XE Market Analysis: Europe - Jan 07, 2021

The dollar has found a footing after posting fresh losses yesterday, despite risk appetite holding up in Asian markets and into European trading. The DXY dollar index has inched above 89.50 after yesterday posting a 33-month low at 89.21. Markets are digesting the largely unexpected outcome in the two Georgia runnoff elections, which were won by Democrat candidates. Prospects for a Democrat Presidency, House and Senate have greatly increased the prospect for much more fiscal stimulus than there would have been in the scenario of a split House. Markets have been overlooking the protests by Trump supporters on Capitol Hill, which have petered out, and with the president having called on them to step down. Obviously the situation warrants close monitoring, both near term and in the bigger picture, given the existential threat that the GoP is facing from Trumpism. Market commentaries, meanwhile, have been attributing the new lows in the dollar to the anticipation of larger U.S. trade and budget deficits as a consequence of the runoff elections. Investors have also been recognizing the probability for a higher inflation differential between the U.S. and most of the main economies, which should in turn ratchet down the negative U.S.-versus-peers real interest rate differential given the Fed's built-in inflation tolerance in its monetary policy objective. It should be noted that there are also dollar positives, not least being prospects for increased U.S. growth. We retain an overall bearish view of the dollar, which is likely to continue to lose ground in the unfolding reflation trade, though we are some degrees less bearish than we would have been in the scenario of a Biden administration operating with a split House.

[EUR, USD]
EUR-USD dropped back to levels around 1.2300 after capping out at a 33-month high yesterday at 1.2350. Markets are digesting the upcoming Biden administration with Democrat control of both the House and Senate. The protests of Trump supports at Capitol Hill also caused some concern. Together, they have prompted a modest rebound in the dollar. The Democrat sweep will see a rising budget deficit and the raises prospects for stronger growth. This could be chalked up as a dollar positive influence, though inflation is also set to rise further in the U.S. than under a split House scenario, which, given the Fed's inflation-tolerant lower-for-longer monetary policy strategy, will impart a downside bias on real U.S. interest rates. Already the U.S. has discernibly lower real interest rates versus Japan and the Eurozone, among other peers. With regard to the euro, the common currency has recently been attracting demand as a consequence of the EU's historic EUR 1.8 tln budget-and-recovery package. Since late October, the EU's has issued several social bonds under the EU SURE instrument (Support to mitigate Unemployment Risks in an Emergency), all of which were massively over-subscribed, reflecting demand from long-term investors like life insurance companies, who have a prevailing need for long-term triple-A bonds to invest in to match their liabilities. While not the first time the European Commission has borrowed in capital markets on its own account, it marks a significant upscaling. In 2021, the European Commission will launch borrowing under the €750 bln NextGenerationEU instrument, which is a pandemic recovery investment finding vehicle aimed at investing in green and digital technologies.

[USD, JPY]
The yen's broader performance should continue to derive from the level of risk appetite in global markets. Japan's surplus economy, where yield-seeking domestic investors are apt to invest in foreign assets during times of confidence, but repatriate funds when times are uncertain, has established the yen as a low-beta haven currency.

[GBP, USD]
The pound been in the underperforming lane of currencies during the first week of the UK having left the EU's common market and customs union. The underperformance is more attributable to UK nations, as of yesterday, having gone into a 'tier 5' lockdown, the most restrictive level since the full lockdown of spring last year, although manufacturing, auto repair businesses, DIY and garden stores, remain open, along with food sellers. High street retail, aviation and other public transport, along with the hospitality sector, are bearing the brunt of the lockdown, as in other nations, although the percentage impact on GDP from these sectors being closed is bigger in the UK than most peers. The UK economy underperformed its G20 peers during lockdowns last year, so the thinking, as being expressed in market narratives, is that the UK will be apt to underperform again (although the way the UK compiles GDP data relative to other G20 nations may have exacerbated the picture). Then there is the fact that UK's terms of trade with the EU has eroded in the post-Brexit world, despite the deal, with the key financial services sector left in a strategically more precarious position than before, with participation in EU markets dependant on the latter's equivalency rules, although London's competitive advantage in this area should protect the sector over the near- to-medium term. This said, there is potential for pent up business investment, with Brexit uncertainty having finally cleared, while the UK is ahead of the pack in rolling out a Covid vaccination program. Weakness in the pound may prevail for a time, but with the government aiming to have nearly 25% of the UK population vaccinated by mid February, including all of the most at-risk groups -- the pound looks a much better bet in the bigger view.

[USD, CHF]
EUR-CHF has lifted back above 1.0800, influenced by gains in EUR-USD. Risk-on positioning had been weighing on the Swiss franc with investors factoring in a sea change in optimism about a vaccine solution to the Covid-19 crisis. The recent weakening of the currency will have been pleasing to policymakers at the SNB, given their chronic disquietude about the franc's value. Unlike most central banks, the SNB explicitly incorporates the franc into monetary policy to ward off speculative purchases of the currency, which would impart deflationary forces (via cheaper imports) with the consequential impact of an unwelcome tightening in real interest rates. The central bank repeated at its latest quarterly monetary policy review that the franc remains "highly valued" and said it is ready to intervene directly in the foreign exchange market.

[USD, CAD]
USD-CAD has settled above yesterday's 33-month low at 1.2628, though the pair has remained heavy looks likely to foray further into major trend low territory. Oil prices have gained for a third consecutive day, which has seen front-month WTI futures print a new 11-month high at $51.28, the culmination of a 5.6% rally on the week so far. Crude prices have been underpinned by weekly U.S. inventory data yesterday showing a drop in stockpiles, and by Saudi Arabia announcing that it will be unilaterally dropping its output quota for two months. Prospects for a big spending Biden administration in the U.S. have also been in the mix. Earlier in the week, the OPEC+ group had also announced that prevailing production quotas, which are been decided on a monthly basis now, would be maintained in February, although Saudi's subsequent unilateral action means that supply will in fact drop. Altogether, these developments have turned around what had been looking to be a bearish phase for oil prices, given the demand-sapping impact of Covid lockdown measures across Europe and other major economic areas across the northern hemisphere.