Is FX broken? Depends on the time zone

If you spot an FX trader after work looking a bit glum, spare them some words of encouragement…It’s been a tough time for trading cross market correlations.

 In FX we know the frameworks and we’ve coded up the signals. But frameworks prove temporary, and flows lacking a clear economic rationale can drive the price action instead. That’s what the past two months have been. Nikhil the FX options trader sat to my right exclaimed “Why!?” so many times, when trying to explain price action, that I bought him a hat with his new catchphrase emblazoned on it.

 The typical list of factors for USD FX trading are to watch are economic growth differentials, differences in monetary policy, relative equity valuations, commodity terms of trade and Cross-border flows.

 “Cross border flows” is a “catchall” with a lot going on in it. But in this regime, they are everything. Non-economic flows (FX hedging, corporate exporting, re-balancing portfolios, M&A transactions) have driven the agenda for USD price action, whilst the usual “Econ” drivers such as rates spreads and oil have argued the opposite (USD should be much stronger). But not all correlations are gone, some have substantially picked up with Gold and USD FX trading in lockstep, a pattern last seen in 2022 when Russia’s central bank reserves were frozen…

 The big question is are we nearing a local maximum in this “de-dollarization” phase? When will we have a drawdown in the longer-term USD downside story? A few signals such as 1) FX hedging ratios already shooting higher in April or 2) extended USD short positioning would make me heed caution as I had been a few weeks ago. But price action suggests the European USD selling flow has yet to end.

 Time zone analysis (chart below) suggests Europeans have been better buyers of EUR/USD in the London sessions in June, whilst the opposite can be said in the NY evening. Overall this would suggest European USD selling flows are accelerating, not slowing down! When it comes to the evening sessions USD buying, the pattern could have been exacerbated by the reverse yankees and such other type of issuances leading to US corporates EURUSD selling.

 What does this mean for the EUR/USD view? For now, the non-economic flows are in the driving seat, with a economic European Renaissance narrative in the background that makes me suspect this is a cycle similar to 2016/17 when EUR/USD traded up to 1.15-1.20. We stay long EUR looking for 1.175 by September, 1.20-1.22 by year end. It was a cycle with rather limited EUR drawdowns along the way too.

 The charts below walk you through what you need to know when trading USD FX here.

 Jord

1. The typical cross market drivers of FX (Rates and commodities) are broken. EUR would be trading at 1.10 if real rates were in charge.

2. And the spike in oil would suggest a 7% move higher in DXY.

1. But one correlation goes, another arrives. DXY is trading in lockstep with Gold – it’s all the same “de-dollarization” trade.

2. Which makes us think about the bigger picture, after a decade of EUR being undervalued 5-20%, could we be entering a new era of a 10%+ overvaluation (to capture the German issuance story)?

1. For those who like analogues – for me this is reminiscent of the 2016/17 playbook (Trump disappointing in WH, European renaissance). EUR to 1.20-1.25 over the next 12 months?

2. The one issue is positioning, it’s already short USDs, but the price action on a day-to-day basis doesn’t look like the market is overly short USDs either (EUR quick to rally back).

1. Could it be the non-economic FX flows such as real money FX hedging? Using the monthly Danish pension flow data as a European proxy, April saw a spike higher in the FX hedging ratio from 61% in January to 74% in April. We’ve seen 80% levels before, so there is room for higher and also more consistent FX hedging for all European investors, that will naturally see EUR selloffs on newsflow faded on a day-to-day basis until that flow peaks. We’re not there yet, but we’re a lot closer.

2. Or are we? An interesting new pattern has emerged in EURUSD time zone analysis. Asia had been the largest driver of USD selling in April and Late May. But in June, Asia flow has been less impactful and it’s been during the London hours where we’ve witness the EUR buying flow. And do we stay long EUR all day? Sure, but it’s a drag in the NY session, down 4.3% YTD! Overall this would suggest European USD selling flows are accelerating, not slowing down!