Macro Strategy: Keeping the faith in the USD; UST 10Y yield above 3%

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September 21, 2018 News No Comments

Philip Wee, FX Strategist
Duncan Tan, Strategist
DBS Group Research

FX: Keeping faith in the USD

The market is assessing how much lower the USD Index (DXY), which has traded below its 100-day moving average this week, can correct in the near term. This would help to clear out the weak long USD positions and provide USD bulls a better level around 92-94 to push the DXY into a higher 95-100 range in 4Q18. We believe that USD bears are underestimating the risks from China-US trade tensions, and overly optimistic on Brexit and Italy.

There have not been any significant changes in the medium-term fundamentals that favour the US over its peers. This week, major US stock indices hit new record highs while the US 10Y bond yield rose above 3%. The ground is set for the Fed Funds Rate to increase a third time this year by 25 bps to 2.25% at next week’s FOMC meeting on September 26. The Fed is likely to reaffirm the stance to gradually increase rates, not only in 4Q18 but also into 2019. Against this background, USD bears looking for a pause in the Fed hike cycle are likely to be disappointed.

Washington and Beijing have and will continue to agree to disagree on trade. US President Donald Trump’s tariffs on another USD200bn (vs USD50bn in July-August) of Chinese goods entering the US from September 24 did not trigger another sell-off in the Chinese yuan. This was attributed to Chinese Premier Li Keqiang’s pledge not to weaken the exchange rate to boost exports. That said, there was no rush to buy back the yuan. China’s policy responses to cushion the economy from increased trade tensions would not stop growth from slowing and its current account and fiscal balances from weakening. More so if Trump follows through with his threat to impose tariffs on the rest of Chinese goods into the US, possibly ahead of the US mid-term elections scheduled for November 6. USD/CNY is more likely to consolidate in a 6.80-7.00 range than to reverse trend.

On Brexit, British PM Theresa May appears to be able to achieve a deal with UK lawmakers or Brussels, not both. Ever since her gamble at the 2017 elections backfired, PM May has been fending off leadership challenges from her Conservative party (Tories). Lately, the opposition Labour Party believes that it can win the next election by backing a second referendum on Brexit. The Irish border remains a contentious issue in negotiations with the EU. Why else would UK and EU push the deadline to agree on a Brexit deal out to the Salzburg Summit in mid-November. In summary, all sides are still muddling through Brexit, which has moved the debate from “Hard or Soft Brexit” to “Deal or No Deal Brexit” towards what is increasingly looking to be a “Blind Brexit”. Hence, the British pound’s latest recovery is more likely a USD correction story than one pointing towards a favourable Brexit outcome. We still see GBP/USD eventually moving lower into a 1.25-1.30 range this year.

In a same vein, Rome and Brussels are on a collision course over Italy’s fiscal plans. The newly-elected Italian government wants to widen the fiscal deficit to 2-2.5% of GDP to fulfil its growth pledge to voters. On other hand, EU is not letting up in ensuring that Italy keeps the gap below 2% to improve or keep its structural deficit stable. Meeting EU’s demands would undermine the unity between the far-right and anti-establishment parties within the coalition and open the prospect of fresh elections next year. Hence, we don’t share the euro bull’s optimism on Italy. We see the upside for EUR/USD capped at 1.18 (or 1.20 at most) before reality drives it down to 1.10-1.15 in 4Q18.

Rates: UST 10Y breached 3% despite tariff escalation

Despite a significant escalation in US-China trade tensions this week, global rates markets seemed rather sanguine with little evidence of flight-to-safety flows. Post the Trump administration’s announcement of new tariffs on USD200bn of Chinese goods (to take effect Sep 24th), UST yields tick higher in a steepening fashion. We think markets were prepared for an immediate 25% tariff rate and thus were somewhat relieved to get 10%. Notably, the UST 10Y yield broke past 3%, closing at 3.06% yesterday.

Attention will now turn to likelihood of further escalations. In the following days, US President Trump could initiate the next round of tariff action (remaining USD267bn) which would then cover almost all of China’s exports to the US. If the above sequence of events play out, we could see markets swing into risk-off mode and UST yields pull back. We also prefer to fade this week’s re-steepening of the UST curve (2Y/10Y: 6bps, 5Y/30Y: 3bps). The drivers for long-term flattening trend are still intact, in our view.

The reaction of Asian rates has been rather muted despite the region’s exposure to China. Chinese Premier Li Keqiang’s comments on Wednesday where he ruled out active devaluation of the yuan (key risk event for Asian markets) likely helped to cushion the impact. We are also beginning to see some signs of stabilization within the Asian rates complex. Indeed, the increase in Asian rates this month has been chiefly driven by higher US rates and not outflows or EM contagion. Even in the more vulnerable markets of Indonesia and Philippines, key funding rates and sovereign bond yields are coming off elevated levels.

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