Central Bank Weekly Talking Points:

With the US-China trade war back in a state of détente – China is now saying that they will not escalate further, and they expect the US to deescalate – US Treasury yields have turned higher, provoking the US Dollar (via the DXY Index) into a bullish breakout attempt.

Fed funds are pricing in an 100% chance of a 25-bps rate cut in September and a 85% chance of 50-bps of rate cuts by the end of the year. Meanwhile, Eurodollar contracts are only pricing in a 31% chance of 50-bps of rate cuts by the end of 2019.

Retail traders are turning more bearish on the US Dollar despite gains in recent days.

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Global financial markets are taking another spin around the ‘trade war news cycle.’ As we’ve previously noted, the cycle goes: (1) Trump administration is tough on China; (2) financial markets sell off on trade war concerns; (3) Trump administration hints at US-China trade deal; (4) financial markets rally on trade deal hopes; (5) No deal materializes.

Now that US President Trump has indicated he is having “second thoughts” on escalating the trade war further, and that China is now saying that they will not escalate furtherand they expect the US to deescalate, it now appears that financial markets are firmly in stage (4). In previous spins through the trade war news cycle, stage (4) has been accompanied by higher US equities, higher US Treasury yields, and a stronger US Dollar. The driving factor behind all of these moves remains Fed rate cut odds.

US Treasury Yield Curve Remains Inverted

Now that the US-China trade war back in a state of détente, US Treasury yields have turned higher. As a result, market participants have lowered expectations for an aggressive Fed rate cut cycle.

US Treasury Yield Curve: 1-month to 30-years (August 29, 2019) (Chart 1)

While the 2s10s spread has moved in and out of inversion territory in recent weeks, the two key spreads of the US Treasury yield curve – the 3m5s and 3m10s – have been inverted for several weeks now. In turn, US recession odds have jumped.

The Fed Rate Cut Cycle Looking Less Aggressive

With the US yield curve inverted in the key portions, rate cut odds remain frontloaded. After the Fed’s Jackson Hole Economic Policy Symposium, Fed funds futures were discounting a 100% chance of another 25-bps rate cut in September and a 92% chance of a third and final 25-bps rate cut in December. There was a 17% chance of a 50-bps cut at the September Fed meeting.

Federal Reserve Interest Rate Expectations (August 29, 2019) (Table 1)

Now, Fed funds futures continue to price in a 100% chance of a 25-bps rate cut at the September Fed meeting, but the odds of a 50-bps rate cut have dropped from 17% to 10%. Meanwhile, odds of a third and final 25-bps rate cut in 2019 have dropped from 92% to 85%.

Eurodollar Contracts Remain Less Dovish than Fed Funds

Eurodollar contracts continue to be less aggressively dovish than Fed funds now that the Fed rate cut cycle has begun. We can measure whether a rate cut is being priced-in using Eurodollar contracts by examining the difference in borrowing costs for commercial banks over a specific time horizon in the future.

The chart below showcases the difference in borrowing costs – the spreads – for the continuous front month/January 20 (orange) and the continuous front month/June 20 (blue), in order to gauge where interest rates are headed in the December 2019 Fed meeting and the June 2020 Fed meeting.

Eurodollar Contract Spreads – Continuous Front Month/January 20 (Orange), Continuous Front Month/June 20 (Blue) (December 2018 to AUGUST 2019) (Chart 2)

Based on the Eurodollar contract spreads, a 25-bps rate cut is fully discounted at the September Fed meeting. There is only a 31% chance of seeing two 25-bps rate through the end of 2019 and a 55% chance of three more 25-bps rate cuts coming by June 2020.

Fed Rate Cut Odds are Frontloaded Due to US-China Trade War

This point bears repeating time and again. Traders should continue to respect the fact that markets believe that if Fed rate cuts are coming, they’re going to come quickly over the next several months, a direct response to the growing threat of the US-China trade war. It thus stands to reason that if a US-China trade deal materializes at any point in time there will be a repricing of Fed rate cut odds in favor of a stronger US Dollar.

DXY INDEX TECHNICAL ANALYSIS: DAILY PRICE CHART (AUGUST 2018 TO AUGUST 2019) (CHART 3)

In our last DXY Index technical forecast update, it was noted that “price action has continued to firm up, and as a result of the DXY Index’s momentum profile has turned more bullish.” Indeed, the DXY Index continues to trade above its daily 8-, 13-, and 21-EMA envelope, while both daily MACD and Slow Stochastics are trending higher in bullish territory.

Now, the symmetrical triangle in place over the past six weeks appears to be getting ready for a bullish breakout attempt. In clearing out the bearish outside engulfing bar/key reversal set on August 23, the DXY Index would have cleared out the most swing high, suggesting that traders should be on alert for prices to rally back to at least the 2019 high set in July at 98.93.

The big picture for the US Dollar (via the DXY Index) is potentially troublesome, especially if the triangle’s bullish breakout attempt fails to set a new 2019 high. In doing so, the DXY Index is looking to retake the rising trendline from the February 2018, March 2018, and March 2019 low lows – the backbone of the entire bull move. Failure to retake the uptrend would suggest that the major topping potential for the US Dollar remains valid.

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--- Written by Christopher Vecchio, CFA, Senior Currency Strategist

To contact Christopher Vecchio, e-mail at cvecchio@dailyfx.com

Follow him on Twitter at @CVecchioFX

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