DB FX Daily: Pause in Carry Drawdown Allows Brief Focus on Cyclical Factors

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FX Daily: Pause in Carry Drawdown Allows Brief Focus on Cyclical Factors

Pause in Carry Drawdown Allows Brief Focus on Cyclical Factors

The short-term consolidation in the carry drawdown combined with the approaching ECB decision and US payrolls data may allow the FX market to focus on cyclical factors and rate differentials over the coming days. The correction in many financial markets over the past week has seen a substantial shift in market pricing of short-term rates over the coming year as a flight to quality and the perception of building downside risks to central bank forecasts (either from financial markets or soft data in the case of the US) has led to a sharp rally in short-term rate futures.

The chart at left below tracks the difference between the 1st and 5th Euribor and Eurodollar contracts and shows the market largely taking out the probability of rate hikes beyond a forecasted 25 bp rate increase from the ECB this week and also pricing more than 50 bps of easing from the Fed in addition to fully pricing a 25 bp rate cut by the August FOMC meeting. The market has consistently leaned towards higher rates in the Eurozone in 2007, and the market may well return to pricing a higher probability of rate hikes beyond tomorrow. Our economists continue to forecast 3.75% as the likely peak in this cycle and the scope for pushing significantly higher is somewhat limited as indicated by the now flat yield curve in the Eurozone. On the US side, rates have moved more aggressively than in the Eurozone seeing spreads tighten on the back of some weaker data as well as the perception of building financial risks. But the amount of easing priced in is now close to what was observed in late 2006 and may be vulnerable to a correction should US labour market data top expectations which have recently been creeping lower. The latest release of the DB Macro Pulse Index (MPI) shows a high level of positive data surprises out of Europe and negative surprises out of the US taking the spread between these two series to the highest level since Q4 2005. While this may support the current shift in spreads in favour of EUR and against the USD, it also presents the risk of mean reversion given the current high reading. The alternative scenario of a very weak payrolls could potentially push the market to price more cuts and weigh on the USD but the greater risk for FX markets could be if a weak reading were to weigh on stocks and help spark another leg of the drawdown in FX carry trades and the rally in JPY.