Risk head-fake
On the surface, risk is building, yet underneath, volatility continues to compress. The VIX volatility index at 12.33 is at levels not seen since January. Financial markets are less concerned about geopolitical hype and more focused on fundamentals. Economic slowdown in Asia and Europe is not alarming, while central banks’ normalisations remains gradual. Equity valuations outside the US are at manageable levels. While protectionism remains a risk, Asia’s internal trade keep the region supported. Growth in the developing East Asia and Pacific regional is expected to reach 6.4% in 2018; China is outpacing estimates, tracking toward 6.9%.
We are bearish USD (bullish INR, THB and IDR), yet uncertain how the massive debt sale will affect emerging markets’ capital outflows. This week a US rate hike of 0.25% is universally expected. There is risk of four rate hikes in 2018, up from currently expected three. Four hikes would give the USD a minor, short-lived boost.
Trump-Kim dollar push didn’t last long
The US dollar started the days off to wheel as investors cheered the successful conclusion of the Trump-Kim summit. During the Asian session, the dollar index bounced to 93.89 as the single currency fell as low as 1.1741, USD/JPY rose to 110.49 and USD/CHF hit 0.9884. The two leaders signed an agreement that Donald Trump qualified as “comprehensive” and “important”, which suggests it could be a game changer. Nevertheless, the agreement is so “comprehensive” that it doesn’t tell much about what North Korea will actually do regarding denuclearization, neither what would be the reward from the US. In our opinion, the statement is too vague to draw any solid conclusion. Yes, it shows good will; unfortunately, both leaders have a spotty record in keeping promises. Therefore, there is little doubt it won’t be an easy ride.
It didn’t take long for investors to figure that out. During the European morning, the buck reversed early gains. EUR/USD bounced back above 1.18, USD/CHF eased to 0.9840 and USD/JPY retuned to 110.30. Even though we agree this is an historical step, for both countries, we believe this is just the beginning of a long and bumpy road.
Market participants will quickly but these geopolitical developments on the backburner ahead of the FOMC and ECB meetings. The main even of the day will be the publication of the US inflation report for May. The headline gauge is expected to rise 2.8%y/y, compared to 2.5% in April, while the core measure should print at 2.2%y/y (2.1% in the previous month). Above forecast reads could awake bulls at the Fed and lead them to push for a fourth rate hike this year. Therefore, the risk is mostly on the upside for the dollar today.
