Another Broken Market: “FX Trading Has Been Reduced To A Leap Of Faith In The Fed Put” Tyler Durden Thu, 06/11/2020 – 14:24
With a growing chorus of established traders and strategists echoing what we have been saying for the past decade about the Fed’s catastrophic impact on capital markets, overnight BofA’s FX strategists led by Ben Randol have taken aim at yet another market which, until recently at least, appeared somewhat immune to the tinkering of central banks: currency trading.
As the bank’s FX traders posit, “traditional fundamentals have not mattered” as “FX trading has been reduced to a leap of faith in the Fed “put,” as evidenced by SPX being the only significant factor on average across the top G5 currency pairs in our multivariate framework for the last 10 weeks.” In short moves in equities – which are a function of central bank intervention in fixed income – now determine moves in FX.
Yet unlike some suggestions, such as that from Jim Bianco, that the Fed will never again be able to ease back off the accelerator, BofA has a somewhat optimistic conclusion, writing that “eventually, equity factor dominance will fade, and FX will once again reflect macro fundamentals.” Or so one hopes. That said, the bank’s traders writes that they have “serious doubts about the sustainability of the recent USD decline absent clarity on the longer-term pattern of recovery across the global economy, and particularly given the surge higher in relative US growth in recent quarters.” They argue that “even if the US growth advantage plummets to zero (from nearly 3% in 1Q), rate differentials are not justified below current levels. In fact, lags in relative growth suggest that US rates should rise on a relative basis. Alternatively put, US growth has to meaningfully underperform in the quarters ahead to justify lower relative rates and a weaker USD. Whatever the outcome, the pattern of global recovery from COVID-19 needs to be watched carefully as it will undoubtedly influence FX and the broader USD. Until then, however, the equity grip on FX could last a bit longer.”
In short, if anyone wants to trade stocks without actually trading central-bank manipulated stocks, the FX market is a welcome alternative.
The full BofA note is below.
FX market upended by liquidity-fueled equity rally
Getting FX right since late March-i.e., short USD broadly and long higher beta FX-has required buying into the strong US equity market rally. This has been made all the more challenging by the anticipatory nature of the market response in 2020 vs 2008-09, during which delivery on a massive monetary stimulus, not simply announcement, was required to stabilize markets.
As our factor analysis shows, traditional fundamentals have not mattered. FX trading has been reduced to a leap of faith in the Fed “put,” as evidenced by SPX being the only significant factor on average across the top G5 currency pairs in our multivariate framework for the last 10 weeks. This is unprecedented and antithetical to the way FX markets are supposed to work, as macro factors related to relative cycle and terms of trade have simply not been relevant. We do see the equity grip on FX eventually loosening as conditions normalize. Initial evidence suggests this may be starting to happen. This will make the pattern of recovery across the global economy critical for FX and the broad USD directionally. Absent significant US cyclical underperformance (not our baseline), we find it hard to rationalize a bearish long-term USD outlook and expect a medium-term rebound ahead.
A deluge of liquidity (again), but this time is different
COVID-19 prompted a Fed monetary policy response of historic proportions, but the risk asset response in comparison to 2008-09 has been strikingly different. Whereas in 2008-09 it took a 2.5x balance sheet expansion to finally stabilize the equity market after six months, the market began rocketing higher in 2020 merely on the announcement effect of stepped-up asset purchases (Chart of the day). Thus far, driven by a 1.75x rise in Fed assets, SPX has rallied by about 40% over the last 10 weeks, a somewhat faster rebound compared to early 2009, as well as more “efficient” one in the sense that it was achieved by proportionately less asset expansion in percentage terms. Global central banks are involved also. Our projections suggest the aggregate global central bank balance sheet will ultimately expand by 50% (+$ 7tn) in YoY terms (Chart 1). The world finds itself awash in liquidity – again.
Clearly, there are contextual factors to consider. First, in dollar terms the Fed’s expansion has been larger at $ 3tn and counting vs about +$ 1.3tn in the initial 2009 run-up. After all, levels do matter in addition to rates of change. Second, this time around US fiscal expansion has been highly aggressive at mid-double digits as measured in percent of GDP. And third, whereas the financial system was under existential threat in 2008, so far we have not seen this type of shock materialize, probably a self-reinforcing result of the Fed’s preemptive actions to stabilize markets. To be clear, we are not saying that the directional response of risk assets is ultimately wrong this time. But its anticipatory nature unambiguously suggests belief in a Fed “put” is operative. Indeed, balance sheet-based econometric models would have been bearish risk over the last couple of months, not bullish. Essentially, this is because in 2008-09 as Fed assets expanded risk assets fell (a negative correlation). In this way, the present reaction is akin to a leap of faith, made all the more striking by substantial downside economic and potential solvency risks lurking amid the worst global recession in modern history this year.
The point of all this is not to debate the equity market’s highly bullish verdict to date (we are skeptical), but rather describe in objective, quantifiable terms the profound effect that US equity market buoyancy-itself a reflection of generous liquidity provision-has had on the FX market. This “beach ball under water” effect has been truly seismic and disruptive to FX, as we aim to show. Although broader global sentiment shifts likely play a role, our analysis suggests US equity performance, specifically, has emerged as a critical driver of recent US dollar weakness and higher beta FX outperformance (Chart 2). While some FX risk premium compression is the inevitable by-product of aggressive policy response, recent FX market dynamics suggest that this time has been different, and moreover very challenging to call.
The great FX factor rotation
Our rolling multivariate factor analysis of USD-based FX pairs suggests a clearly visible rotation of explanatory factors occurring around the onset of financial market turbulence and subsequent policy response (Chart 3). Into February, a traditional paradigm prevailed under which 2y spot interest rate differentials were the dominant factor. Notably that month, terms of trade began to assert particularly late in the month as commodity (emphasis: energy) price weakness in response to spreading COVID-19 led to FX depreciation in cyclically sensitive pairs, particularly USD/CAD, AUD/USD and USD/NOK. From 20 February through mid-March, terms of trade supplanted spot interest rates as the sole statistically significant factor, as accelerating commodity price weakness spurred an ever-higher rate of adjustment among commodity-oriented FX. The broader USD rallied on perceived “safe haven” status as FX risk premium rose, effecting higher beta FX as well as EUR/USD and USD/JPY, which had initially adjusted on carry unwinds.
And then there was SPX
Beginning 20 March, the week of the Fed “bazooka,” the SPX factor took over as the sole statistically significant explanatory factor in our FX framework. Aside from brief resurgences in spot interest rates and economic data surprises (the latter likely reflective of a market briefly focused on the pattern of G10 growth profiles under COVID-19 influence), it has remained so ever since. Make no mistake, SPX is a consistent factor presence, being statistically significant on average about 45% of the time over the last 15 years, a distant second to spot rate differentials (significant on average about 80% of the time). This makes sense as US equities are correlated to global risk appetite, which tends to influence FX risk premium. However, two things stand out about the current factor configuration that are worth emphasizing.
First, with a beta of 0.20 on average since end-March (z-score of about 1), FX sensitivity to SPX has been notably elevated. This means that on average a 10% move higher in SPX is associated with a -2% move lower in spot USD on the pairs. For some pairs, SPX sensitivity has been more muted; for others, stronger (Chart 4). EUR initially benefitted from the first leg of the equity rally with a beta of about 0.10, as was the case more broadly vs USD. The beta then flipped negative from late April through late May, likely reflecting Euro Area policy coordination issues, before once again rising back to 0.10 as of early June. Consistent with historical pattern, JPY has consistently traded with a negative SPX beta in the -0.10 to -0.20 range since the equity rally began, but this influence has fallen off over the last week. GBP has consistently exhibited a positive beta around the 0.20 average, though it spiked higher (over 0.40) into April as the sterling selloff reversed sharply higher. CAD began the year with a high SPX beta of about 0.30, which compressed and fell out of significance during the risk meltdown as the terms-of-trade shock became the sole driver of adjustment. It has since risen back to 0.15. For AUD, sensitivity to SPX has been remarkably high and a standout story in G10 FX. Its SPX beta has steadily risen from 0.30 in the initial stages of the market rally to nearly 0.60 at present, meaning that a 10% rise in SPX has mapped to about a 6% rise in AUD/USD on average, about the 90th percentile historically.
Second and more importantly, SPX dominance as sole explanatory factor on average for the last 10 weeks in our multivariate framework is simply unprecedented. A review of history confirms this. Recently, the period late 2018 through early 2019 was no doubt an equity-influenced FX market (traditional fundamental factors remained statistically significant as well), but not an equity-driven one. One has to go back to the first half of August 2014 to find the last instance of sole equity factor dominance, and this lasted for a mere two weeks. Prior to that, we find September 2009, which is probably the closest macro analog in terms of crisis followed by policy response. We should point out, however, that by that point in the 2009 equity market rally US growth had rebounded into positive territory, in stark contrast to now (we are at the depths of contraction). The point being, there has never been a prior instance of the FX market being as a blatant a reflection of the US equity market for this length of time in the last 15 years, according to our analysis.
So what happens now?
Eventually, equity factor dominance will fade, and FX will once again reflect macro fundamentals. Our analysis suggests this could be starting to happen. Interest rate differential beta coefficients are beginning to rise toward more “normal” levels for some pairs, approaching thresholds of statistical significance (Chart 5). These include GBP/USD, USD/CAD and AUD/USD (for EUR/USD the coefficient is actually negative at present). To the extent that relative interest rates and the dollar reflect the broader relative growth cycle, this is a positive sign that fundamentals will start to matter for FX again. Related, we have serious doubts about the sustainability of the recent USD decline absent clarity on the longer-term pattern of recovery across the global economy, and particularly given the surge higher in relative US growth in recent quarters (Chart 6). Even if the US growth advantage plummets to zero (from nearly 3% in 1Q), rate differentials are not justified below current levels. In fact, lags in relative growth suggest that US rates should rise on a relative basis. Alternatively put, US growth has to meaningfully underperform in the quarters ahead to justify lower relative rates and a weaker USD. Whatever the outcome, the pattern of global recovery from COVID-19 needs to be watched carefully as it will undoubtedly influence FX and the broader USD. Until then, however, the equity grip on FX could last a bit longer.