FxWirePro: A bid adieu to 2017 and roadmap ahead for 2018

There is no doubt what is right at the top of the future Fed chair Jerome Powell’s wish list for Father Christmas. Exactly the same that his predecessor Janet Yellen had probably already asked for the previous year: inflation. Of course, there is the possibility that her wish will still come true, as inflation data (PCE core rate) is due for publication one last time for this year today.

The global picture on the volatility front hasn’t really changed in recent months. Implied and realized volatility is still hovering in their low or very low percentiles. The currency market has been acting as the adjustment factor between countries positioned at different parts of the economic cycle clock built by few analysts. It has been one of the few assets on which carrying long volatility positions has not been a constant pain. It has also led to a dramatic reversal in the correlation regime, leading to some significant discounts on equity options contingent to currency levels.

A tough year is ending badly as we have conspired to lose money on a range of tactical USD longs and a number of idiosyncratic trades in G10 (short GBP) and EM (bearish ZAR and bullish HUF). We leaned long dollars from the backend of October as leadership in near-term macro momentum had rotated towards the US and it seemed that sentiment could get a further boost from 1) the political imperative to deliver tax reform by the end of this year, and 2) a Fed which we expected to hike and potentially also to signal a faster clip of tightening for next year.

But the Fed demurred on the raising the 2018 or 2019 dots. Meanwhile, the directional signal from macro momentum, which had proved so prescient earlier in the year in capturing the dollar’s demise and the euro’s cyclical upswing, has deteriorated rather in recent months (the 3-month return from the Forecast Revision Index systematic model is 0.7%).

Instead, much of the price action in FX has been sufficiently choppy on a higher frequency basis to dislodge our cash positions yet at the same time remaining essentially trendless and thereby causing our option-based directional trades to expire OTM. 

From a fundamental perspective, the underlying issue for the dollar continues to be encapsulated by the incessant and idiosyncratic flattening in the US curve (refer above charts). The impression is of a market which just can’t shake its rather downbeat view of the terminal policy rate, even after growth has accelerated above3%and with the Republicans strong-arming fiscal reform through Congress. Pricing the terminal policy rate matters rather more for the dollar than the pace at which the Fed aims to get there, hence the dollar's abject failure this year to appreciate despite the Fed finally delivering what it signaled at the start of a year. This disconnect between a more upbeat reality and less ebullient late-cycle expectations doesn’t bode particularly well for USD going into 2019 as we expect growth to revert to trend or a little bit below at 2% in 1H’18 and then 1.8% in 2H’18. Courtesy: JPM, SG