Quantifying the shift in China's FX policy

Following on from Wednesday's post, it seems clear that at some point over the last year there's been a shift in China's FX policy.  Frustrated by the implications of dollar strength on the RMB nominal effective exchange rate (a natural outcome of pegging to the dollar), the authorities not only moved to a basket peg but also changed how the RMB's parity to the basket changed vis-a-vis changes in the dollar's value.

Macro Man ran a series of correlations over several time frames after adjusting for issues like lags in the data (RMB fixings for day t reflect  FX changes on day t-1), Chinese holidays, etc.  Because some of the FX fixings are not available before the beginning of last year, he calculated a synthetic CFETS basket using tradeable currencies (including the CNH instead of a CNY fixing.)  As you can see, for the most part the two series line up pretty well, especially before last August.


Obviously, the CNH appreciated markedly versus the reference basket from October 2010 though last summer.  Not only was the USD appreciating against other basket constituents at the time, but the CNH was appreciating against the dollar!

If we look at a full sample of the tradeable basket versus the DXY, what do we find?  Even during (or perhaps because of) the persistent rise in the RMB's NEER, the currency was generally more responsive to following along with dollar down days than up days.  Not only is the R-squared higher, but the beta coefficient is as well.



OK, so what if we break that down into different time buckets?  Let's first look at October 2010 (when Macro Man's data begins) through the end of 2013, when things were ostensibly still hunky dory in China:


Although the R-squareds are much closer, the beta was still notably higher on down days than up days.   Let's now look at 2014-15, when the rumblings of trouble first emerged and the pressure on the external balance exploded into the public consciousness last August:


It's interesting to note that even as correlations fell, the betas increased.  This is consistent with the notion of China gradually introducing more volatility into FX regime.  Of course, it could also merely reflect those few days last August when the RMB had a very sizeable beta indeed during the mini devaluation.   What does 2016 look like?

OK, so this is very, very interesting.   While the betas have dropped back towards historical norms (perhaps reflecting the lack of step-deval?), the correlation of the tradeable basket to the DXY collapsed on dollar up days, while the correlation on dollar down days remains as it was.  The upshot appears to be that when the USD sells off, the RMB tags along for the ride (rising slightly against the dollar but falling more dramatically against non-dollar currencies), but when the dollar rallies, the CNH weakens enough to almost entirely wipe out its gains against other currencies.  In other words, USD/CNH realized vol is a lot higher to the upside than the downside, which of course you knew and saw reflected in risk reversal prices, but perhaps did not consider the consequences of.

Of course, one could argue that the CNH is only a dirty peg that the authorities may only partially control, and perhaps does not reflect the actual policy intentions of the PBOC.  Will we find anything different if we look at the official fixings in 2015-16? Consider last year first:

It is interesting but unsurprising to see the betas lower than for the tradeable basket; after all, there is no intraday movement or volatility with an FX fixing.  It's notable, however, that we already see a large discrepancy in the R-squareds.  Let's look at this year:


Hoo boy, there you go.   The CNY is more responsive versus its basket than it's ever been (on an R-squared basis) when the dollar goes down, and less responsive (based on beta and nearly on R-squared) when the dollar goes up.  The difference in each measure when the dollar goes down and when it goes up is striking.

And this is how the Chinese have managed to fool the world (or at least lull some parts of it into a false sense of security); buy allowing the RMB to "strengthen" (versus the USD) only modestly when the dollar goes down, the authorities manage to ensure that the RMB weakens considerably versus its reference basket.   When the dollar strengthens, however, the CNY takes enough of the brunt that the basket barely moves, as we saw to some degree on Wednesday.

It's all well and good as long as the dollar trades sideways to lower; if trend appreciation ever reasserts itself, however, the Chinese FX mechanism will find itself in a spot of bother.
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Nico G
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June 10, 2016 at 8:18 AM ×

whatever they do Chinese need to buy more Vuitton bags

Europe is heavily breaking down this morning

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Anonymous
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June 10, 2016 at 9:28 AM ×

Little rewards, lots of risk being long into Euros and Brexit. Nice trading Nico.

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Cityhunter
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June 10, 2016 at 10:00 AM ×

Thanks for the great post, MM, as always.

Another factor for the calmness is that there is basically no liquidity to build sizable short position in CNH. The housing beast is released again in the beginning of the yr to fight slow down in China, which in turn drives the demand for the commodities pushing up EM etc. We all know this is jsut not sustainable.

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Anon 451
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June 10, 2016 at 10:21 AM ×

Say what you like about Nico but the guy has balls if he's trading that size. Love it. Sry, back to lurking now.

Short risk, until Brexit. (Not really, actually flat nursing some losses anyway...)

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checkmate
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June 10, 2016 at 11:04 AM ×

Appreciated your analysis. Thanks.

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Anonymous
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June 10, 2016 at 11:18 AM ×

What about long DAX vs S&P500 here? the under performance of the last 3 days is quite remarkable (about 3%). Also 1)ECB still in full QE and balance sheet expansion while the FED balance sheet will stay flat ; 2)macro data are not that bad in Germany; 3)if EURUSD depreciates further should be positive fro European equities.

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Nico G
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June 10, 2016 at 1:00 PM ×

be careful

long Europe short US has been tried so many times since 2009 - it is pretty much going against not one but two opposite trends

let's say there is more rigging (buybacks etc) in the US and more realism in EU equities thus so hard to predict when that would turn around.

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Error404
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June 10, 2016 at 1:26 PM ×

Thanks for the excellent analysis MM.

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abee crombie
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June 10, 2016 at 1:27 PM ×

nico knows EU! while i dont always agree, I do enjoy the commentary.

They are just selling banks and autos there. While banks have negative EPS revisions, not the same with autos (as a group, Daimler isnt so hot though). while at the same time Industrials have seen pretty strong bounce in EPS forecasts since end of march. But I guess the leading power of financials in EU overwhelms anything else. Though quick look at the CoCo's and they arent moving (yet?)

Bund is going to go parity with 10YR JGB?

ECB to buy European Bank CoCo ;-) . It will come soon enough

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Leftback
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June 10, 2016 at 1:31 PM ×

Anon, I think the DAX right now is one dip that you shouldn't buy..... will outline reasoning later.

For the moment, LB is going to eschew any complex thoughts and offer simple observations. He will not use the word Sp--s. Crude oil's recovery has led this market higher. This seems incontrovertible, so allow me to continue with my simple thesis. Oil's rise has dragged (especially) CAD/RUB/NOK etc, EEM, US high yield, XLE and IWM along with it. I will refer to this simply as the oil block. Everyone OK with this? We suggest that crude oil has been technically, fundamentally and seasonally overbought. One can argue the fundamentals (not really) but the other aspects seem quite clear. Additionally, the dollar has been oversold recently, and a rising dollar is negative for crude oil, all other factors begin equal. Not to say that oil might not climb from here, but the headwinds are considerable.

As soon as oil turns lower (we saw this yesterday and today) it will take all of its admirers with it. CADUSD, HYG and IWM are all linked to the price of oil in this current market epoch. The trade that has pushed crude oil higher has been funded in USD and JPY, so that as this unusual commodity carry trade unwinds there will be pressure to repurchase those currencies. Any renewed dollar strength will accelerate the selling of the oil block [INDEPENDENT OF THE ORIGIN OF DOLLAR STRENGTH]. In other words, once it starts, it doesn't matter why people are buying dollars/yen, they will just continue to buy them and sell the oil block, and economic fundamentals and the FED are going to be irrelevant. Just as with all of the carry trade unwinds we have witnessed in our long and inglorious investment career, this one will just unwind until some significant technical level is tagged or some fundamental issue changes in global markets.

SO how are we playing this? We are of course mainly in cash, also we are short the entire oil block, as defined above, and also short EURUSD and long UUP. The above is a purely operational description, absent psychology or predictions about the Fed, global growth, commodity super cycles etc.. or any other existential factors.

As for Spoos, we don't play, our proxy is IWM (it has some nice chart gaps way down there, all the way to 90) and as Nico pointed out you could do worse than have a few deep OTM puts here, b/c as was the case during many other rolling tops we have witnessed, everyone thinks that there could be a correction, but most people don't think it will even be 5-10% and NOBODY (even this writer) thinks that it could be as bad as 10%, and certainly not as bad as 20%. This is the kind of universal complacency that leads to failed dip buying, stop hunting algos, that can lead to a rapid change in mood, and eventually to the "sell it all" psychology that generates crashes. We haven't seen this mood ("yeah it might fall a bit, but a deep correction? The bears are out of their tiny minds") since 2007-2008. Looking back, we often questioned our sanity at expecting a 20% drop back then, only to be truly shocked at the carnage that played out, which was far worse than we had imagined in our darkest most bearish moments.

Now, speaking of out of their minds.... Europe? Are you insane? The ECB/BoJ isn't doing QE/NIRP for fun. This is just killing the banks in Europe, which are full of NPLs and now can't make any money. We are likely already quite close to one major bank going under or even a national banking crisis in one of the larger EU countries where corruption and denial leads to accounting scandals (is Italy just too obvious?). Nico is watching these factors much more closely than most armchair observers over here and has been on the money, in my opinion. Right now, Europe once again (why is it always mid-summer during the footy guys?) seems more likely than China to provide the spark to light the fuse for the global risk asset meltdown. LB was burned by the midsummer massacre of 2011 and has vowed never again to ignore the continent of Yoorp.



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washedup
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June 10, 2016 at 2:50 PM ×

@Left - u know I generally agree and everything - most interesting observation is the following:

"Right now, Europe once again (why is it always mid-summer during the footy guys?) seems more likely than China to provide the spark to light the fuse for the global risk asset meltdown."

I confess that struck me a bit like a bolt - I assure you that is not the consensus view - I don't think people are particularly focused on financial contagion from europe at all, even as the China 'situation' is fairly well advertised (or as Janet Yellen thinks, 'fixing itself'!)

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Anonymous
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June 10, 2016 at 3:06 PM ×

"I assure you that is not the consensus view"

Washed - how so ? Given it was europe DB cocos that helped the 2nd plunge earlier this year, it is not exactly left field ?

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washedup
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June 10, 2016 at 3:12 PM ×

@anon - perhaps I am projecting my own ignorance then, but frankly since the ECB stepped in to buy corporate fecal matter, I honestly haven't heard much serious conversation on it as a catalyst.

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June 10, 2016 at 4:42 PM ×

“Markets say the ECB is done, their box is empty,” Vasiliauskas, who heads Lithuania’s central bank. "But we are magic people. Each time we take something and give to the markets -- a rabbit out of the hat.( may 2016)

magic? is meaning that they will evaporate bank stocks?? ahahhh

my biggest hope is that their insanity will be reknowned briefly... but i think will be a long way again..

As you know i'm bearish on equities and i think that europe is a mess but at this prices i think that a long Eurostoxx/short Spoos is well rewarded. I've begun to accumulate size on this spread, particularly today.

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June 10, 2016 at 4:45 PM ×

Better trade could be a call spread on Eurostoxx and a put ATM on Sp500

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CV
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June 10, 2016 at 5:05 PM ×

Well, you guys have done the heavy lifting already here, so I don't have much to add. I agree with LB's view on oil. The squeeze there has lifted a lot boats despite them being full of holes. The interesting thing about EM, though, is that if the evil eye of Mr. Shorty turns to EU/EZ/Brexit soon, then EM could perhaps go relatively unscathed. After all, if Europe shows signs of cracking with Draghi buying corporate in the PRIMARY market of NAMED firms, then .. well where do you thing U.S. front end yields will go? As a GBP based investor, I have to think about my currency exposure. I have one big short in the U.S and PLENTY of cash, but all that cash in GBP and I could still get caught out. I am leaning towards a small long in the turds of turds in U.K./EU banking which will scream if the Blighties vote to remain in, and a big long position unhedged in U.S. front-end paper. Just musing ... and all ;).

Now, on Europe in general. EZ banks are indeed getting killed here. But here is the thing. We are one day into the ECB corporate bond buying program and they're already buying junk bond debt. I really think people need to sit back and let it sink in exactly what is happening to fixed income markets in the EZ.

Could they buy financial bonds?

In the end, I think they will do everything to muddle through and if this means diluting bank shareholders into infinity, well that is what will happen, but a huge "going under" crisis. Nope, don't see it. Sorry. These things will give in equal measure to latecomers on either side of the trade in the next few quarters. You need to look at the CA deficits. If they open up again in the periphery we're off to the races. The ECB can't print foreign currency in the end! But we see few signs of this ... Portugal is a tricky one, though, and I concede that they will be rolling their debt into HIGHER yields this year ... not exactly what the doctor ordered.

I am vigilant, however, of a turning point in the EZ business cycle next year which could get things going. Because you know, inflation is only going one way, and that is UP. Even in the Eurozone, and this will constrain the ECB's ability to go completely overboard.

Now, on the long stoxx/short spoos trade (given all of the above); I am strangely unexcited about that one. I don't think it will give much to be honest, but I don't think it will be a disaster either. Tactically/strategically I am with LB/Nico ... I see few reasons to be long here, and plenty of downside.

Meanwhile, I repeat. Long front-end bonds in Brazil as a play on global carry is good little punt given the silliness of yields elsewhere.

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Leftback
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June 10, 2016 at 5:22 PM ×

@CV. I agree, no Lehman moment for DB. Italy, not so sure, maybe the Germans would like to "teach someone a lesson", Bear Stearns style. My point re: EU banks is this, that it always takes a very severe crisis to make the ECB (with approval of the BuBa) take the next unpopular step (buying financial bonds and diluting shareholders as per Citibank), and finally may make a gift equivalent to the US TARP. That is what they probably want to do here, and so here is Mr Market simply saying "YOURS, Mario". As a consequence, EU financials are offered and EURUSD is weak in anticipation of more funny business with the bazooka.

When the crisis arrives, and Draghi conjures the next rabbit from the hat and when finally they do it, then I think you are correct my friend, one can probably safely get long Eurostoxx for a decade. More pain ahead before we get there.....

I like the Brazilian and Russian bonds idea. Deflation and lower rates coming to EMs again very soon. Lock in those 10 percent yields and hedge FX exposure with some dollar calls?

Dame Janet would love a crisis here, btw, so she could avoid doing anything at all, like Carney during the last stagflation bout in the UK, he was saved by Europaniques Un and Deux. Euro 2016 footy today. Can Europanique Trois be far away?

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CV
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June 10, 2016 at 5:32 PM ×

"Can Europanique Trois be far away?"

Indeed, that is the question. Japan shows us that a current account surplus, ZIRP and the occasional QE can keep a lid on the panic even if it means that the economy, and banks, simply drift into oblivion. Key risk of course a break-up of the EZ itself. But, would the populations of the South really want to devalue and leave with Draghi at he helm? He is their best friend!

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June 10, 2016 at 5:35 PM ×

To buy financial bonds don't Change nothing!! Please take a look to fin paper ( not only coco..) and tell me where's the problem!! The problem is Nirp and as consequences absolute level of rates! Draghi is yet giving free money to banks!

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Anonymous
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June 10, 2016 at 6:55 PM ×

DAX downside appears to be picking up speed...spot on with the last two bears.

http://www.onlypricesmatter.com/2016/06/10/the-dax-bear-rolls-on/

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Nico G
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June 10, 2016 at 7:22 PM ×

May the Euro footy thingy go without incident - allez la France

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CV
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June 10, 2016 at 7:32 PM ×

+1 Nico ...

Oh, and having fun with GBP, my dear FX punters. This will get silly in the next few weeks I think.

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Leftback
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June 10, 2016 at 8:00 PM ×

LB looks forward to some great games and to some noise being made by the dark horse teams. Croatia, both Irish teams (because, well... Guinness!) Iceland, Poland and... (ahem) England.

At the CDG early departure lounge in a few weeks we would dearly love to wave goodbye to España (so, so, so tired of tiki-taka, Ole Ole, and most of all, hordes of yappy bandwagon-jumping Yanks wearing Barça, Atleti and Real kits) and Portugal (look, it's not a one-man game and they are a one-man team). Equally as likely to excel as to underachieve and implode in an orgy of self-flagellation: any one of Italy, Sweden and Belgium, all in one group. Take your pick.

At this point we would like to wish all a happy weekend and a very enjoyable Euro 2016. A special thought for a happy Summer goes out to those dip-buying Anons who were dip buyers at SPY 210 and CLN6 50. We hope that you and your most recent and perhaps future purchases enjoy each other a great deal since there is every likelihood that you may be together for some time.

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Skr
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June 10, 2016 at 8:01 PM ×

Agree Nico, and maybe some more of these...

https://youtu.be/H-7n7gyOpCE

Enjoy the weekend lads.

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Leftback
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June 10, 2016 at 9:10 PM ×

Thanks for the splendid goals, Skr, but couldn't help notice that they are almost all long speculative punts...
A lot of the time the important goals that win championships are scuffy little short efforts. Winning ugly.

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Skr
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June 10, 2016 at 10:17 PM ×

I get what you mean leftback, but sometimes you gotta just back yourself when you see the shot.
It's what separates the exceptional from the good.

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checkmate
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June 11, 2016 at 9:30 AM ×

http://www.advisorperspectives.com/dshort/updates/NYSE-Margin-Debt-and-the-SPX

Comments ?

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Bruce in Tennessee
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June 11, 2016 at 4:26 PM ×

Well, I think Gross's analogy of a supernova from NIRP is probably not exactly correct. I think of it more of a black hole. Sucks in money from all over, just because it is there. Not an explosion, just a massive vacuum.

With respect, I read CV's thoughts about only one direction for inflation, and that is up. After thinking about it for awhile, that is what happens if the CB's efforts are successful, but if our 8 year experiment with massive credit increases doesn't work the way Bernanke et al visualized then I could see deflation. Why? Because those not in the top 10% are thinking times are getting tougher. Even the big dogs are begging to put on new shorts, and times are certainly interesting. It may not be pushing on a string, it may be stretching a spring...

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washedup
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June 11, 2016 at 5:38 PM ×

@BinT - Supernova, Black holes - I can't believe that my twin passions, cosmology and global macro, have finally come together on the same blog.

FWIW I think you and CV are both correct, and here is the piece of string theory (!) that connects the concepts - the CB assumption/dogma has been that low interest rates inherently create deleveraging across balance sheets of various stripes via two channels, 1) accelerating productive investment that in essence creates its own end AD though multipliers, and 2)worker productivity growth outpaces worker compensation, which takes equity values up.

I think these assumptions worked reasonably well from the 1992 recession to the first half of the Bernanke era in 2013, partly because they got lucky and perhaps more importantly because demographics and worker profiles were still rather supportive. Now, temporarily or not, we are experiencing a mix of deflationary effects because of AD shortfalls, overcapacity, and debt, and inflationary effects on worker compensation due to productivity issues and skills mismatches - this tug of war was very common in the late 60's and 70's, and the general lesson fm that era is to expect a pretty wide range of valuations on both equities and bonds while basically not going anywhere. The turbulent politics of that time will, of course, also make a comeback if it hasn't already.

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Booger
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June 12, 2016 at 12:24 PM ×

Washed: I think QE and ZIRP are probably deflationary because they favor large corporations that can access the bond market. It is killing small businesses everywhere. Basically, it is very hard to compete against large corps buying out everything and operating with miniscule cost of capital when you are a small or medium enterprise. It also encourages overproduction and deflation everywhere from China to the U.S. That is a very long term thing and may take a long time to play out.

Movement in bonds is very interesting. I wonder if the frontrunning the ECB program and the squeezing of shorts is done yet and perhaps we see some pullback in bonds soon.

Brexit: a large short interest in GBP.USD is developing and so would be prone to a major squeeze if there is a remain vote. Then again if they do vote to leave, could fall ten handles so hard to play going into that. Options also very expensive.

Oil: hard to call here too but I tend to think the reflationary trades have a bit further to run for another month or 2.

Comm bloc: could well rise further, as the housing bubble in Canada, Australia and NZ are still going strong. Which will keep the central banks in those countries tied down in terms of further rate cuts in the next 3-6 months.

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Bruce in Tennessee
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June 12, 2016 at 2:47 PM ×

http://www.telegraph.co.uk/business/2016/06/11/why-record-low-interest-rates-are-a-cause-for-alarm-not-celebrat/

Hey, Washed, look what I found today in my readings:

"This has been an implosion rather than an explosion, more black hole than supernova."

Of course Jeremy doesn't give of the Schwarzchild radius for ZIRP and NIRP...perhaps there isn't one.

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Nico G
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June 12, 2016 at 7:57 PM ×

oh well

Hooliganism is back it seems

May they leave the EU

AND stop visiting our shores

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Anonymous
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June 16, 2016 at 3:51 PM ×

"Another factor for the calmness is that there is basically no liquidity to build sizable short position in CNH."

Don't know where you are shopping for your FX, but unless you need a nine-figure number of USD, you ought to be able to fill your bucket in a day without even breathing hard.

A few minutes ago, I saw on my trading platform 6.60125/6.60135 2mx1m (this in early European hours). Now, it has widened to two ticks (but is 2mx2m). That is pretty typical of what I see, though I don't concentrate much on this pair.

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