Ahead of the US presidential election, a Democratic ‘blue wave’ was judged by the market as the most reflationary scenario. That wave has come to shore, and we know that the rolling out COVID-19 vaccine turbo-charges the reflation trades.
This Economic textbook 101 reflationary narrative poses two risks, which question the short US dollar consensus for 2021.
Higher observed US CPI inflation on base effects should materialize by March, driving US inflation break evens higher still.
However, in typical FX trader fashion, it will grow increasingly possible that the G-10 reversion desks will test the Fed’s commitment to allow inflation to run hot if they even sniff a significant bump in inflation from March as we advance. FX traders tend to price this stuff forward by 4-8 weeks, so we are entering that testy window.
In turn, that could pressure high-yielding Emerging market currencies and even mid-level yielders as its the Fed’s capping inflation commitment mantra that is key and will be watched closely for long equity and short USD positions.
Meanwhile, a faster vaccine rollout in the US than the Eurozone could limit further upside in EURUSD.
If the market decides that the Fed might taper in late 2021, the narrative will change dramatically and the idea that the denominator for discounting all assets to 0 might shift a bit.
On the other hand, this could be another case of too many cooks in the US Fed’s kitchen, and Clarida will set things straight. Either way, the importance of Clarida’s speech today has gone from a 1 to 10.
The possible Fed change in language naturally unnerves dollar shorts, but it’s not 100% clear this is a real thing yet.
Also, real yields have barely moved, which is more important for FX than nominals in the current regime. The strong US growth that leads to early tapering is a confusing one for FX. Let’s see what the Vice-Chair says before jumping the gun on this one.
But rest assured if the Fed pivots, there will be an initial taper tantrum knocking risk assets down more than a peg or two before mounting another recovery.
And while the US dollar halcyon days are not about to return anytime soon, the US economy will recover quicker than Europe, particularly as Joe Biden aggressively pushes vaccination efforts, so dollar losses are capped.
But let’s see what the Fed’s Vice-Chair says before jumping the gun on this one.
The second risk relates to how much fiscal stimulus a Democratic-controlled Senate with a razor-thin majority can realistically pass. The most optimistic take is that the very narrow effective Senate majority curbs tax hikes – both corporate and personal – leaving markets to focus on higher spending that would be consistent with a US Treasury curve bear steepening, an ongoing everything rallies, and the dollar weakens.
However, more limited fiscal spending driven by more conservative Democratic caucuses could slow the rise in inflation break evens, the rally in industrial metals, and value outperformance vs growth in stocks.
Gold on the defensive
The US dollar’s recent gains, higher yields, and the equities rally is keeping gold on the defensive.
The yellow metal lost more steam overnight; the mid-week bearish engulfing candle suggests lower prices, with $1900 the support. The bottom of the sell-off candle was above $1900, while the 100dma sits at $1893.
And I would be surprised to see paper gold margin increase to take a shot where gold could be sitting in the weak hand if the Fed’s taper talk increases.
Gold retail traders today continue to buy on dips, while big players continue with long liquidation.