FX Daily: Tipping Point

Markets reached a point of inflection yesterday, where the sell-off in French debt broke the narrative of ever-higher short-term market interest rates. This questions whether central banks are about to extend into policy error territory with tightening cycles. If that is the case, the ECB has less cause to tighten than the Fed, and EUR/USD can stay offered.

EUR/USD is expected to stay offered as markets price in French risk premium and rethink ECB tightening.

USD: Pricing of Fed cycle looks stickier than most

A big day in FX markets yesterday saw the sell-off in French government debt dominate global markets. And it was the first time since late August that short-dated US interest rates had a sizeable fall. Here investors have started to reassess whether central banks – more so the European Central Bank than the Federal Reserve – need to deliver another 75bp of tightening to subdue inflation. We discuss the ECB and the euro below.

Perhaps adding to the correction lower in US rates were comments from Fed Vice Chair Philip Jefferson echoing remarks from John Williams earlier in the week that the Fed should not rush into back-to-back rate hikes. Pricing for a Fed hike in October has now dropped to just 28% from 70% a week ago, and it looks like the market is going to settle into the view that the next hike comes in December.

Feeding into the Fed story will be today's release of the September non-farm payroll figure. Consensus expects around an +85/90k headline gain, an unemployment rate remaining low at 4.1% and a healthy average earnings figure near 3.1% year-on-year. Given very low growth in the US labour force, we doubt a downside disappointment in the headline number will weigh heavily on US rates or the dollar.

With energy prices remaining at their highs and the US activity story resilient, it looks like the dollar can largely hold gains if not extend a little higher – especially against the euro. DXY broke to a new high for the year above 101.80 yesterday and looks biased to head up to the 102.85 area.

EUR: Most roads lead to a weaker EUR/USD

EUR/USD decisively broke to new lows for the year yesterday as the sell-off in French debt finally came home to roost. Little prospect of fiscal consolidation anytime soon leaves French debt vulnerable over the coming months, and yesterday dramatically questioned whether the ECB could push ahead with another 75bp of tightening during a very difficult time for European government bond markets. In particular, the central bank must be worried about the contagion of the French sell-off into the likes of Italy and even Spain. Investors assume that any ECB fix to the bond market sell-off either involves much less or no tightening of policy (euro bearish) or, in extremis, the use of the Transmission Protection Instrument to buy bonds (very euro bearish).

My colleague, Francesco Pesole, wrote a nice article on how the market could easily add another 2% in risk premium to the euro if this bond market sell-off extends. And after the break of technical support yesterday, near-term EUR/USD looks biased to 1.1100/1120, if not closer to 1.10. We would expect upside corrections to be relatively shallow now.

The French debt sell-off, the rise in volatility and, most importantly, the softening of interest rates all conspired to send the Swiss franc a lot higher yesterday. If the re-pricing of ECB rates lower is going to be the dominant narrative near term, EUR/CHF can correct back to the 0.9250 area.

CEE: Romania risk rises, koruna turns bullish

Yesterday, the Romanian leu recorded its largest one-day move since the government collapsed in May, with EUR/RON jumping from just below 5.280 to 5.344. The move followed the new government’s failed confidence vote the day before and came one day before S&P’s key sovereign rating review. Our baseline is for no rating change today, supported by an improving fiscal profile and continued EU fund inflows, but market stress has raised speculation about a downgrade.

Romania is already rated at the lowest investment-grade level with a negative outlook. A downgrade, particularly a loss of investment-grade status, would likely trigger renewed pressure on Romanian assets and a sharper reaction in both FX and bonds than seen this week. Romanian yields remain low relative to CEE peers, leaving expensive bonds vulnerable to such a shock, in our view. Meanwhile, the central bank appears increasingly willing to allow greater EUR/RON flexibility, adding further upside risk to the pair.

Elsewhere in the region, the calendar is quiet today, with attention focused on US payrolls. However, yesterday’s massive repricing in front-end core rates should have repercussions in the region, and we are likely to see a rally in CEE rates as well. The drop in EUR rates should imply a widening of spreads and provide some support for FX. Given that the global environment remains risk-averse and EUR/USD is eyeing new lows, we prefer low-beta currencies, specifically, the Czech koruna.

EUR/CZK remains driven primarily by the interest rate differential, whereas the forint and zloty are more sensitive to outright energy prices and market sentiment. Consequently, EUR/CZK could dip back below 24.400 today, and we expect the Czech National Bank to adopt a more hawkish stance looking ahead. We therefore believe that EUR/CZK has peaked, and we are turning bullish on the Czech koruna.

KZT: Growing state FX sales backlog should cushion downside

The tenge appreciated by 4.8% against the USD in September, outperforming our expectations despite a stronger DXY. In our view, the move was driven primarily by private capital inflows, most notably continued non-resident demand for KZT government bonds. Additional support may also have come through corporate borrowing and other private-sector inflows, while the contribution from the trade channel remains less clear given CPC-related export disruptions.

Looking ahead, portfolio inflows should remain supportive. Kazakhstan continues to offer an attractive real rate of around 7%, while positive rating momentum, improving market infrastructure and growing market liquidity underpin foreign investor interest. However, after appreciating roughly 12% against the USD since the outbreak of the US-Iran conflict, the tenge is now trading near levels rarely sustained before 2022 and, according to our models, is approaching fair value.

At the same time, the growing backlog of state FX sales may offer support in case of deterioration in the market mood. Since June, NFRK FX sales have effectively been capped at around $200m per month, well below estimated fiscal financing needs of $500-600m per month, as the authorities sought to avoid excessive FX supply on the domestic market. As a result, a sizeable FX sales backlog is accumulating. We estimate the deferred sales requirement at around $1.0-1.5bn, reflecting fiscal spending obligations that will ultimately need to be financed.

Overall, we see the balance of risks as supportive for KZT stability. While further appreciation may prove difficult from current levels, the combination of still-favourable capital inflows and potential state FX sales should help keep the currency broadly resilient. The stronger KZT, which has contributed to the slowdown in CPI to below-consensus 9.3% year-on-year in September, also reinforces the case for another modest National Bank of Kazakhstan rate cut on 23 October, although we continue to see only limited scope for a deeper easing cycle in the medium-term.