Broad markets remain highly uncertain, but for the moment, forex markets are trading with an extra lack of conviction. Significant conflicting forces are acting on currencies at the moment. These are generating false breaks and particularly difficult trading conditions. Whilst Omicron infections continue to spread, these difficult trading conditions may persist.
- High levels of inflation are nudging central banks towards tighter monetary policy.
- COVID infection rates are soaring and fuelling an appetite for safe-haven currencies
- The result is elevated volatility and choppy markets
Central banks are moving towards tighter policy
Major central banks are moving towards tighter monetary policy. Some are moving faster than others, but the trend is towards fighting inflation with tighter policy.
The Fed is tapering faster than originally planned. FOMC board member and permanent voter, Christoper Waller said that the Fed wanted to get the taper done earlier to make the March meeting “live” (i.e. possible for a rate hike).
The Bank of England surprised everyone last week with a rate hike. Even the glacial pace of monetary policy tightening started to thaw slightly on Thursday with a form of tapering asset purchases. We are also seeing the Bank of Canada and Reserve Bank of New Zealand pushing ahead with tighter monetary policy.
When there are hawkish shifts as to how central banks are aligned on monetary policy then currencies tend to perform well. This is why we saw GBP and EUR spiking higher last week.
Omicron is a big fly in the ointment
However, tighter monetary policy moves are also coming at the same time where Omicron is proving to be a significant risk. Surging cases of the new dominant variant of COVID are causing huge headaches for governments. Especially in Europe, we are seeing social restrictions creeping in. A national lockdown has already been announced in The Netherlands, whilst France, Germany, and the UK are also contemplating additional measures.
This creates a significant risk to levels of economic demand. Lower demand (or even the potential for it) increases levels of fear in trading sentiment. This will favor the safe-haven currencies, in other words, currencies with more dovish central banks. The Japanese yen is a key beneficiary here, but also the Swiss franc and to a lesser extent, the euro and US dollar.
Balancing out the forces leads to choppy uncertainty
The big problem for traders is that this is leading to highly uncertain conditions with a lack of conviction. Ranging conditions are a feature of some major pairs, whilst failed recoveries have also shown through.
EUR/USD and USD/JPY have both become stuck in ranges. EUR/USD cannot find traction either way and has been trading in a 200 pip range between 1.1185/1.1385 for more than a month now. There is still the undoubted negative bias of the primary downtrend (falling at 1.1480 today) but this period of consolidation is set firm for now.
USD/JPY is also lacking conviction in its neutralized 300 pip range between 112.50/115.50. We are seeing momentum almost entirely neutralized with the RSI around 50 and moving averages flattening. A bullish move (mini 2-week uptrend) within the range has also been negated in the past couple of sessions.
False breakouts have made an unwelcome appearance for traders on several major forex pairs. This is certainly true of GBP/USD (on the BoE hike). A bull failure on the spike to 1.3375 has entirely unwound and the key support band 1.3160/1.3195 is now being tested. Sterling bulls will need to fight hard to prevent another downside break. However, the negative bias has decisively renewed.
Another major pair with a failed break higher is AUD/USD (where a bounce came from AUD being massively oversold and a false improvement in risk appetite). A well-constructed recovery above 0.7185 came last week before a complete shift on the deterioration in risk appetite. Now traders will be busy watching the 0.7081 reaction low as a breach would re-open the 0.6990 key support.
Omicron is the force to tip the balance. Currently, there is a safe haven bias. If infections continue to soar and governments head back into lockdown, then there will be an even more significant lurch into safe havens. This will especially impact negatively on higher-risk commodity currencies such as the AUD and NZD.
However, if Omicron begins to peak soon (and is seen as not as severe an infection as delta) this could tip the balance the other way. Given the tighter monetary policy conditions, there will likely be a big risk really taking hold.
It appears that all things remaining equal, there will be a safe haven bias to forex trading this side of Christmas. This also means that these tough trading conditions may last for a few more sessions yet.