May Monthly

After generally trending higher in the first quarter, the dollar slumped in April.  An important leg of support was cut, as interest rates fell.  The 10-year yield slid by more than 20 bp at one point despite the unambiguous evidence that the economy was strengthening, and input prices were rising, not just stemming from comparisons with last year's depressed levels.  The implied yield of the December 2022 Eurodollar futures contract is lower than at the end of February. Yet, we expect the dollar to perform better in May and yields to rise.  

Growth was not rewarded broadly last month by the foreign exchange market. Three of the currencies we look at below, sterling, the Canadian and Australian dollars, which were among four top-performing major currencies in Q1, under-performed in April.  The Norwegian krone was the exception, and it was in the top three major currencies in April, rising almost 3%. The Norges Bank has indicated that it is prepared to hike rates toward the end of the year.  For its part, the Bank of Canada reduced its bond-buying in late April and brought forward by six months to H2 22 when its economic slack would be absorbed, which is understood as the timeframe of a rate hike.  The Bank of Canada's balance sheet has been shrinking since mid-March when the emergency lending facilities formally began winding down.  The Bank of England and the Reserve Bank of Australia may recalibrate their monetary policy in Q3.   

Neither the Federal Reserve nor the ECB meets in May, but the June meetings will be important.  We suspect it will be increasingly difficult for the Fed to justify $120 bln a month of bond buying indefinitely as the economy accelerates and a reasonable case can be made that the bar to tapering ("significant further progress" toward the Fed's targets) has been met.  The consensus at the Fed will begin fraying and some regional Fed presidents favor talking about tapering soon.  That said, given the uncertainties around the pandemic, fear of economic scarring, and the more patient stance reflected in targeting the average rate of inflation, the Fed may wait a bit longer.  Tapering could be hinted at the Jackson Hole confab in August or at the September meeting.    

The increase in ECB bond purchases starting in March will be reassessed at the June meeting.  It is difficult to consider the counter-factual, where yields would be if the ECB had not accelerated its bond-buying under the Pandemic Emergency Purchase Program.  What we do know is that European benchmark 10-year yields rose in April, and the premium offered by Italy over Germany rose by almost 15 bp. Still, barring a new negative shock, the ECB will likely slow the pace of its purchases.  Officials may be reluctant to call the exercise of its built-in flexibility "tapering". It will likely assure investors that strong monetary stimulus will continue and that PEPP runs through Q1 23.  

The EU's Next Generation (recovery fund) that will be financed by a common bond has not been ratified by all the members yet, overshooting a self-imposed deadline of the end of April.  Poland represents the chief hurdle now as a junior member of the governing coalition has balked.  Still, the most likely scenario is that the new facility begins distributing funds in Q3, coincidentally around the time that some US fiscal measures begin expiring and the US debt ceiling looms.  

European politics are moving into the spotlight.  The situation seems very fluid. In France, the shift is to the right, and although the national election is not until next year,  polls showing Le Pen ahead of Macron have made the news. Germany seems to be moving in the other direction, as recent surveys show the Greens may secure a plurality of votes. The CDU/CSU selection process was bruising. Some speculate that the Bavaria-based CSU could split from the larger CDU, but it may confirm that while the "realos" are in ascendancy among the Greens, the "fundos" have the reins in the CSU.  

UK local elections on May 6 are center stage. In some ways, it will serve as a referendum on the government's handling of the pandemic and Brexit.  The most important race is not for the Mayor of London. Khan will be easily re-elected.  The focus is on Scotland.  A majority of Scottish voters wanted to remain in the EU and the First Minister Sturgeon was credited with the handling of Covid.  Despite a split in the Scottish National Party, it appears that a majority of Scots now want independence.  If that is the result of the election, then a clash with Prime Minister Johnson is inevitable.  Wales is a traditional stronghold for Labour, and polls suggest it may hold on to 29 of the 60 seats.  However, the polls have not included 16 and17-year olds who will be allowed to vote for the first time.  

Japan has lagged Europe in rolling out the vaccine and four prefectures are formally in states of emergency, including Tokyo and Osaka. This will likely dampen the recovery from what is expected to have been a nearly 4% annualized contraction in Q1.  Prime Minister Suga has seen his support erode, and ideas of an early election have been dashed.  Suga insists on pressing ahead with the Olympics, which is also terribly unpopular.  There will be a leadership contest in the Liberal Democratic Party in September ahead of the general election that must be held by late October.  A supplemental budget may be delivered ahead of the election.

China's economy expanded at a modest rate of 0.6% in Q1, which was less than half of what economists had anticipated.  The early indications for April suggest the momentum has not picked up at the start of Q2.  Officials have moved to discourage banks from expanding lending, except to small businesses.  It is difficult to tell whether Beijing's anti-monopoly stance is truly about the concentration of market power or a crackdown on the private sector.  While China's voracious appetite for industrial metals may have been tempered, it apparently has stepped up its buying of soy, wheat, and corn.  China's buying amid tight supplies and challenging weather conditions in some key growing areas in the US and Brazil have seen prices rise to the highest levels in eight years. 

Emerging market currencies mostly gained against the dollar in April.   Eastern and Central European currencies, in the euro's orbit, as a whole did best. The Turkish lira was an exception.  Its small decline brought the year-to-date loss to around 10.3, after around a 20% drop last year.   Rising grain prices did the Argentine peso few favors.  With its nearly 1.7% decline in April, it was the weakest among the emerging markets. It is off 10% so far this year.   The public health tragedy that continues to unfold in India, sapped the rupees strengthen, and darkened the economic outlook. It recovered in the last week of April as international assistance was offered.  The 1.3% losses in April followed a nearly flat performance in Q1 when it was the best performing emerging market currency.    

The Bannockburn World Currency Index, a GDP-weighted basket of the top 12 economies (with the eurozone counting as one) rose by a little more than 1.1% in April, the first monthly gain of the year and nearly offsetting the March decline in full.  This reflected the US dollar's heavier tone after broadly trading higher in Q1 after its slide accelerated in the last two months of 2020.  The Indian rupee was the only currency in our index to have fallen against the dollar.  The Brazilian real's nearly 3.5% gain was the best performer.  The larger than expected 75 bp rate hike in mid-March (lifting the Selic rate to 2.75%) and progress on the budget helped the real pare the 7.7% decline in Q1.  With inflation pushing above 6%, the central bank is expected to lift the Selic rate another 75 bp when it meets on May 5.  

Dollar:  The dollar trended lower in April. The Dollar Index rose in nine sessions of the 22 sessions in the month.  The retreat was likely corrective after rallying in Q1. Yields softened too. About 18 hours after the Federal Reserve Chair said that it was too early to "talk about talking about tapering" the $120 bln of bonds it is buying a month, the US reported that in nominal terms, the economy expanded by 10.5% in Q1. The economy is surging and nonfarm payrolls likely rose by around a million in April after an almost 920k increase in March. Efforts to legislate the Biden Administration's Job and Family initiatives with their accompanying progressive tax increases will likely take several months.  In the Senate, conservative Democrats may prove to be more effective than Republicans in moderating the proposed expenditures and revenues.  After the April slide, the technical indicators warn that the greenback is oversold.  The strength of the bounce may be shaped by the trajectory of US yields.  

Euro:  After falling for each month of the first quarter, the euro traded higher in April. The pullback in US yields and some position adjustment helped the euro find better traction. In the larger picture, the euro's pullback in Q1 may be seen as a correction to last year's rally.  That correction may not have been completed and the April bounce stalled around where it had to for the view to hold.  Momentum indicators are stretched and recognizing the importance of initial conditions, we see potential toward the 200-day moving average of around $1.1950. The vaccine rollout is improving, and this promises to lift growth going forward.  Barring a new shock, at the June 10 ECB meeting, the staff will upgrade its growth forecasts, and this may be sufficient cover to ratchet down the bond purchases from the accelerated pace in Q2. Still, the ECB will argue that conditions continue to require extraordinary levels of monetary support.  The national ratification of the EU's Recovery Fund may be more protracted than desirable, but it will likely be able to begin making distributions in Q3. 

 

(end of March 2021 indicative prices, previous in parentheses)

 

Spot: $1.2020  ($1.1730)

Median Bloomberg One-month Forecast $1.2010 ($1.1830) 

One-month forward  $1.2025 ($1.1735)    One-month implied vol  5.3%  (5.8%)    

 

 

Yen:  The dollar's 1.3% decline against the yen needs to placed in the context of its nearly 4% drop in March, the biggest monthly advance since the 9.2% gain in November 2016. Rising US interest rates seemed to be the most important driver, though Japanese investors' appetite for foreign assets seemed to have been dampened by the weaker yen. The dollar pared its losses against the yen as the US 10-year yield rose.  In February, speculators in the futures market began trimming the net long yen position in the futures market.  The move accelerated in March and swung to the largest net short position in more than a year, where it remained through late April.  The formal emergency in Tokyo and other areas in the first part of the year, a fire at a semiconductor chip factory, and a powerful earthquake point to a possible contraction of 4%-5% in Q1 before a rebound in Q2.  The third formal emergency in Tokyo and three other prefectures runs through May 11.  While the JPY109.60-JPY110.00 may offer stiff resistance, rising US rates could lift the dollar back to the late March high around JPY111.00.

 

Spot: JPY109.30 (JPY110.71)      

Median Bloomberg One-month Forecast JPY108.60 (JPY109.30)     

One-month forward JPY109.00 (JPY110.65)    One-month implied vol  5.5% (6.4%)  

 

 

Sterling:   The vaccine rollout is keeping the UK on track to allow a full economic re-opening on June 21.  The recovery seems to be taking hold, though the extensive government support may conceal the scarring. The social restrictions in the first part of the year warn that the UK economy likely contracted in Q1 (GDP due May 12) by as much as 2% quarter-over-year.  However, the high-frequency data suggest the upside momentum is building.  The Bank of England will likely recognize this and the fiscal stimulus, which will boost its confidence in a vigorous economic rebound.  Although it will standpat, in May, we suspect it could taper the bond purchases in Q3.  Local elections are on May 6, and it will be partly be seen referendum on the government's handling of the public health crisis.  At the same time, a strong showing by the nationalists in Scotland will hasten the confrontation with Britain over a formal referendum. . Sterling rallied about 10.75% from early last November (~$1.2855) through late February (~$1.4235).  It consolidated mostly in $1.3670-$1.4000 trading in March and April, and its attempt to push through the top was again rebuffed.  This warns of the likelihood of a test on the lower end.    

  

Spot: $1.3820 ($1.3780)   

Median Bloomberg One-month Forecast $1.3860 ($1.3825) 

One-month forward $1.3825 ($1.3785)   One-month implied vol 6.9% (7.0%)

  

 

Canadian Dollar: Between the fiscal support of Ottawa and Washington, the Bank of Canada became the first G7 bank to announce a slowing of its bond purchases (to C$3 bln a week from C$4 bln), with an eye toward ending them,  and brought forward by six-month to mid-2022 when it projects that the economic slack will be absorbed.  This, in turn, encourages the market to price in a rate hike late next year.  Canada's two-year yield is near 30 bp, only behind Norway among the high-income countries.  Meanwhile, the government's fiscal support remains strong, with over C$100 bln for new initiatives, including childcare, which will likely also serve as a re-election platform for the minority government.  The trajectory of the policy mix is support for the Canadian dollar, which strengthened for the third consecutive month in April.  Much good news has been discounted, including three rate hikes by the end of 2023, but the policy mix often leads to currency overshoots, and the OECD's model of Purchasing Power Parity has the Canadian dollar undervalued by 2.5%.    

 

Spot: CAD1.2290  (CAD 1.2565) 

Median Bloomberg One-month Forecast  CAD1.2400 (CAD1.2575)

One-month forward CAD1.2300 (CAD1.2560)    One-month implied vol  6.2%  (6.6%) 

 

 

Australian Dollar:  The Australian dollar rallied strongly on the reflation meme that began in earnest in early last November and peaked in late February a little above $0.8000.  It has spent the last two months confined mostly to a $0.7600-$0.7800 trading range. The range was frayed on an intraday basis but did not close outside of it a single time in April. The risk in at least the first part of May seems to be on the downside, which may extend toward $0.7500.  The central bank could taper its quantitative easing and yield curve control in Q3  A rate hike looks largely discounted for Q3 22.  A full third of Australia's exports are shipped to China, yet the strategic interests diverge.  Canberra recently canceled two projects in Victoria under the auspices of China's Belt Road Initiative.  This will further antagonize the strained relationship.  

Spot:  $0.7715 ($0.7600)       

Median Bloomberg One-Month Forecast $0.7705 ($0.7635)     

One-month forward  $0.7720 ($0.7605)     One-month implied vol 8.6  (9.7%)   

 

 

Mexican Peso:  After falling at the start of the year, the peso trended higher since early March, but the recovery ended abruptly in late April. Two of the three legs on which the peso stood weakened. The large trade surplus swung into deficit in March, and its interest rate appeal slackens as other emerging market countries begin a tightening cycle (e.g., Brazil, Russia), the high-income countries seem around peak easing in aggregate. Rising price pressures and an economy proving resilient (Q1 GDP 0.4% quarter-over-quarter and was forecast to have stagnated) will prevent Banxico from resuming its easing cycle, and that also changes the outlook for Mexican bonds for fund managers. In contrast, Brazil's central bank meets on May 5 and it is likely to deliver its second consecutive 75 bp rate hike, which would lift the Selic rate to 3.50%.  A move above the MXN20.50 could signal a test on MXN21.00.

 

Spot: MXN20.2460 (MXN20.4415)  

Median Bloomberg One-Month Forecast  MXN20.3820 (MXN20.4350)  

One-month forward  MXN20.3150 (MXN20.5115     One-month implied vol 12.5% (14.8%)

  

 

Chinese Yuan:  The yuan will take a four-week advance in tow, but it will likely be broken at the start of the new month if we are right about that the dollar will take on a better tone. The yuan's 1.2% gain in April represents a middling performance in the region and among emerging market currencies more broadly, though it matched the gain of the JP Morgan Emerging Market Currency Index.  Chinese officials are withdrawing fiscal support by discouraging increases in lending (banks) and borrowing (local governments), but it does not appear to be considering a rate hike. Chinese regulators have toughened their stance toward the large new economy companies, which are not coincidentally in the private sector.  This may have a cooling-off effect.  Three months into the Biden administration and there does not appear to be any improvement in the bilateral relationship.  At the same time, China's aerial harassment of Taiwan is unabated, keeping the geopolitical tension elevated.   

 

Spot: CNY6.4750 (CNY6.5530)

Median Bloomberg One-month Forecast  CNY6.4885 (CNY6.5140) 

One-month forward CNY6.4900 (CNY6.5760)    One-month implied vol  4.7% (5.0%)

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