Key FX markets nearing an inflection point

Earlier this year, the USD broke its downtrend to the upside which was confirmed when it closed at a new six month high on a daily basis.  As has been the case since the beginning of the 2000s, periods of dollar strength have tended to coincide with weakness and volatility in risk-assets along with rising credit spreads.  Thus far, 2018 has followed this pattern albeit much more violently in emerging markets.  Given the above, the purpose of this post is to highlight critical support and resistance areas in specific currency pairs that have exhibited clear risk-on and risk-off behaviors as a way to understand whether or not this phase of dollar strength is likely to continue or dissipate.  To be clear, the USD is still very much in an uptrend within a multi-year sideways consolidation.  Risks remain elevated until the greenback breaks down.        

• As the chart shows, UUP- US Dollar Index Bullish Fund has rallied since the end of January 2018 after a one year price decline.  Seeing as 2017 ushered in a low volatility advance in global equities, tightening credit spreads, and emerging market outperformance, price action in 2018 has been the obverse.  
• A sustained move above 27 would therefore result in much more pain for risky securities whereas a trend below 24.9 (September low) should providing at least temporary relief.
• Big picture, unless the dollar's relationship with risk-assets changes, how this multi-year sideways consolidation resolves itself should provide a massive clue as to where markets are in this cycle.         

• Trends in USD/CNH have corresponded nicely with risk-on and risk-off periods.  After bottoming in 2014, it went on to trend higher until 2016 where it failed right underneath 7 yuan (offshore) per dollar.  Throughout much of that time, global markets remained under pressure.  Subsequently, a top in this pair at the end of 2016 helped confirm the nascent risk-on rebound.  If the USD/CNH peak toward the end of 2016 helped validate renewed bullishness, its March 2018 bottom at 6.23 provided a red flag.  It has since gone on to retest the now psychologically important 7 level.  
• A second failure here should bode well for risky assets.  A break below 6.78 would help confirm this whereas a trend continuation above 7 would hint that something bigger may be in the cards.         

• USD/JPY does not provide as clear a picture of when risk-taking or risk-aversion is underway given that market participants have had a tendency to favor the Yen vs non-US currencies when seeking safety.  Despite that, it's still important to note how the FX pair is attempting to breach 114/115 for the fifth time since 2017.  Another rejection here would serve as one indication that the dollar has potentially hit another high against a broad range of currencies.

• Following the Eurozone Crisis & 2015-2016 global sell-off, the Euro found support just above parity vs the USD.  The 2017 low volatility risk-on trade saw EUR/USD trend above 1.13/1.17 resistance until it hit 1.25 in the first quarter of this year.  From then on it has traded lower finding support at the prior 1.13 resistance level.  Bulls will not want to see EUR/USD fall much lower.  A potential break below the 2017 low would send a strong signal that not all is well in the Eurozone.  On the other hand, a rebound above 1.18 could set up a retest of the 2018 highs.     

• EUR/JPY even more so than EUR/USD tends to rise along with risk appetite and fall with risk aversion in a clearer fashion.  The market stress that culminated in 2016 saw the Euro bottom against the Yen and rebound until correcting in early 2018 (sound familiar?).  Between these two phases, the FX rate has formed a multi-year wedge suggesting that markets may be nearing another critical juncture with EUR/JPY now trading within a 137.5 & 124.6 range.  The way this resolves itself will be telling for how markets trade over the coming months. 

• Although the British pound has its own idiosyncratic issues due to Brexit, GBP/USD faces similar questions as the Euro.  Will it now attempt to test the 2017 bottom or rebound near 1.27 support?  A strong move above 1.33 would go a long way toward suggesting that 1.27 support may hold for the time being.

• Similarly to Euro vs Yen, GBP/JPY is also trading in a range with a top end of roughly 156.60 and the bottom between 140/135.6.  A trade above may signal continued relief and possible market optimism in Britain whereas a failure in this zone may serve as a warning.

• The strong bout of dollar appreciation and the China scare from 2014-2016 hit AUD/USD hard as it fell over 35%.  Although it did bounce along with global risk-taking between 2016-2018, it has returned near its lows where it has found support.  The China bulls will not want to see the AUD/USD fail here and decline below .7/.68

• Following the end of the GFC in 2009, AUD/JPY has bounced off 72.5 four times.  Therefore it's likely critical that this exchange rate remain above this level.  Meanwhile a break above 90 should coincide with a market environment more conducive to risk taking.  Much like the FX pairs listed above, the eventual resolution may mark an important inflection point for global markets. 

• CAD/JPY fell during the 2008/2009 Global Financial Crisis, the 2011 Eurozone Crisis, and 2015/2016 China scare & Brexit.  Thus, CAD/JPY has served as a useful barometer of global risk appetite.  Following each risk-off episode, CAD/JPY put in a series of three higher lows and has been consolidating between 91.6 & 80.6/80.55 from the beginning of 2017.   Bullish market participants should heed the warning if any or all of the aforementioned lows fail to hold.

Concluding Remarks:

2017 ushered in a powerful low volatility global rally in risk-assets which corresponded with CNH, EUR, GBP and to a lesser extent AUD & CAD strengthening.  This eventually gave way to renewed USD appreciation and a correction in risk sentiment throughout 2018.  As a result, markets may be approaching a critical juncture in 2019 that will lead to a resolution one way or another.  Is 2018 only the start of a leg down in risk that will see the dollar trade above multi-year resistance in 2019-2020? Or is this just a corrective phase of 2017's strong global rally that will eventually reassert itself?  

A continuation in risk-taking that brings the dollar down will likely correspond with better than expected outcomes in China, the Eurozone, and post-Brexit Britain.  It goes without saying that this would bode well for global growth.  Conversely, if market participants continue to push the Chinese Yuan, Euro, and British pound lower simultaneously, this would be a major red flag that the global economy could be on the brink of a major disruption which would take global equities lower and credit spreads wider.

Simply put, Pay attention to the US Dollar and key FX markets in general.  From last month's post:

Therefore, it goes without saying that the dollar's direction bears watching.  In the coming months or years depending on when this multi-year consolidation resolves itself, markets may be on the cusp of a secular move higher or lower in the US dollar.  Seeing as the greenback anchors 70% of the world's currencies and with 11 trillion worth of dollar denominated debt issued by non-bank borrowers outside of the United States, its next move could spell either much needed relief or far greater pain than what we have recently witnessed since the beginning of  2018.  Thus, its path will not only determine the fate of risk-assets but also the global economy, which is precisely why this writer considers it the most important chart in the world.  Pay attention to the USD.

It's important to note the reflexive relationship between the dollar, dollar denominated debt, global growth, and the perception/expectations of market participants.  When investors fear that worse than expected outcomes may materialize for highly levered issuers of dollar denominated debt*, they begin to make protective/defensive portfolio decisions.  This causes the dollar and foreign credit spreads to rise.  The rise in spreads (sell-off in riskier bonds relative to safer ones) in turn increases debt servicing costs as foreign currencies fall.  Inevitably questions about how this will affect or slow global growth start to become an immediate concern and the cycle of worry continues.**  In part, market participants reinforce the very conditions which they fear.  Thus, dollar appreciation not only acts as a tightening of international financial conditions but is a symptom of increasing risk aversion among asset managers.

To end on an optimistic note, given the low valuations in equities outside of the US, an eventual top in the US dollar could set up a generational buying opportunity in foreign markets.  In that case, it's probable that US equities will underperform, but that can be offset with exposure to international securities.  With that said, the USD is still in control and must be respected for the time being.



*Counties that peg to the dollar or manage their FX rate using dollar reserves face a similar cycle.

**This hasn't been unique to EM economies.  Whenever the Euro depreciates and periphery vs core credit spreads widen, market participants may be pricing in the increasing possibility of redenominaiton risk.  Whenever the next global downturn takes place (no prediction), serious questions will be asked as to whether the Eurozone can continue together when fighting the effects of another recession.

***Although market participants have been worrying about the possibility of a financial disruption emanating from the US corporate sector or more generally within the US economy, it still appears more likely that any potential disturbance will be triggered by events coming from outside the US.