Tapering is coming and the dollar still can’t fly – SocGen

G3 currency pairs are locked into painfully tight ranges, with political developments in NAFTA, New Zealand and Turkey behind the biggest FX moves, according to Kit Juckes, Research Analyst at Societe Generale.

Key Quotes

“Real yields on TIPS are also trapped in a range, and that is feeding the yield-hunting trend. Meanwhile, the ECB is set to announce an extension to its bond buying but at a slower pace. This will sow the seeds of the euro’s next leg higher but isn’t likely to propel it out of its range just yet.”

“Amid all the analysis of Black Monday (“crowds of young brokers swilled their beer from the bottle, their hands trembling from the day’s havoc but still cracking nervous jokes”, according to The Times), my first thought is that this was the day 10-year notes left 10% yields behind – never to return. As yields fell, the dollar had a two-day rally on risk aversion, before falling 10% by the end of the year. By Halloween, it was trading exactly where it is today. The other side of the fall in yields, of course, was the recovery of equity indices. The S&P has delivered a total return of 1,940% to anyone who bought it on the close on Black Monday and kept it ever since.”

“Falling yields fuelled the S&P rally, and more recently low real yields have underpinned risk assets more broadly. With 10-year TIPS yields stuck in a 20-70bp range, it’s hard to see, yet, what will cause the asset rally soufflé to deflate. As for the dollar, what matters is relative rates and, these days, relative long-dated real yields. It is no great surprise that while spikes and troughs in DXY match the highs and lows in TIPS yields, the two series don’t really correlate. In particular, there was a clear break in June when Mario Draghi talked about tapering bond purchases at the Sintra conference. But more recently, the correlation has recovered: 47bp for TIPS as I write and DXY stuck below 94.50, with significant support at 92.60 first and then 91.0 (which matches the EUR/USD 1.21 peak, when TIPS yields were threatening 20bp).”

“From here, I’m struggling to see the range break. If it’s just down to US yields, then it would be a huge surprise for the economy to soften enough to justify a break below 20bp for real yields any time soon (I’ll include all of 2018, for starters). So a break below that level requires a break in the correlation, and in turn, that probably requires a move higher in yields elsewhere and in particular in Europe.”

“Bund yields have been depressed by QE but not only by QE – negative rates and low inflation have played their part too. Next week sees the likely announcement of an extension to the ECB’s QE programme until September at a reduced pace of €25bn per month. Over time, however, the disconnect between real Bund yields and the strength of the eurozone economy will probably act as a magnet dragging the euro higher in due course.”