One of my favourite FX trade indicators is about to make its long-awaited return. Central bank differentials.
I still hold the view that over the coming 12 months the reflation trade is still the most influential indicator for FX trading and that the decline in US bond yields over the past 2 weeks is unlikely to last – I see 2% on the 10-year come December as the most likely scenario 2021.
But there is no doubt that as we move from COVID stimulus to COVID tapering and eventually rate rises to respective cash rates – differentials will be the main game in town.
And last week was a prime example – let’s compare the news from Ottawa and Frankfurt.
First the Bank of Canada (BoC) – although it left rates on hold at 0.25% which, was expected.
It was the change in its bond buying program that has signalled differentials are back.
The BoC had foreshadowed the move and economists did expect it but the fact it has actually following through was a signal for FX to start repricing. The reduction in its bond purchase pace from C$4 billion per week to C$3 billion is the first signal monetary
accommodation will change, but that we as FX traders need to start factoring in which central banks will follow suit and which will hold the line.
Thus, let’s take the European Central Bank’s (ECB).
It, as expected, left its policy settings unchanged and reiterated its intentions to increase the pace of its COVID bond buying program through the current quarter but wants to slow the pace later this year. This will be interesting considering the reacceleration of COVID on the continent. The Bord did acknowledge the improving global demand story and that inflation
is seen as rising temporarily, with spare capacity. It also mentioned the recent EUR appreciation would cap medium term inflation; so again, slowing its pace of purchases looks unlikely despite its current desire.
President Lagarde was questioned on this point and did say that talk of slowing PEPP was premature, and that is dependent upon economic developments.
This could not be two more different set ups and makes for interesting trading going forward.
Trades of note:
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