G10 FX Weekly: December Dollar Downside? Patience the Modus Operandi for Short GBP

Summary

• We expect USD downside in December, mostly in the last two weeks. However, the outsized November fall may have already accounted for much of the move.
• We still think GBP will underperform over the next three months. However, our favoured expression (long EUR/GBP) requires patience. There, whether 0.86 holds is the big question.
• AUD has rallied on buoyant risk appetite and yield spreads, not exports. As such, further strength requires more progress towards Federal Reserve cuts. We outline our plan to turn long AUD vs GBP.

Market Implications

• USD is likely to drift lower through December.
• We expect better entry to turn long EUR/GBP.
• GBP/AUD downside is worth playing, soon.

Introduction

The month has seen the US dollar index slide just over 3.5%, its worst performance since this time last year.

The greenback is down across the board against all its G10 peers.

We think that the DXY will probably continue to drift lower next month, although the magnitude of the move will probably not match what we have seen this month.

Beyond the USD, we still favour GBP downside, and explore potential trades where we can short the pound.

USD Can Keep Sliding Through December

The dollar is down a little over 3.5% this month. That is the biggest monthly drop since last November and leaves the dollar little-changed for 2023. We do not a expect a major drop for the dollar next month, but three factors should nudge it lower into year-end:

1. Month-end flows.
2. Seasonality.
3. Buoyant risk appetite.

1. Month-End Flows to Weigh on USD

We have seen dollar selling into month-end. As Bilal wrote, US stocks have outperformed developed market peers, suggesting USD selling into month-end as equity investors rebalance their portfolios.

2. Seasonality Drags USD Lower (Sometimes)

Seasonality also implies a weaker dollar in December (Table 1). However, that alone would be a lazy claim to make. You must understand the distribution of the month, currency evolution for the month, and the context entering the period:

• The December USD distribution sees only slight downside skew (Chart 1). That implies a fair share of up months, while the average appears driven by some extremities.
• The real down move comes in the second half of the month, while December post-GFC is split between up and down months (Chart 2).
• November 2023 may force a December caveat. USD fell through November, in line with the recent five-year trend (Chart 3). However, this year’s the fall was much quicker. That may mean the actual seasonality we see (some year-end USD downside) has already happened in November.

 Overall, seasonality suggests December dollar downside. However, a strong November may cause confusion. Instead, we note the strong bullish seasonality for NZD.

3. Risk Appetite Supporting Other Currencies, Not USD

The dollar should face additional downward pressure from buoyant risk appetite (Chart 4). Our Market Risk Barometer has shot lower (indicating stronger risk appetite), in line with rebounds in DM equity indices. Currently, equities are the biggest driver for EUR/USD.

Equities should stay buoyant into year-end. There is a growing consensus that central banks on both sides of the Atlantic have completed their respective tightening cycles, and market pricing points to easier monetary policy ahead. Given the initial strong sales numbers reported from both Black Friday and Cyber Monday, this should also contribute to positive risk sentiment.

EUR/GBP Long Looks Attractive, But Patience Needed

We stay bearish sterling. As we highlighted last week, we are still looking to go short GBP against various G10 currencies, including EUR/GBP. The past week or so has seen the pair retreat ~1%, to levels where we initiated longs earlier this month. As with the other sterling crosses, however, we anticipate better entry levels are coming.

In the very near term, GBP/USD can outperform EUR/USD into month-end (by about 0.5%). This will lead to some additional downward pressure on EUR/GBP.

Moreover, heading into December, if we are correct about buoyant risk sentiment being a key factor, GBP/USD should outperform EUR/USD. We therefore wait to go long EUR/GBP.

GBP/USD looks to be trading towards 1.2800, while EUR/USD looks likely to find resistance at 1.1050. That would place EUR/GBP around the October lows. Passing that would have EUR/GBP trade towards 0.8600, a level it has not closed below since mid-September.

Will AUD Prosper?

Having driven 5.5% higher since mid-October (vs USD), we now refocus on AUD. We must answer:

• Why has it rallied?
• Will the rally continue?
• What is the trade?

Why Has It Rallied, and Will It Continue?

Looking through the usual suspects, we find:

• Yield spreads have a role to play (Chart 5). This is no surprise following the recent sharp turn lower in US yields. However, given Dominique’s continued view for no Fed cuts in 2024 and Mustafa’s view on UST risk premia, there should prove for a floor for yields across the curve. The risk is if the Fed proves a leader in easing monetary policy – something the market has taken in its stride following Waller’s comments earlier this week.
• As do commodities. Or at least it seems they do. Citi’s Term of Trade measure for AUD is correlating well (Chart 6). However, the measure is failing to pick up China’s continuous woes; iron ore is trading at highs but with tightening 62% – 58% iron ore spreads, showing lessening demand (Chart 7).
• Risk is a big driver. Copper is off to the races and correlating well with AUD TWI (Chart 8). Our Market Risk Barometer shows a similar narrative.

Going forward, the main consideration is the evolution of Fed expectations and risk appetite. We see three possible outcomes:

Scenario 1 (25%): The Fed are forced to cut in line with market pricing.

This would likely support risk and be bearish for USD. The obvious trade here then would be long AUD/USD (alternatively, a long EMFX trade – not another year of FX carry trades, surely?!). An alternative would be to find different central banks that are ripe for cutting the policy rate. We remain bearish on the UK economy, so short GBP/AUD could work here, too. That would align with other pieces we have released.

Scenario 2 (60%): The Fed eventually cut in 2024 but later than currently priced.

In this scenario, we likely grind through ranges, kicked about by data outturns and caught-out positioning. It is a hard one to call. AUD would probably sell off when markets are forced to shift their narrative to re-pricing hawkishness (or less dovishness). Thereafter, it is likely a positive for AUD. Given a lot has been priced out for the BoE, it would mean GBP/AUD trades higher before trading lower.

Scenario 3 (15%): Core inflation ticks higher, prompting a higher-for-longer regime.

This is outright bad for AUD. Risk would take a beating, as could commodity prices. Being short AUD would make sense here.

What Is the Trade?

We lean towards bullish AUD over the medium term, especially versus GBP. Given our view that positivity could be priced out, GBP/AUD might trade higher before lower. As such, we wait to turn short GBP/AUD. We plan to turn short in two scenarios:

1. If a snap out of this current dovish pricing takes us above 1.95 and in line with a multi-year resistance. That would open very attractive levels.
2. If we break through the recent lows around 1.8960. This would happen on a BoE repricing alongside persistent risk-on. Our target is to trade through 1.80.

Richard Jones writes about FX and rates markets for Macro Hive. He has traded and invested in interest rate and FX market portfolios spanning three decades, both on the buy-side and sell-side.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)