In our FX review this week, we chat through the high US inflation print and what this means for the upcoming Fed meeting, as well as what recession fears could mean for trade ideas.
Houston we have a problem
US inflation for June came in at 9.1%, beating expectations and also the prior reading for May. It matches the current rate of inflation in the UK, and highlights the problems that developed nations have. The knock on impact here is that the pressure is now on the US Fed at the next meeting on 27th July to hike by 100bps. To put this into perspective, only a month ago markets were pricing in 50bps worth of hikes. Following the 75bps move at the last meeting, expectations jumped to 75bps for the July meeting. Now after this week, it’s jumped to 100bps!
Even though this does feel a little reckless, it’s worth noting that the last time US inflation was this high, rates jumped to 20%. So even a 1% increase (taking the base rate up to 2.75%) pales into insignificance.
The move has helped to keep the USD strong, and some of our favoured trades over the past few weeks have been tactical long USD positions. However, this week we put on two short USD trades, one versus CAD and the other versus GBP.
We think that the May GDP figure for GBP was a bonus win, and that too much negativity is being priced in, making it ripe for a reversal back above 1.20 in the short term. USDCAD also has struggled around the 1.30/1.31 level and so could turn lower, aided by the fact that the BoC jumped the gun and raised interest rates by 1% earlier this week.
We aim to take profit on these positions before the next Fed meeting, and play it neutral until we see a reaction. If the committee make it clear that further hikes are coming to quell inflation, we struggle to see the USD from not marking on, regardless of it it looks overvalued. If investors can pick up 3-4% by year end from holding USD at a time when there are negative returns from bonds and stocks, why not?
Recession trade ideas
If high inflation pushes a cost of living crisis to a point of causing an economic downturn, what are the best FX plays?
Traditionally, both the CHF and JPY are the safe havens of choice. However, JPY has weakened over 20% year to date against USD, as the BoJ have artificially kept a lid on rising bond yields. With no increase in rates either, the Yen has performed terribly. Therefore, we would steer clear of it, even on recession fears.
Long CHF is therefore our favoured trade idea, especially with the SNB raising interest rates. We would short EUR or even a high beta currency such as AUD or NZD.