Principles of fundamental analysis cannot be ignored forever

While investors are racking their brains, not knowing how to play out the factor of trade wars, analysts are tearing out their hair trying to figure out what is happening. Standard Bank is regularly adjusting forecasts due to the changing reality. Societe Generale honestly admits that it cannot understand why the Japanese yen is not strengthening, and Commerzbank stated that it was at a deadlock because of the success of the US dollar in the second quarter. On the market, it is said more and more often that politics and the economy are pulling the blanket, that the fundamental principles are being violated because of the impact of protectionism. Some, on the contrary, believe that investors are still ignoring the factor of the trade war, but all this can not continue for long.

Theoretically, the deterioration in global appetite for risk due to the increased likelihood of a global economic slowdown due to trade friction between the US and China should lead to sales of income assets, including currencies of developing countries. At the same time, the demand for safe haven assets as the yen, franc and gold should grow. In reality, the first part of the equation works, the second part does not. What's the matter? In my opinion, the clue should be sought in the volatility and in the monetary policy of the Fed.

Typically, the drop in the volatility of market quotes allows carry traders to sell funding currencies and buy risky assets. If investors ignore the factor of trade wars, then the appetite for risk is neutral, i.e. it does not interfere with the activity of players on the difference. Indeed, we see that volatility has fallen from the extreme levels that took place at the height of the political crisis in Italy, and has reached the very bottom since the beginning of the year. This makes it possible to explain the weakness of the Japanese yen's funding status.

Dynamics of volatility
 
Source: Bloomberg.

What is the reason for the success of the US dollar? Yes, there is such a trump card on its side as a divergence in monetary policy. However, at the stage of completion of the economic cycle this factor is usually not as significant as in its middle. In my opinion, the clue is the increase in the cost of borrowing in the United States. Rates for 2-year US bonds currently exceed the counterparts in all G10 currencies, the yield of 10-year Treasuries is second only to New Zealand bonds. Based on the indications of the debt market, greenback is almost the main risky currency of an elite club, so the interest of carry traders in it is quite understandable. What's next?

In my opinion, the drop in volatility cannot last indefinitely. Liquidity goes away from the market, as, first, the leading central banks of the world are turning off stimulus measures, and secondly, July-August is the traditional time of holidays. The growth of volatility of quotations will contribute to stabilization of the EUR/USD and USD/JPY in the ranges 1.15-1.2 and 109-114. I do not think that Donald Trump will step back from his plans to punish China, which will keep pressure on the closely connected Australian and New Zealand dollars.  

 

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Volatility will open Forex's eyes

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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