US buying relief on Warsh news – but will likely fade

USD: Understandable initial FX reaction

The US dollar has advanced further this morning which we view as an understandable reaction to the news that President Trump is preparing to announce the nomination of Kevin Warsh to be the next Fed Chair. It’s an understandable reaction as this would confirm who the next Fed Chair will not be – Kevin Hassett or Rick Rieder. Both of these candidates have been in the running and were deemed favourites at different stages and were perceived by the markets as being inexperienced and being too close to President Trump and hence would be more easily influenced.

That is certainly not the case with Kevin Warsh and for most of last year the probability markets rarely gave him more than a 20% chance of becoming Fed Chair. He has experience having served on the board before but that time on the board was a period in which he was viewed by the markets as a hawk. His prospects had improved after meeting President Trump on 10^th December and prior to that any public comments made were certainly consistent with wanting rates lower. On 23^rd July last year Warsh stated that he would support a rate cut at the FOMC meeting the following week (they didn’t cut) and perhaps importantly in explaining why he looks to have got the job added back in July that “we need changes in leadership” and “regime change in everything the Fed does”. On 17^th July Warsh spoke of the need to address the lost credibility at the Fed by introducing fundamental change and strongly criticised the Fed for delaying rate cuts. Of course the Fed did then cut further, by 75bps, so how strongly Warsh now believes rates should be cut is less clear as he has made no public comments of late. But it is safe to assume that if he is getting the job, he likely believes there is still ample room to cut further. He is also a strong advocate of the Fed separating itself from fiscal management and has previously called for a notable reduction in the size of the Fed’s balance sheet.

This will make for an intriguing period given the Fed has just announced a renewed expansion of the balance sheet but if he is to push on balance sheet shrinkage then we are certainly likely to see a reduction in longer-term Treasuries held on the balance sheet. Curve steepening is clear to see today in the UST bond market and that makes complete sense.

Who Kevin Warsh is not, like stated above, means the bounce for the dollar is understandable. Warsh is a strong advocate of Fed independence so fears over independence being eroded should recede which is also dollar supportive. However, Warsh is a strong advocate of cutting rates. One important difference potentially could be Warsh’s credibility vs the likes of Hassett or Rieder. That stronger credibility means Warsh stands a much better chance of swaying the rest of the FOMC in the direction he advocates and hence an initial period of rate cuts should actually now be viewed as more likely. Also, if balance sheet shrinkage is a goal pursued, rate cuts at the short-end of the curve would be an important offset. Curve steepening tends to coincide with US dollar depreciation and with rate cuts potentially more likely to be delivered under a Warsh FOMC we suspect this initial bounce for the dollar will fade.

A STEEPER US YIELD CURVE TENDS TO COINCIDE WITH WEAKER USD

Source: Bloomberg, Macrobond & MUFG GMR

USD: Geopolitical risks into the weekend

The risk aversion emanating from the correction in AI stocks yesterday could potentially be reinforced by an uptick in geopolitical risks over the weekend. The S&P remains resilience and closed only 0.1% lower but gold is currently correcting sharply, down over 4.0%. Crude oil prices closed up 3.4% yesterday but has corrected modestly lower today, in part on the stronger dollar. The justification for an attack on Iran has changed from initially being about protecting protesting civilians from suffering at the hands of the regime to now being about ending its nuclear program. This shift in reasoning certainly points to a risk of an attack that is now being reported as imminent given the arrival in the region of the Abraham Lincoln carrier strike group.

We know from past examples of US attacks that there is a tendency for these to take place around weekend time. Last year the US attack on Iran’s nuclear facilities took place on Sunday 22^nd June and this year the US attack on Venezuela took place on Saturday 3^rd January. So investors will be on heightened alert given the reports that an attack is imminent.

How extensive any attack is, if something was to happen over the weekend, would shape the financial market response on Monday as this will shape risks over a possible response by Iran. Fears of retaliation would certainly likely see crude oil prices extend gains (already 15% in January) which would be modestly supportive for the dollar.  But given the ongoing USD debasement concerns we would not expect any meaningful gain for the US dollar. Last June there had been a build-up of speculation that supported the dollar but the de-escalation immediately after the attack (and the symbolic retaliation by Iran) saw the dollar drop sharply. Similarly, the dollar opened stronger after the Venezuela attack but closed weaker on the Monday following.

NOK is the top performing G10 currency this week, unsurprising given the gains in crude oil and NOK and CAD will continue to be determined by how crude oil responds to any US attack. A quick de-escalation would see crude oil fall sharply although with US objectives less clear it is hard to predict. Iran is certainly weak and hence its ability to retaliate meaningfully is limited. While CHF gains this week are more modest than oil-related FX gains, we would still see CHF as a most likely to sustain gains if geopolitical risks were to intensify over the coming days. SNB intervention is a risk but probably only if CHF was to advance very sharply from current levels.

G10 FX VOLATILITY HAS PICKED UP RECENTLY BUT REMAINS LOW

Source: Bloomberg & MUFG Research

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com