Fed Funds are trading at a higher yield than the entire U.S. yield curve for the first time since 2008—it cannot hold, writes Matt Weller.
After all the turmoil in markets last week, traders are seemingly taking a pause in early trade this morning. Equity indices across Asia, Europe, and the US are either trading higher or pointing to a higher open, the “safe haven” Japanese yen is the weakest major currency so far today, and oil is rallying by 3%.
While the two-day weekend break from trading certainly helped to “cool off” emotions, the biggest factor stabilizing markets is the belief that central bankers will ride to the rescue once again. At the Asian open, the Bank of Japan issued a brief statement acknowledging that, “Global financial and capital markets have been unstable recently with growing uncertainties about the outlook for economic activity due to the spread of the novel coronavirus” and vowing to “closely monitor future developments, and… strive to provide ample liquidity and ensure stability in financial markets through appropriate market operations and asset purchases.” The central bank subsequently injected ¥500B in two-week funds to support markets.
Looking ahead, the proverbial elephant in the room will be the Federal Reserve. In an unscheduled statement of his own on Friday, Fed Chairman Jerome Powell said that the Fed would “act as appropriate” to support the economy in the face of risks posed by the epidemic. Following last week’s massive selloff in risk assets, traders believe Powell was hinting at an imminent interest rate cut, perhaps even before the Fed’s scheduled meeting in two weeks.
As the chart below shows, U.S. interest rates have fallen off a cliff in recent days, with the one-year, two-year, five-year, and 10-year tenors all shedding at least 40 basis points over the last two weeks alone.
Source: TradingView, GAIN Capital
The last time the Fed Funds rate was higher than the entire U.S. yield curve (as we saw briefly last night) was in 2008, amid the Great Financial Crisis. At the moment, the March Fed Funds rate is trading at 1.25%, nearly 40 basis points below the current Fed Funds rate of 1.62%, signaling that traders believe the central bank will be cutting interest rates dramatically and rapidly, perhaps as soon as today or later this week.
Situations like this are exactly why the Federal Reserve raised interest rates off 0% over the last few years, and the central bank will not be afraid to use the (limited) ammo it has at its disposal. Indeed, the Fed could very well take interest rates below 1.00% this summer to cushion the blow of Coronavirus-related economic disruptions.
For the FX market, this means that the U.S. dollar’s relative yield advantage over its G10 rivals could soon evaporate, and traders have been consistently selling the greenback as a result. After probing 100.00 less than two weeks ago, the U.S. Dollar Index has fallen six of the past seven days to trade back at its 200-day exponential moving average near 97.75.
If the Fed does follow through with a 50-basis-point interest rate cut, either this week or at its regularly-scheduled meeting in two weeks’ time, the dollar could finally bounce in a “sell-the-rumor-buy-the-news” reaction. That said, the near-term momentum has clearly shifted in favor of the bears, and if the dollar index breaks below its 200-day exponential moving average near 97.70, a move toward the bottom of the one-year range near 96.00 could be next.
Hear what Matt Well had to say about Geopolitics, Economics and the Forex Markets at the recent Las Vegas TradersExpo. Matt Weller | Global Head of Market Research | GAIN Capital email@example.com | w: www.forex.com www.cityindex.co.uk
Source: GAIN Capital, TradingView
Why EUR/USD is Surging
The euro is the strongest major currency on the day despite the accelerating spread of Coronavirus on the continent. Assuming we close anywhere near where we’re currently trading, this would mark the seventh consecutive rally in EUR/USD, which has tacked on more than 300 pips in that time.
So, what’s driving the euro higher against its major rivals? It’s certainly not the economy, which remains mired in a slow growth, high unemployment state, despite negative interest rates and aggressive asset purchases.
Instead, the euro is rising on the exact same dynamic that makes the Japanese yen a “safe haven” currency: the reversal of carry trades. In a carry trade, investors buy higher-yielding currencies and sell lower-yielding currencies (like the euro), seeking to benefit from the positive “carry” between the two currencies in addition to any price moves in their favor. Traders typically put these trades on when they’re confident in the prospects for the global economy, which tends to benefit higher-yielding emerging market and commodity-correlated currencies.
Of course, markets are two-way animals, and these dynamics occasionally reverse as we’ve seen in the last couple of weeks. As traders become fearful about the prospects for the global economy, they emphasize the return of their capital over the return on their capital and accordingly “unwind” their carry trades. This means that they must sell the higher-yielding currency and buy back the lower-yielding currency used to fund the trade (commonly the euro of late). It’s this dynamic that has led to the massive rally in the euro, which has counterintuitively become a “safe haven” currency of sorts.
There is a technical case for the EUR/USD rally to end soon assuming sentiment around Coronavirus can stabilize. The world’s most widely-traded currency pair is currently testing its long-term 200-day exponential moving average, as well was the topside of a multi-year bearish channel. Meanwhile, the relative strength index (RSI) oscillator is approaching overbought territory after starting this vicious rally from its most oversold levels in years less than two weeks ago.
Source: TradingView, GAIN Capital
Bearish traders will want to watch for signs that price action is starting to reverse, perhaps in the form of a reversal candlestick pattern on the four-hour or one-hour chart, before considering sell traders against the strong bullish momentum. Positive global economic news, even if it comes in the form of a Fed rate cut, could also help EUR/USD find a near-term top. On the other hand, a break of the current resistance levels would suggest that the buyers remain in control and open the door for a continuation toward the New Year’s Eve highs above 1.1200 next.