Post- summer trading conditions continue to keep FX volatility subdued, leaving largely anchored. Still, our models are pointing to some short-term undervaluation in the pair, supporting our moderately bullish bias for coming weeks. Gulf headlines remain a marginal factor for FX, more visible in some relative value trades than USD crosses
USD: Looking for a Shift in Fedspeak
The post-CPI midsummer environment is understandably weighing on FX vols. We argued yesterday, that this could remain the norm for at least the next couple of weeks. At the same time, we retain a preference for dollar downside, as we still believe market conviction around further tightening by the Federal Reserve is too strong.
For now, Fedspeak offers the clearest potential catalyst for market moves. There is still considerable uncertainty over the message that could emerge from the late-August , particularly after a report that leaned dovish without delivering a definitive signal. Yesterday, we heard from Beth Hammack, who voted for a and continued to make the case for tightening, but also from Tom Barkin, who raised some doubts about the need for higher rates despite not being considered a dovish voice within the FOMC. Let’s see if more centrist members start to soften their hawkish tone.
Today’s US calendar includes July , expected at a modest 0.1% month-on-month, and the University of Michigan surveys, which are expected to show little change from August. These second-tier releases would likely need to deliver significant surprises to trigger a meaningful dollar reaction.
Meanwhile, headline fatigue surrounding the Middle East remains elevated. US-Iran negotiations appear to be at a stalemate, but declined yesterday, providing some support for global bonds. The bar for the dollar to rebuild a strong direct relationship with oil prices remains quite high, and the impact of developments in the Gulf may remain more visible in G10 relative-value trades, where pairs such as NOK/SEK and AUD/NZD continue to track the energy story quite closely.
EUR: Showing Some Undervaluation
Our models suggest EUR/USD’s short-term fair value sits in the 1.160-1.1650 area. That’s primarily on the back of the c.10bp tightening in two-year swap rate spreads, which retain a significantly higher beta than other drivers.
That supports our positive bias on EUR/USD, even though we aren’t convinced a break above 1.160 is on the cards in the coming days unless communication from the Fed starts to surprise on the dovish side. For now, EUR/USD bulls like us may be content with strengthening technical support around 1.1500.
In the eurozone, the second release of 2Q will be released today, with no expectations for meaningful changes to the advance 0.4% quarter-on-quarter print.
JPY: BoJ Policy Story Having Little Effect So Far
Despite some sharp moves in Japanese money markets this week, the yen is failing to find any lasting support. Here, the big story is that the Japanese government might be more tolerant of a faster tightening cycle by the Bank of Japan. The prior assumption had been that a government focusing on growth would only allow the BoJ one hike every six months. The suggestion now is that Tokyo has elevated FX as a policy priority and wants to ensure that the first joint intervention with the US to buy the yen since 1998 is a success.
Markets now price close to a 75% chance that the BoJ hikes 25bp in September. That has seen two-year US:Japan swap differentials narrow nearly 40bp since mid-July. That should be weighing on . The fact that it is not may owe to benign conditions that continue to favour the yen-funded carry trade. That said, the risks to funding in yen are squarely increasing, and if we are right with our call for unchanged Fed rates in September, USD/JPY could well be trading back below 158. And to play independent yen strength in the interim, expect a lot more focus on short positions.
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