Bond Yield Spreads Playing A Greater Role in FX

While it may be argued that there is still some residual demand to be found once the US and China can ink a trade agreement, the price action this week is quite revealing about a potential permutation in regime.

Date: 3/6/19

The Daily Edge is authored by Ivan Delgado, Market Insights Commentator at Global Prime. The purpose of this content is to provide an assessment of the market conditions. The report takes an in-depth look of market dynamics, factoring in fundamentals, technicals, inter-market in order to determine daily biases and assist one’s decisions on a regular basis. Feel free to follow Ivan on Twitter & Youtube. If you'd like to experience first-hand interaction with other like-minded traders and the author, feel free to also join our open invitation to our discord room, a place for all to hang out and get to know each other while trading the markets.

Quick Take

While it may be argued that there is still residual demand to be found once the US and China can ink a trade deal, the price action this week is quite revealing about a potential permutation in the rhetoric that has dominated flows.

Are we getting to a point where the market has priced in all there was to be discounted from the Sino-US story (assumption is a deal is almost baked in the cake) and the attention is swiftly shifting towards economic fundamental divergences?

Risk on risk off fluctuations, the growing influence of capital flows derived off yield spreads (US at the forefront of the recent divergences spotted) must simultaneously coexist with the immediate risk of politics in Europe (Brexit) as we enter a key period.

In the last week or so, the typical risk-on, risk-off gyration have started to decouple due to fundamentally-charged triggers in Canada, Australia to name a few. That's why it's been a fairly disjointed affair finding the connections between risk and sensitive currencies to deleveraging episodes in financial markets. This decoupling also applies to the USD, which by default tends to debilitate when risk thrives; it has not been the case as the currency keeps its appeal intact.

What we are seeing is a market that is increasing its correlations toward bond yield spreads, and that is evidence that more attention is being paid towards the prospects of growth and economic divergences on an individual merit basis. At the center of this new re-adjustment towards yield differentials we find the sell-off in US bonds, which keeps stubbornly high demand towards the US Dollar in a world with ultra-low interest rates.

If you are looking for that extra layer of conviction on your Forex trades, this is the time to factor in the bond yield spread to gauge the next flows while keeping an open mind about what currencies may or may not benefit from risk-on or risk-off as fundamentals and politics (EUR, GBP) play an increasing role.

RORO - Risk On Risk Off Conditions

In the near term (microflows), the pendulum has swung towards ‘true risk off’ conditions, an environment characterized by a firmer JPY and USD. The recent aggressive setback in the S&P 500, alongside back-to-back corrective days in US yields coupled with a rising USD, qualifies the latest daily fluctuations as a juncture not risk friendly, even if the relatively contained range in the S&P 500 over the last 24h has somehow tamed the selling of risky assets.

Evidence of that, even if more fundamentally driven, is the performance of the Aussie and the Kiwi, on the back of the RBA policy meeting. I must say that in the last week, we are starting to see some disjointed FX moves away from respecting RORO conditions, as divergence in fundamentals take centerstage.

That’s the reason we’ve seen such a depressed CAD since last Friday, as the market prices in a more dovish BOC this week. In terms of the EUR and GBP, as the Brexit deadline approaches, that’s at the epicenter to determine next flows. Meanwhile, the USD and US yields for this matter, have both been rising as the US economy keeps showing signs or a strong comeback after the hiccups of Q4 and post the US government shutdown.

We are transitioning into a period where fundamental divergences may start to play a greater role to assess the forward-looking performance in currencies, a very important consideration that one must reconcile with when looking to gauge flows beside the RORO-led rotations.

When it comes to the macro picture, the 5-DMA slope in the DXY and US yields is firmly pointing upwards, which when combined with a flat 5-DMA slope in the S&P 500, makes the current context a source of concern to see further deleveraging on risky assets if equities remain fragile. If the risk-off conditions extend, playing risk-sensitive currencies such as the CAD at a time of negative fundamental news, can potentially result, as seen recently, in ample movements.

Dashboard: Intermarket Flows & Technical Analysis


EUR/USD: In A Bearish Cycle Phase, Divergence W/ Bond Yield Spread

  • Technicals are clearly bearish with lower lows printed.
  • Negative Brexit headlines the catalyst for the latest sell-off.
  • Clear divergence opening up between price action and 10-y bond yield spread.
  • Higher risks of playing bullish yield divergence as Brexit key driver and situation fluid.
  • The 5-DMA slope has turned lower for the first time since mid-February.

GBP/USD: V-Shaped Turn at Key Horizontal Line

  • The Sterling is knocked down by negative Brexit headlines that led to algo selling.
  • The rebound off 1.31 round number erases most of the daily losses.
  • No clear directional biases developing amid two of the strongest currencies as of late.
  • The bond yield spread still constructive but DXY adds downward pressure.
  • The pair no longer characterized as in a bullish trend from a macro perspective (5-DMA).

USD/JPY: Return Of Risk-Off Flows Encapsulates The Pair

  • The micro trend in US yields is causing JPY demand to make its way back.
  • The sharp sell-off in US equities on Tuesday has firmed up prognosis of value selling strength.
  • The DXY strength keeps demand on weakness but alone unlikely to sustain the bull trend.
  • A resolution of the tight range critical to stimulating next directional flows.
  • The overall technical outlook remains positive as per higher highs prior to current acceptance.

AUD/USD: Sellers In Control As Range Breakout Looms

  • The Aussie is pressured on the back of a poor Aus Q4 GDP reading.
  • Across the board bearish signals from intermarket analysis see risk skewed to the downside.
  • Macro bearish trends in AU-US bond yield spread and DXY+Yuan (inverted) adds to AUD - case.
  • Break and hold sub 7050/60 swing low is critical to open up next target at 70c.

USD/CAD: Clearest Bull Trend In the FX Space

  • Combo of risk-off and negative Canadian GDP last Friday a double whammy for bears.
  • The order flows continues to play out in a low vol fashion, with momo traders thriving.
  • No indication via DXY or bond yield spread that the trend is unjustified.
  • BoC policy meeting is the next catalyst to inject volatility into the pair.
  • The divergence between price action and Oil quite notable (not as big of a role last 5 days).

Gold: Follows DXY/US Yields In Locksteps

  • The perfect bearish storm of higher DXY, short-dated US yields continues.
  • Technicals have turned sour, with the acceptance near trend lows a bad omen for bulls.
  • The synchronicity in bullish movements in the DXY/UST yields is a recipe to sell strength.
  • Micro and macro trends in DXY/UST yields agree for more ambitious bearish targets.

AUD/JPY: Setting Up For An Outlier Move

  • Risk-off dynamics paired with negative fundamentals may see significant supply imbalances.
  • Breakout of the range sets out a projected target of at least 50 pips towards 78.50.
  • USD strength damages outlook for EMs and the Aussie. S&P 500 key determiner.
  • Buy on weakness on the thesis of a China-US trade deal an argument for contrarians.

EUR/AUD: Follow The Yield Spread To Keep You Safer

  • From a macro perspective, the German-Aus bond yield spread has acted reliably.
  • The upward trend in the yield spread alongside corrective structure bodes well for the Euro.
  • The macro trend derived off price action provides further technical support.
  • The developing trend in the Yuan (lower) + negative Aus data adds to the bullish case.

NZD/USD: As Negative As It’s Been For Weeks

  • The absence of own fundamental drivers keeps NZD playing catch up with lower Aussie.
  • DXY strength has all the merit amid a relatively strong performance by the NZD vs peers.
  • Clear macro bearish trend in the NZ-US bond yield spread (highly correlated micro + macro).
  • If momentum picks up, next bear target found at the origin of the RBNZ-led spike at 0.6750.

Important Footnotes

  • Risk model: The fact that financial markets have become so intertwined and dynamic makes it essential to stay constantly in tune with market conditions and adapt to new environments. This prop model will assist you to gauge the context that you are trading so that you can significantly reduce the downside risks. To understand the principles applied in the assessment of this model, refer to the tutorial How to Unpack Risk Sentiment Profiles
  • Cycles: Markets evolve in cycles followed by a period of distribution and/or accumulation. The weekly cycles are highlighted in red, blue refers to the daily, while the black lines represent the hourly cycles. To understand the principles applied in the assessment of cycles, refer to the tutorial How To Read Market Structures In Forex
  • POC: It refers to the point of control. It represents the areas of most interest by trading volume and should act as walls of bids/offers that may result in price reversals. The volume profile analysis tracks trading activity over a specified time period at specified price levels. The study reveals the constant evolution of the market auction process. If you wish to find out more about the importance of the POC, refer to the tutorial How to Read Volume Profile Structures
  • Tick Volume: Price updates activity provides great insights into the actual buy or sell-side commitment to be engaged into a specific directional movement. Studies validate that price updates (tick volume) are highly correlated to actual traded volume, with the correlation being very high, when looking at hourly data. If you wish to find out more about the importance tick volume, refer to the tutorial on Why Is Tick Volume Important To Monitor?
  • Horizontal Support/Resistance: Unlike levels of dynamic support or resistance or more subjective measurements such as fibonacci retracements, pivot points, trendlines, or other forms of reactive areas, the horizontal lines of support and resistance are universal concepts used by the majority of market participants. It, therefore, makes the areas the most widely followed and relevant to monitor. The Ultimate Guide To Identify Areas Of High Interest In Any Market
  • Trendlines: Besides the horizontal lines, trendlines are helpful as a visual representation of the trend. The trendlines are drawn respecting a series of rules that determine the validation of a new cycle being created. Therefore, these trendline drawn in the chart hinge to a certain interpretation of market structures.
  • Correlations: Each forex pair has a series of highly correlated assets to assess valuations. This type of study is called inter-market analysis and it involves scoping out anomalies in the ever-evolving global interconnectivity between equities, bonds, currencies, and commodities. If you would like to understand more about this concept, refer to the tutorial How Divergence In Correlated Assets Can Help You Add An Edge.
  • Fundamentals: It’s important to highlight that the daily market outlook provided in this report is subject to the impact of the fundamental news. Any unexpected news may cause the price to behave erratically in the short term.
  • Projection Targets: The usefulness of the 100% projection resides in the symmetry and harmonic relationships of market cycles. By drawing a 100% projection, you can anticipate the area in the chart where some type of pause and potential reversals in price is likely to occur, due to 1. The side in control of the cycle takes profits 2. Counter-trend positions are added by contrarian players 3. These are price points where limit orders are set by market-makers. You can find out more by reading the tutorial on The Magical 100% Fibonacci Projection
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