bit of a wildcard on the risk of a Trump victory, but may get too cheap versus the others commodity currencies if the market overreacts, but NZDCAD may fall nonetheless. SEK has gotten too cheap, while NOK is getting more fairly priced but is still probably too cheap, even though it offers the G10’s most negative real interest rates.

Is the yuan devaluation going to remain on hold? The Chinese regime’s intentions on currency policy are inscrutable, but with the obvious and very scary build up in its credit bubble and the inevitable non-performing loans this bubble has created, one of the safety valves available to relieve the pressure is a further currency devaluation. China will likely keep the rate very stable until at least the other side of the US presidential election.


China is likely to keep any further yuan devaluation on hold until the other side of the
US election but it is a very obvious safety valve as its credit bubble builds. Photo: iStock

 — Edited by Martin O'Rourke

John J Hardy is Saxo Bank's head of forex strategy

05 October
Steve Lucas Steve Lucas
Thanks John, always find your posts interesting. Of course there are always risks, but for me the main risks to your bullish US$ call are a) the US don't raise rates, b) they do raise rates - as historically the $ rises in anticipation, but then falls as soon as they start to tighten, c) the market realises the $ is losing its status as the worlds reserve currency - though this may take a while to unfurl and d) technically, at this stage the charts don't support the view. Cheers Steve


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