Dollar sells off as risk appetite improves

ommodity currencies led the way in hopes of a faster economic recovery, and the lagards were the yen and sterling. The latter is still struggling to find its footing as markets fret over the state of Brexit negotiations. Everywhere in the G10, short-term rates are at rock bottom levels and political pressure is growing everywhere for more intense fiscal stimulus, resulting in a general steepening of the interest rate curves as traders price in waves of government bond issuance.

With the Democrats widening their lead in the polls and lower prospects for a disputed election in the US, attention should shift to the EU summit this week, which Boris Johnson has claimed as a deadline of sorts for reaching a Brexit deal. Inflation data out of the US Monday should get some attention, as we have seen some divergence in inflation dynamics between the US, where it has rebounded back to pre-COVID levels, and the Eurozone, where it continues to print record lows.

GBP

Sterling traders are squarely focused on the 15th October deadline set by Boris Johnson to pull out of Brexit negotiations if no deal is reached by then. We think it likely that the deadline will get pushed back, as both sides are making positive noises about the progress being made towards a modest deal.

The employment report on Tuesday is likely to be overshadowed by the drama of the EU-UK negotiations right before the EU summit, but it will provide key insight about the impact of the COVID second wave on the labour market.

EUR

While the euro rebounded nicely last week on the back of increasing risk appetite, we are starting to see short-term risks accumulating for the common currency.

First, new COVID cases continue to increase, and have just crossed the US level. The resulting partial lockdowns will affect Eurozone economic performance. Second, the minutes of the ECB September meeting highlighted the institution’s concern with deflationary risks; this was before the even more dismal September inflation numbers were released. The chance that the ECB will ease further in December is growing.

Finally, traders’ speculative positioning in long euro trades has barely begun to shrink from the record levels of late-August. All in all, we see some risks for a temporary pullback in the common currency over the next few weeks.

USD

In a data-light week, politics are likely to drive dollar trading. Investors will be looking for fresh polls to confirm the likelihood of a Democratic wave that pushes off the prospect of a contested election and makes it more likely that additional fiscal stimulus will be forthcoming in 2021.

In the shorter-term, we still think we are likely to see a compromise spending package before the election, as the market is increasingly pricing in. This would be unambiguously positive for emerging market currencies, though the impact in the EUR/USD rate is harder to predict.