With US markets largely closed for Columbus day and Canadian traders enjoying Thanksgiving, liquidity in USDCAD was thinner yesterday. The 0.4% rally in the currency pair was largely a by-product of the broader G10 move as opposed to any material development in the economic fundamentals. However, with US markets reopening today, and hawkish positioning for tomorrow’s US CPI release likely to take precedence for traders, further upside in the USDCAD pair is likely. This has already been witnessed overnight as the pair opens the European session 0.34% higher this morning.
With US fixed income markets closed for Columbus day yesterday, FX volatility was arguably lower than what it would have been if Treasuries were trading. Nonetheless, big moves in the dollar still occurred as the broad dollar DXY index climbed and closed above the 113 handle for the first time this month. While rising geopolitical pressures in Europe and a slowing Chinese services sector drove the move into the dollar on a haven basis, the greenback has continued to trade firmer this morning as US Treasuries play catch up to yesterday’s increase in yields. Positioning ahead of tomorrow’s key CPI release will be the aim of the game for FX traders today, as markets continue to look for 75bps in November despite more dovish commentary from Fed members Brainard and Evans yesterday; both of which voiced concerns regarding over-tightening. This is especially the case as the economic calendar contains just the NFIB measure of small business optimism while Fed member Mester is the only central banker on the agenda to speak.
The escalation in geopolitical tensions in eastern Europe kept European assets under immense pressure yesterday. However, for the euro, some of that pressure was alleviated by rumours that German Chancellor, Olaf Scholz, was becoming more sympathetic towards using common borrowing measures to cushion the economic blow across the entire trade bloc from the energy crisis. The news immediately narrowed the Italian BTP – German Bund spread, with the 10-year differential falling by 21 basis points, as the cheaper lending conditions applied to Italy via joint debt issuance reduced some of the risk premia in BTPs. With the 10-year spread falling back below the 250bps threshold, the ECB’s path for normalising policy will be less constrained by bond market fragmentation. The news therefore led to more rate hikes being factored in by money markets. Overnight index swaps now imply an interest rate close to 3% in the eurozone by June 2023. Despite the positive fiscal developments, optimism is still being capped by the escalation in geopolitical tensions. Markets will be paying close attention to the outcome of the G7 meeting with Ukrainian President Zelenskiy today for that reason, especially after the rhetoric from Moscow escalated yesterday. Thus far, markets already know the US is on board with supplying Ukraine with more munitions as President Biden announced such plans overnight.
The pound notched a middling performance against the broad US dollar yesterday. Not only was the 0.63% decline masked by the wider surge in the dollar against G10 peers, but it was also overshadowed by developments in the UK bond market: the 2 and the 10-year gilt yield spiked by 22bps, while in inflation-linked bond markets, the 20-year jumped by over 79bps. The focus on the bond market continued this morning, as the Bank of England announced that it was expanding its liquidity backstop (previously announced on September 29th following the budget) to incorporate not just longer-term UK bonds but also inflation-linked gilts. In addition to this, and outlining the breadth of the dysfunction in UK bond markets, the Bank also announced that it would cease any active sales in corporate bonds this week. The decision taken by the Bank of England suggests to us that they will be hard-pressed in trying to end their mini-QE programme this week, and will instead have to extend it to encompass the November meeting in order to keep bond markets trading in an orderly manner. This is especially the case if they opt to meet market expectations and hike in excess of 100bps. In our view, the current measure of an emergency repo market wouldn’t be aggressive enough to suppress the bond vigilantes and those institutional investors, such as pension funds, that are facing liquidity squeezes from margin pressures. Additionally, an indefinite suspension of their plans to actively start selling UK government debt as early as November is likely required to ease further concerns. The reactionary measures taken by the BoE today reek of desperation and will do little to shore up investor sentiment at the moment. In this environment, the pound is likely to return to underperforming the broader G10 space. Today, with bond market pressures remaining elevated, the 30-year inflation-linked bond auction by the government at 10:00 BST will be closely watched, along with comments by Deputy Governor Cunliffe and Governor Bailey at the IIF conference in Washington at 19:00 and 19:35 BST respectively.