Potential limits to the divergence trade but geopolitics a further factor

USD: Fed in focus as markets price divergence

We start this week with certainly greater anticipation of increased FX volatility after a big move stronger for the US dollar last week as investors pulled back the scale of Fed easing after the CPI print. Our momentum indicator (based on z-score analysis) for EUR/USD revealed the largest three-day shift in momentum to the downside (relative to the past 3mths) since March 2020 when the global pandemic erupted. Back-testing analysis points to a higher probability of further declines in EUR/USD this week based on the previous eight occasions since EUR trading began in 1999 when the momentum shift to the downside was as great or greater than last week. So there is certainly scope for further dollar gains this week, especially given the upturn in geopolitical risk after Iran’s attacks on Israel over the weekend (see below).

It is a busy week for Fed speaking events and hence this week will give us a better sense of how last week’s CPI print may have altered the thinking amongst Fed officials. There are no less than thirteen separate Fed speaking events through this week with ten different Fed speakers. Fed Chair Powell will participate in a moderated Q&A with BoC Governor Macklem tomorrow at 18:15 BST which may be the highlight although Vice Chair Williams is scheduled to speak in a Bloomberg TV interview today at 13:30 BST. Vice Chair Jefferson will also give a keynote speech at the Fed’s International Research Forum on Monetary Policy tomorrow at 14:00 BST. Given the way the FOMC dot profile shifted at the last meeting, the endorsement of three rate cuts this year is likely something we are going to hear less of after the CPI print.

Still, the jump in yields does mean the markets are a lot better positioned for hawkish communications from Fed officials this week and with OIS pricing indicating a full 25bp cut is not priced until September – four meetings away – hawkish rhetoric is unlikely to have as much impact. A lot can still happen even by the June meeting given we will have two rounds of inflation and employment data released by then.

Friday’s price action also serves as a reminder that there are limits to the scale of divergence ahead. The S&P 500 closed down 1.5% and the weakness of the equities markets saw demand for fixed income rebound with both the 2-year and 10-year US Treasury yields falling 6bps. At these level of yields we suspect a much greater sensitivity to weaker incoming economic data and/or equity market declines.

USD / YIELD CORRELATION SURGES ON FED EASING PULLBACK

Source: Bloomberg, Macrobond & MUFG GMR

USD: Geopolitics in focus after Iran attack on Israel

Part of the reason for the US equity and yield drop on Friday was the increased safe-haven demand ahead of the weekend with expectations of a possible attack by Iran on Israel. That’s of course what happened but Iran has been quick to try and draw a line under the attack by stating this attack is over and the matter “can be deemed concluded” according to the Iranian mission to the UN. Iran stated the attack was a direct response to Israel’s attack on the Iranian embassy in Damascus on 1st April. Of the reported 300 or more drones and missiles fired by Iran, 99% were intercepted. Iran has stated it deliberately limited the attack.

What investors will be watching closely today and over the coming days is whether this attacks is a “one-and-done” scenario and that will be key for financial market moves. The US has stated it would not support an Israeli counter-attack according to an unidentified White House official. This so far has helped contain the financial market response to date.

Nonetheless, this is a clear sign of escalation and a broadening of the conflict in the Middle East that will leave the crude oil market in clear upside price risk territory. Crude oil prices have already jumped around 4%-5% in the aftermath of the Israel attack on 1st April and hence some risk was already priced. The contained attack and the prospect of no immediate tit-for-tat spiral should help to contain the financial market fall-out for now. Crude oil prices have declined today and US equity futures are higher indicating an air of relief over the market but also possibly in hope that this escalation will be contained quickly.

For the US dollar, there is certainly no evidence of any risk aversion or flight to quality. The Swiss franc is unchanged, the yen is weaker and underperforming other G10 currencies followed by AUD. For now the hope of containment in the escalation in the Middle East is containing financial market moves. That could change quickly though if Israel was the retaliate aggressively given Iran’s promise to respond more aggressively if Israel takes action. This uncertainty may not be fuelling risk aversion but it is also likely to at least contain risk appetite until there’s a greater sense of Israel’s response.

OIL / FX CORRELATIONS HAVE BEEN WEAKENING MORE RECENTLY

Source: Bloomberg, Macrobond & MUFG GMR

KEY RELEASES AND EVENTS

Source: Bloomberg