e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

23 September 2018

FX weekly: Twindeficit scare #2?

Martin Enlund | Andreas Steno Larsen

We judge that a return of the twin deficit story seems consistent with mostmoves over the past week, though it’s too early to tell if that’s where we’retruly heading in these fishy markets. Our portfolio is at a cross-road, we addlong NOK/SEK.

Table 1: Our current list of convictions

Fish markets? No, fishy markets!

The past week has seen some EM reflation, somewhat higher commodity prices, a break higher in theEUR/USD as well as higher US rates & yields. Drivers of these moves range from focus on Chinese stimulus(lower import taris and increased infrastructure spending), a hawkish repricing of the Fed, to divergingeconomic surprise indices within the G10. Comparing the latest economic surprise indices vs their readingstwo weeks ago yield a picture in which EUR, GBP and USD have fared somewhat worse while AUD, CAD,CHF, NZD and SEK have fared better.

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

Chart 1: G10 surprise indices now vs two weeks ago

Details in the New York Fed and Philadelphia Fed surveys suggest clear downside risks to the US ISMmanufacturing gauge in September, so maybe it does make sense that the USD has been weakening – as themarket is front-running imminent data weakness.

But if the dollar is weakening because of fading growth momentum, why then are cyclical equitiesperforming as if growth momentum is picking up? Philly & NY Fed suggests that cyclical equities shouldunderperform, while August’s outliery ISM manufacturing suggests cyclical equities should be picking up., asthey have been doing recently.

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

Chart 2: ISM tells us to buy cyclicals, Philly Fed & NY Fed to sell

It may be that the dollar has been weakening as the market is front-running (or repositioning) ahead of theSeptember FOMC rate decision, since e.g. only one dot is required to cut the 2018 and 2019 median rates.The Fed has however recently assessed that “financial vulnerabilities are building” with risks notable inthe corporate sector (this can’t be risk-positive news!). Fed-dove Brainard also argued recently that “rich levelof current asset valuations .. could push the short-run neutral rate above its longer-run value”. This rhetoric isconsistent with a hawkish shift from the Fed rather than a dovish one…

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

Chart 3: G10 surprise index has been rising, which is supportive of risk sentiment

One might also look at the recent US curve steepening as a growth-positive and hence as a risk-positive sign. The improvement in the average G10 surprise index has indeed been negative for bonds butpositive for equities, though the G10 surprise index turned higher already in June – so this can hardly explaineverything. Some of the most recent steepening may also reflect the passing of the September 15deadline for paying into underfunded pension schemes. Recent steepening may thus be attributable to aslacking of duration demand rather than growth optimism. If so it should be risk-negative.

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

Chart 4: US Treasuries oer lousy return when FX-hedged

But what if it was primarily the front-loading of pension demand ahead of the September 15 deadlinewhich scared away the twin deficit story early this year? At the beginning of this year, the marketexperienced a twin deficit scare and everybody was asking who is going to fund the growing US’ budget andcurrent account deficits? This twin deficit scare went away quickly once e.g. Japanese lifers and others startedbuying US Treasuries partly or fully unhedged in late February onwards. Front-loading of pension demandsurely also helped. If this was a material driver, then fading duration demand from local accounts could meanthe US will again have to increasingly rely on foreign purchases of USTs.

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

Chart 5: EUR/USD vs 10y spread, adjusted for FX hedging costs

But why should foreigners buy USTs unhedged if the dollar isn’t that cheap anymore, and rates aren’t highenough to compensate against FX hedging costs, and especially if the rest of the world is doing a bit better(lessening the haven demand)? They clearly shouldn’t.

In such a scenario, the US curve would steepen, the dollar weaken, or both, so as to oer better returns. And ifthe dollar weakens, then it’s usually reflationary for the whole wide world and emerging markets. It’s good forcyclicals too…

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

Chart 6: EUR/USD ripe for a bounce according to 2004-2005 ACA/HIA pattern

Late last year Trump’s tax plan triggered expectations of repatriation of capital. This was however soonforgotten as EUR/USD surged over the next two months (during the twin deficit scare). This incidentallymirrored the move after a somewhat similar tax plan being signed by Bush Jr in 2004. EUR/USD hasalso been picking up recently, just as it did at a similar juncture in 2004-2005. In 2004-2005 the pair rosefrom 1.19 to 1.2550 before falling back again, a similar move o the lows in mid-August suggests levelsapproaching 1.20 later this year.

By now we have asked many questions but provided few answers. And that’s because we’re not that certainwhat to make of recent market moves. We judge that a return of the twin deficit story seems consistent withmost moves over the past week, though it’s too early to tell if that’s where we’re truly heading.

Scandis: No Norges Bank support for a short EUR/NOK position, but go longNOK/SEK

Norges Bank didn’t deliver hawkishly on Thursday. Rather the rate path was brought down. Theymanaged to revise up the inflation forecast for 2018, 2019 and 2020, despite prices and wages pulling downin the new the rate path. How does that, eh-em, make any sense at all? Only a central bank that intentionallywants to be perceived dovishly can come up with such a nonsensible cocktail. The only thing that saved theNOK from a bloodbath was the mere fact that the market didn’t buy into the old June rate path from Norge’sBank on forehand. Otherwise NOK would have got hammered even more than what was the case. We decideto take profit on our short EUR/NOK (we have been short from almost 9.80) and opt for an intra-Scandi betinstead (long NOK/SEK).

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

In regards to EUR/NOK, we don’t see big drivers of volatility until year-end (at least not Norwegian domesticdrivers). I) The structural NOK liquidity outlook looks rather stable from here and until year-end (this willchange again Q1 next year). If anything the liquidity story tells you to be long NOK in November and short inDecember (more on that when time approaches) and II) Norges Banks next conventional policy move is stilltoo far o to really matter for the NOK for now (NOK: What now?)

Chart 7: Changes in structural NOK liquidity relatively stable for the rest of the yearcompared to earlier in 2018

And while we don’t have a strong short-term conviction for lower EUR/Scandis, we think it makes increasingsense to re-bet on higher NOK/SEK, after the recent central bank action from the Riksbank and Norges Bank.

We see several reasons why NOK/SEK is a decent long from current levels, i) The Riksbank now has a moreaggressive rate cycle planned in the rate path than Norges Bank. Who wants to bet that Stefan Ingves willout-hike Øystein Olsen? We certainly won’t. ii) Relative PMIs should continue to support a higher NOK/SEK. While PMIs in Sweden and Norway are volatile (and unreliable on a monthly basis), we tend to thinkthat the bigger trends in these PMIs matter. If the Norwegian manufacturing PMI just stays at 55 (that lastreading was above 60), while the Swedish Manufacturing PMI is unchanged at 52.5 (we see downside risksto that view), then the average PMI reading should support at re-break of 1.10 on the topside in NOK/SEK(see chart 8).

The bottom-line is that we enter long NOK/SEK, as we also like the technical picture in a long NOK/SEKposition from levels just above 1.0750.

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

A continued broad-based USD sell-o (in line with a twin deficit scare part 2) could prove to bepositive news for NOK and SEK versus EUR, as we judge that the pension funds sector in Scandinavia ingeneral is slightly “underhedged” on foreign assets due to the weak Scandi currencies (and strong USD). Aweaker USD may thus prompt an increase in USD/SEK hedge activity (escalating the downside pressure).

Chart 8: Relative PMIs could lead NOK/SEK above 1.10 again.

DKK: Pensions funds are pushing up EUR/DKK.. A general Scandinaviantendency?

At least in Denmark it is relatively easy to show that local pension funds have pushed up theexchange rate in EUR versus the local Krone terms. It is a badly-kept secret that the geographical assetallocation of the Danish pensions sector has a significant impact on the EUR/DKK rate. Especially the relativeallocation between the Euro area and the USA (and the rest of the world) is aecting EUR/DKK as a naturalconsequence of the Danish fixed exchange rate regime (Pension funds have pushed up EUR/DKK – andmore is on the cards). That is because Danish pension funds generally adopt a very dierent approach whenhedging their EUR and USD assets. According to an analysis by the Danish central bank, the average hedgeratio of the Danish pensions sector for EUR assets is around 20% and for USD assets close to 80%.

Since mid-2017 the asset allocation of the pensions sector has been shifted towards more EUR assets relativeto USD equivalents (primarily on the fixed income side). As purchases of EUR assets to a larger extent aremade “naked” without subsequent currency hedging, a higher allocation to EUR assets will triggernet EUR purchases and net DKK sales (see chart 9).

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

While these conclusions are obviously not transferable to Sweden or Norway (e.g. due to the lack of a fixedexchange rate regime in Sweden/Norway), we suspect that also EUR/NOK and EUR/SEK have beenpushed higher by pension fund hedging behaviour (or rather the lack of).

Chart 9: Relative more US assets on the books in Danish pension funds -> lower EUR/DKK

JPY: The negative USD/JPY vs. DXY correlation

One of the very few currencies that has suered versus the USD is the JPY. As the DXY index hasdropped, USD/JPY has risen. The current negative USD/JPY vs. DXY correlation from August and onwards isusually a short-lived phenomenon. So don’t expect it to persist for long. Only in 2001 and 2013, have we seena running 252 trading days with more days of negative USDJPY vs. DXY correlation than positive. So a longerperiod of negative correlation is VERY unusual (see chart 10)

Usually these periods are driven by a substantial drop in treasury volatility (chart 10), as low volatility in USbonds allow USD/JPY to strengthen despite a weaker USD - Exactly what we see now. TYVIX, the volatilityindex for Treasuries is trading at an all-time low – allowing USD/JPY to rise, despite a weaker USD broadly.The issue is that as TYVIX is already all-time-low, it is hard to see how Treasury volatility should move muchlower from here (especially if we are on the verge of a twin deficit scare part 2). This also limits the scopefor a prolonged period of negative DXY vs. USD/JPY correlation.

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

Chart 10: Sustained periods of negative USD/JPY vs. DXY correlation are rare

Portfolio update: AUD/CAD, NZD/JPY, AUD/USD & EUR/GBP

We have taken a negative mark to market on our short AUD/CAD, AUD/USD and (in particular) NZD/JPY positions. All three bets are in one way or the other performing, when the market is in a late-cyclicalmarket mind-set. The recent re-ignition of risk-on and a broad USD sell-o have worked against this.

This leaves all of the three abovementioned shorts at important crossroads technically. We don’t like tobe short if, i) 0.74 is broken on the topside in AUD/USD, ii) 76 is broken in NZD/JPY & iii) 0.9450 is broken inAUD/CAD.

We stay short and await further signals from the potentially developing twin deficit scare. Prolonged Chinawoes, a late-cyclical market mind-set and a flatter USD-curve are prerequisites for the trades to perform. Let’ssee. (Our Canary of the week chart at the bottom indicates further China woes).

Even though Theresa May did a lot of damage to our short EUR/GBP view with her “impasse-remarks”on Friday, we are still in the money. While it is obviously hard to predict the outcome of the EU/UK Brexitnegotiations (you could just as well take a spin on the roulette), we still like GBP for other reasons.

Last week’s inflation data proved our point that the drop in inflation is now fairly priced (or even toobearishly priced) in UK, which means that BoE should be “on our side” in a bet on a stronger GBP, as theywill continue to have very low tolerance for a weaker GBP. Secondly, the positive retail sales data on Thursdayconfirmed that short-term fears of further housing market downside in UK will alleviate shortly (see chart 11).

We stay short EUR/GBP (and would stop/loss around 0.9070).

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

Chart 11: Theresa May doesn’t help the GBP, but key figures do.

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

Canary of the week: Are China woes really over??

Previous FX weeklies:

·FX weekly:  The Pope of Nope has spoken! (16 Sep)

·FX weekly: Who wants to impeach a +60 ISM president? (09 Sep)

·FX weekly: It is time to go long Scandis again (02 Sep)

·FX weekly: The Conte-Trump alliance (26 Aug)

·FX weekly: Fat-burning shorts (19 Aug)

·FX weekly: Time to call in Steven Seagal(12 Aug)

·FX weekly: Is the cyclical momentum over-priced? (05 Aug)

·FX weekly: How to trade a cease-fire? (29 Jul)

·FX weekly: What's that curve? (22 Jul)

·FX weekly: The China Factor (15 Jul)

·FX weekly: Take a short trade war breather (08 Jul)

·FX weekly: Trump will never #238 (01 Jul)

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

·FX weekly: The USD is the best carry currency in the world (24 Jun)

·FX weekly: Dollar to provide headwinds for earning estimates (17 Jun)

·FX weekly: Fire and fury risks for the USD (10 Jun)

·FX weekly:  It's not only Italy.. (03 Jun)

·FX weekly:  The Sumo SOMA days (27 May)

·FX weekly: EM won't be sprinting, if the Fed is unprinting (20 May)

·FX weekly: The two final nails in the dovish FOMC-con (13 May)

·FX weekly: Is there anything left in the USD bull-run? (06 May)

·FX weekly: Dragon Energy (29 Apr)

·FX weekly: Relative curvature is the new king of FX (22 Apr)

·FX weekly: Why is EUR/USD not trading lower? (15 Apr)

·FX weekly: Like watching paint dry, they said (08 Apr)

·FX weekly: The list of potential USD-positives is getting longer (01 Apr)

·FX weekly: 2 reasons why EUR/USD has decoupled from rates spreads (25 Mar)

·FX weekly: Time to buy a USD lottery ticket? (18 Mar)

·FX weekly: Taxation mirror on the wall, who is the fairest of them all? (11 Mar)

·FX weekly: Trump's game of chicken (04 Mar)

·FX weekly: Will the market neglect the clutch of canaries? (25 Feb)

·FX weekly: Is the correlation break-down driven by FX hedges? (18 Feb)

·FX weekly: The liquidity tide is ebbing (11 Feb)

·FX weekly: Hawkish spectacles (04 Feb)

·FX weekly: Who will stop EUR/USD from moving higher? (28 Jan)

·FX weekly: Did the Democrats dent the Dollar? (21 Jan)

·FX weekly: Is 1.25 the new 1.20? (14 Jan)

·FX weekly: The euphoria rises (07 Jan)

·FX weekly: Paging Dr. Pangloss (01 Jan)

·FX weekly: The R-star of Bethlehem (24 Dec)

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

·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)

·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)

e-markets.nordea.com/article/46095/fx-weekly-twin-deficit-scare-2

· 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

1

Nordea Bank AB Hamngatan 10 SE-105 71 Stockholm

www.nordea.com

DISCLAIMER Nordea Markets is the commercial name for Nordea’s international capital markets operation. The information provided herein is intended for background information only and for the sole use of the intended recipient. The views and other information provided herein are the current views of Nordea Markets as of the date of this document and are subject to change without notice. This notice is not an exhaustive description of the described product or the risks related to it, and it should not be relied on as such, nor is it a substitute for the judgement of the recipient. The information provided herein is not intended to constitute and does not constitute investment advice nor is the information intended as an offer or solicitation for the purchase or sale of any financial instrument. The information contained herein has no regard to the specific investment objectives, the financial situation or particular needs of any particular recipient. Relevant and specific professional advice should always be obtained before making any investment or credit decision. It is important to note that past performance is not indicative of future results. Nordea Markets is not and does not purport to be an adviser as to legal, taxation, accounting or regulatory matters in any jurisdiction. This document may not be reproduced, distributed or published for any purpose without the prior written consent from Nordea Markets.