By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
Monday night's U.S. Presidential debate is the market’s main focus for the next 24 to 48 hours. For currencies, we know that politics can overshadow economics and the first debate between the two main presidential candidates will have a significant impact on the U.S. dollar. We expect an active trading session starting Monday evening with traders in Asia getting the first opportunity to react to the debate results.
Political scientists argue that debates rarely affect the outcome of the election but history tells us that stocks perform terribly. According to studies dating back to 1980, U.S. stocks trade lower the week after a debate 80% of the time with an average 1.5% loss for the S&P 500. Investors are always nervous about major elections but this time the stakes are extremely high for not only the U.S. economy but the world. Hillary Clinton only has a narrow lead as the polls are so close that it could go either way. Traditionally, stocks rise when the current party wins and in this case, there’s so much uncertainty surrounding a Trump victory that if Clinton is crushed in the debate, the sell-off in stocks could be more severe than usual. Foreign investors in particular are extremely nervous about a Trump win and market participants have already sold dollars in fear of this possibility. Unfortunately the market hasn’t sufficiently priced in the possibility of Trump rising victorious from the first of four debates and for that reason, the larger reaction in currencies will be to a Clinton defeat.
While it may be safer to trade after the debate, positioning for a break of 100.00 in USD/JPY beforehand is a viable trade. Technically, there is significant pressure on USD/JPY and as indicated in Friday’s note, its failure to close above 101.25 makes a move below 100 possible. Fundamentally, there are plenty of reasons for investors to be nervous and a further sell-off in stocks will drive USD/JPY lower. It is estimated that Japanese life insurance companies and other similar institutions hedged only 60% of their yen risk. If USD/JPY drops below its August low of 99.50, we could see that ratio rise to 80% -- and that would involve buying more yen. Bank of Japan Governor Kuroda warned on Monday that he's watching FX moves closely and is ready to use every possible policy tool if needed. That warning fell on deaf ears as investors see the central bank’s hands tied. The market also shrugged off Fed President Lockhart’s comment that the case for a rate hike has strengthened -- a sign that no one cares that the Fed could still raise rates in December. If Hillary Clinton crushes Donald Trump, stocks will rise, USD/JPY will rise, the Canadian dollar will rise and emerging-market currencies like the Mexican peso and Chinese yuan will move higher because they stand to lose the most from a Trump Presidency. If Donald defeats Hillary, USD/JPY will fall quickly and aggressively, USD/CAD will hit a fresh 5-month high above 1.3250 and emerging-market currencies will tank.
The OPEC meeting is also underway in Algiers. An output cut is not expected but a production cut is possible. Oil prices traded sharply higher Monday -- up more than 3% -- but interestingly enough, the Canadian dollar was lower. Part of this has to do with Friday’s disappointing economic reports and risk aversion. In contrast, the Australian and New Zealand dollars traded higher despite New Zealand’s surprisingly weak trade balance report. Typically, these currencies fall when investors are nervous and stocks decline, but in Monday’s case, concern centered on the U.S. and these currencies have benefitted from liquidation out of the greenback.
Meanwhile, the euro traded higher on the back of stronger business confidence. The German IFO report jumped 3 points, which was the strongest upside surprise in more than 3 years. As reported by our colleague Boris Schlossberg, “According to the IFO institute the post Brexit news has been digested by the business sector and appears to have minimal impact on trade despite the better than 15% depreciation in the pound. Meanwhile private consumption in Eurozone’s largest economy remains robust although some slowdown is expected in H2 of this year.” We saw no clear opportunity in EUR/USD ahead of the debate as the pair’s tight range puts it at risk of a breakout.
Sterling ended the day unchanged against the greenback and steady-to-lower against other major currencies. Brexit headlines continue to weigh on the currency and as the invocation of Article 50 nears, sterling should come under additional pressure with the August low of 1.2866 likely to be tested in the coming weeks.