e-markets.nordea.com/article/42005/fx-weekly-the-r-star-of-bethlehem

24 December 2017

FX weekly: The R-star of Bethlehem

Martin Enlund | Andreas Steno Larsen

In this Christmas edition of the FX weekly, we show you why the marketssteady view of the neutral USD rate has dented the USD in 2017 and also whyScandi FX is interesting between Christmas and New Year. Merry Christmasfrom Martin and Andreas.

When you wish upon a R-star,

Makes no difference who you are,

Anything your heart desires,

Will come to you

- Jiminy Cricket, as an economistEUR/USD has been buoyant throughout most of 2017 despite supposed headwinds such as a widening 2y &10y spreads (to the US’ advantage), US tax reforms which are seen as boosting growth as well as potentiallyattracting repatriation inflows. That QE was extended to cover most of 2018 hasn’t prevented the EURfrom seeing the strongest trade-weighted gains within the G10 (+8%), while USD is the weakest YTD(-7%).

If January 2017 was the peak in the USD, from a real trade-weighted perspective it occurred roughly one yeartoo early vs the pattern of the two previous post-Bretton Woods mega bull runs of the greenback.

e-markets.nordea.com/article/42005/fx-weekly-the-r-star-of-bethlehem

Chart 1: If the dollar has peaked it was one year too early

So, while the Fed has lifted short rates (US 2Y has risen 62bp since September), this has failed tounderpin the currency. How can this be the case?

First o, it’s not as if the relationship between nominal yield spreads and exchange rates are stable. Evenif you had known the exact path of German and US 10y yields in a given year as well as the relationshipbetween yields and FX as estimated from the preceding year’s data, you tend to be way o in your model-implied forecasts. These correlations just aren’t very robust.

e-markets.nordea.com/article/42005/fx-weekly-the-r-star-of-bethlehem

Chart 2: The relationship between EUR/USD and 10y spreads is far from stable

Another, more interesting reason, why the USD has failed to pick up is because the market’s view of the likelyneutral rate (so-called R-star) has remained steady, whatever the Fed has done or signalled.

For all the din about short rates, the gyrations have thus merely changed the timing of hikes, not theend-level. Indeed, comparing the Fed Funds curve vs the curve pricing a year ago, the only changes worthnoting is to 2018 pricing. The end-point for 2019 is almost unchanged vs a year ago(!).

e-markets.nordea.com/article/42005/fx-weekly-the-r-star-of-bethlehem

Chart 3: The market’s view of the final Fed-rate has trended sideways or lower since late 2016

The Fed’s signal of a low neutral rate via its dot-plot likely serves as a ceiling for forward rates, helpingkeep rates and yields lows via depressed term premiums. This is one reason why we have recently beenmore than a little sceptical about the potential for a new taper tantrum stemming from Fed’s shrinking of thebalance sheet.

e-markets.nordea.com/article/42005/fx-weekly-the-r-star-of-bethlehem

Chart 4: EUR/USD vs forward government short rates and EUR positioning

Moreover, while the 10y yield spread has widened to the USD’s advantage at least over the autumn, forwardsindicate that a tighter EA/US 10y spread nonetheless is on the cards. And forward short rates have moved tothe EUR’s advantage, as has positioning according to IMM data. The market thus overwhelmingly leanstowards an eventual ECB exit underpinning the EUR. This is also a view in line with our longer-termforecasts.

But things might have been dierent. One reason why the Fed sees a neutral Fed Funds rate at 2.75% isbecause of it being perennially negatively surprised (or rather disappointed). In 2014-15 it was surprised bydollar strength, weak oil prices, as well as turbulence in the rest of the world due to monetary policy spill-overs, and recently it has been surprised by weak inflation. As a result it has inferred that neutral rates arelower than it thought.

e-markets.nordea.com/article/42005/fx-weekly-the-r-star-of-bethlehem

Chart 5: USD/JPY vs US 10y yields

But going forward not only could the dollar’s depreciation inform the Fed that neutral rates are nowhigher. A pick-up in core inflation, in productivity growth would also point in this direction, as would ashift towards focusing on financial stability, a theme barely heard of from the G10 since 2013.

One key question for the dollar – especially for a pair such as USD/JPY #– is thus whether such neutral ratesare rising (wouldn’t that be interesting!?), or whether we remain mired in the post-GFC landscape.

We haven’t decided yet. Watch this space.

Scandis and the Christmas season

As we publish this piece on the 24th of December, we can’t refrain from showing a couple of interestingseasonal patterns in the Scandi-space. EUR/SEK has dropped 10 out of the last 10 years between the24th and the 31st of December – and NOK/SEK the same. So maybe this story of poor year-end liquidity inScandis is a bit exaggerated? Or maybe that story is already fully baked in once market participants close thedesks ahead of Christmas?

e-markets.nordea.com/article/42005/fx-weekly-the-r-star-of-bethlehem

Chart 6: EUR/SEK has dropped 10 out of the last 10 years between now and New Year

e-markets.nordea.com/article/42005/fx-weekly-the-r-star-of-bethlehem

Chart 7: NOK/SEK has dropped 10 out of the last 10 years between now and New Year

Also NOK actually fares decently well against the EUR the last days of the year. Here, 8 out of the last10 years have resulted in a lower EUR/NOK between Christmas and New Year. But, still SEK also looksfavourable to NOK from this perspective until we update you again in a weeks’ time.

e-markets.nordea.com/article/42005/fx-weekly-the-r-star-of-bethlehem

Chart 8: EUR/NOK has dropped 8 out of the last 10 years between now and New Year

While we can still explain the current NIBOR fixings from a mix NOK and USD liquidity, we expect the USDleg to be the most interesting in 2018, as NOK liquidity will usually normalize already early January. If thereare more prolonged eects to be expected in the USD basis (outside of this yearly December noise we haveexperienced), then there is also upside risks to NIBOR in 2018. We will be back with more on this topic inthe coming weeks and months.

For now, we (Martin and Andreas) wish you and your family a merry Christmas and happy Scandi FX huntingbetween Christmas and New Year :)

e-markets.nordea.com/article/42005/fx-weekly-the-r-star-of-bethlehem

Chart 9: USD liquidity and NOK fixings could be a story for 2018 also?

Previous FX weeklies:

·FX weekly: A numbers game (17 Dec)

·FX weekly: The year-end liquidty shrink (10 Dec)

·FX weekly: Three reasons why EUR/USD isn't trading lower (03 Dec)

·FX weekly: Which currencies to sell if the housing downturn continues? (26 Nov)

·FX weekly:  The global industrial cycle is set to weaken (19 Nov)

·FX weekly: Is high-yield a canary in the global coal mine? (12 Nov)

·FX weekly: Is this the end of the inflation convergence trade in EUR/USD? (5 Nov)

·FX weekly: Was that it for the EUR bulls? (29 Oct)

·FX weekly: Hawks in opposition, doves in charge (22 Oct)

· FX weekly:Continued convergence or re-divergence?(15 Oct)

·FX weekly: Thingsdon't matter until they do(08 Oct)

·FX weekly:"October seasonality is strong" (01 Oct)

e-markets.nordea.com/article/42005/fx-weekly-the-r-star-of-bethlehem

·FX weekly:“Is 1.20 the new 1.15?”(24 Sep)

· FX weekly:Honey, I shrunk the balance sheet(17 Sep)

· FX weekly: “USD liquidity will turn scarcer, but when?” (10 Sep)

· FX weekly:“Strong currencies and inflation”(3 Sep)

· FX weekly:“USD in the (Jackson) hole” (27 Aug)

· FX weekly:“Q4 is the USD quarter”(20 Aug)

· FX weekly:“In the year 2525”(13 Aug)

· FX weekly:“EUR/USD ceiling or debt ceiling?”(6 Aug)

· FX weekly:“Elevator up, stairs down “(30 Jul)

· FX weekly:Trump “spices” up EUR/USD(23 Jul)

· FX weekly:Flip-flop?(16 Jul)

· FX weekly:Consolidation time?(9 Jul)

· FX weekly:Hawks R Us(2 Jul)

· FX weekly:Another lowflation week?(25 Jun)

· FX weekly:No Fed put?(18 Jun)

· FX weekly:A bouncy dollar?(11 Jun)

· FX weekly:Heating up(4 Jun)

· FX weekly:Summertime sadness(28 May)

· FX weekly:Special counsel lessens Trumpbulence, while OPEC looms(21 May)

· FX weekly:Are China worries old hat?(14 May)

· FX weekly:Inflation week…(7 May)

Martin EnlundChief AnalystMartin.Enlund@nordea.com

Andreas Steno LarsenGlobal FX/FI Strategistandreas.steno.larsen@nordea.com+45 55 46 72 29

28.9.2017

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