Neutral on USD: The USD continued to lack direction last week confirming our neutral stance as political risk drove investors into safe-haven flows with JPY, Gold and Treasuries all ending the week higher. Market measures of inflation (Figure 1) continued to rise further shrinking US real yields allowing most US equity indices to close the week at all-time highs.
We identify President Trump’s address to congress on Wednesday (1pm AEDT) as a crucial risk event as markets are searching for further policy details from the President. If the market is disappointed and there is no timeline or numbers to support Trump’s policy details, there is a risk investors will lose confidence and patience resulting in a move away from a risk supportive environment. Should this happen we see it as a trigger for safe-haven flows allowing treasuries, JPY and Gold to rally.
The alternate scenario is that Trump delivers clarity to the markets supporting risk but raises the risk of the Fed increasing rates, which would see USD rally. We expect volatility around President Trumps address and we have identified AUDUSD, USDJPY, EURUSD and Gold as most vulnerable using 10y UST (US Treasuries) as the base for our analysis.
10y UST is a key market driver and has reached a technical inflection point (Figure 2) that has been made more interesting by speculator positioning. Using a 6m rolling correlation we have identified AUDUSD, EURUSD, Gold and USDJPY as the markets to be effected most by 10y UST (US Treasuries) volatility.
Figure 2: 10y UST respecting crucial resistance (Source: Tradingview and CBOT)
Figure 3: 6m Rolling Correlation vs JPYUSD/Gold/EURUSD/AUDUSD (Source: Tradingview and CBOT)
We compute a Z-score using current market positioning relative to the rolling 2-year average based on the percentage of open interest. A score of +2/-2 identifies to us a period of extreme positioning that can lead to position adjustment. We find that 10y UST has reached a crucial resistance level while being near extreme short levels (Figure 4). The risk is that a break of this resistance could lead to further position adjustment and a short squeeze pushing yields lower and leading to a decline in the USD.
Figure 4: 10y UST (Source: Quandl, CFTC and Tradingview)