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Marc Chandler
GBP/USD, USD/MXN, USD/CAD

Sentiment surveys, while mostly still depressed, were better than April readings. The long slog back has begun. There was also optimism over several different vaccines that had been initiated or soon will begin human tests. The hope is that with regulatory forbearance, a vaccine may be ready by year-end.

At the same time, the US-China rivalry escalated. The novel coronavirus added a new dimension to the older problems. Restrictions on Huawei were tightened. Nearly three dozen Chinese entities were sanctioned for human rights violations. The US may tighten rules on foreign company listings on the US exchanges that may force the delisting of some Chinese-based companies. The Trump Administration is urging that the government pension fund does allow investments in Chinese stocks or bonds.

China continues to press hard. It has struck out at Australia for seeking an independent investigation into the origins of the coronavirus. It successfully blocked Taiwan from being granted observer status at the World Health Organization. Border tensions with India have seen troop movements on both sides. Beijing also signaled that it would insist on changes to Hong Kong’s Basic Law to give local officials greater authority to repress dissent spurring fresh concern. The US announced intentions to curb Hong Kong’s special trade privileges after the State Department questioned its autonomy.

March was when the markets froze up. Governments and central banks around the world began responding in earnest to the pandemic. The MSCI All Country World Index (ACWI) bottomed on March 23. So did the S&P 500, while Europe’s Dow Jones Stoxx 600 bottomed a week earlier (March 16), and the MSCI Asia Pacific Index recorded its low a couple of days later (March 19).

April was about further policy response. Efforts were increased in terms of size, scope, and/or time. Officials were successful in removing the far left-hand tail risk. Punishing volatility in the markets eased. Stress in the funding markets relaxed. The compression of demand, supply chain disruptions, the contagion in the US meat processing industry, and some peculiarities with the settlement of the deliverable futures light sweet crude oil contract, distorted the commodity prices. The negative oil prices were quickly reversed and were near $20 a barrel by the end of the month.

May was when the high-income economies likely hit a trough as many countries begin relaxing their lockdowns. Part of the rise in the price of some industrial commodities, including gasoline and iron ore, reflects a marginal improvement in demand. Of course, the difference between relaxing lockdowns and economic recovery may be quite stark, but the first thing that happens is that contractions slow and stop.

The lack of a strong EU response and a German Constitutional Court ruling made it more difficult for the ECB to keep the peripheral premium from widening over Germany and throwing a spanner into its transmission mechanism. However, the ECB is likely to expand its Pandemic Emergency Purchase Progam of bond-buying and is undeterred by the controversial court decision. The European Commission incorporated that German-French proposal for a 500 bln euro grant facility funded by EU bonds and the desire to appease several Northern European creditor nations, with a 250 bln euro loan facility.

Several countries in eastern and central Europe already had strained relations with Brussels, and they were put-off by all three camps without having been consulted. A unanimous decision is required and this may difficult to reach next month and investors can be expected to punish Europe by withdrawing savings on disappointment (i.e., selling the euro, equities, and peripheral bonds)

Some countries, central banks that have not adopted negative rates, are explicitly considering them. The Bank of England and the Reserve Bank of New Zealand are the leading contender but will likely explore other policy options first. The Bank of England is likely to expand its bond-buying program in June. Several facilities that the Federal Reserve announced are beginning to be formally launched, and this will continue into June.

The Federal Reserve has pushed back against speculation that it would adopt negative rates. Targeting a longer maturity than overnight fed funds is under consideration. In the market’s vernacular, this is called yield curve control.

Several political decisions will be made in June as well that could have a meaningful impact in the months ahead. These include whether UK Prime Minister makes good on this threat to leave the free-trade talks with the EU if there was no substantive progress by June, or will OPEC+ extend its deepest output cuts or begin relaxing them? In the United States, emergency unemployment benefits expire at the end of July. Will they be extended?

Dollar

The early survey data for May showed a definite improvement over April. While it is commonly recognized that the US economy will contract sharply in Q2, data needs set the stage for a recovery in Q3 to validate expectations. The capital markets have continued to stabilize, and this has seen the Federal Reserve taper its Treasury purchases to $5 bln a day down from $75 bln a day at its peak in late March and early April.

Fed officials have made it clear that there is little interest in adopting a negative target rate. Besides scaling its programs, a yield curve control strategy, which would entail targeting a longer-dated maturity in addition to the overnight fund’s rate, could be the next innovation. The Bank of Japan, for example, targets the 10-year bond, while the Reserve Bank of Australia targets the 3-year yield. We suspect that if the recovery disappointed for any reason, it could be adopted by late Q3. There is some risk that the US trade relations Hong Kong is adversely impacted, and exposed businesses should test contingency plans.

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Euro

The euro has remained rangebound against the dollar in May, and volatility has eased. Europe moves to center stage in June. First, the ECB meets on June 4 and is widely expected to increase its Pandemic Emergency Purchase Plan by 250-500 bln euros. The modest usage of the Pandemic Emergency Long-Term Refinancing Operation (less than one billion euros), some observers see the terms (-0.25 bp below the zero repo rate) could be made more attractive. Second, and not entirely unrelated, the ECB’s Targeted Long-Term Refinancing Operation, with a rate that could be as low as negative 100 bp if specific lending targets are met, could see strong demand of a billion euros or more.

The amount is likely to be inflated, but the rolling into the new facility some past operations that were made on less favorable terms. Third, the EU heads of state are expected to decide on the joint effort to promote economic recovery among competing proposals. A compromise between conflicting interests could prevent a unanimous decision and precipitate a crisis. Even if successful, a joint bond may not be the prelude to a fiscal union as partisans argue. The European Stabilization Mechanism and the European Investment Bank issue bonds that are collective obligations. Still, if Europe is the sum of its responses to the crisis, its collective action now is critical.

(end of March indicative prices, previous in parentheses)

Spot: $1.1100 ($1.0955)
Median Bloomberg One-month Forecast $1.1075 ($1.0925)
One-month forward $1.1110 ($1.0960) One-month implied vol 6.4% (6.3%)

Yen

The dollar-yen exchange rate was stable in May between JPY106 and JPY108. Violations were rare and shallow. Public support for Prime Minister Abe has fallen drop, and this may be invigorating plans for a JPY100 trillion (~$926 bln) economic relief package. The decline in energy prices, which Japan does not exclude from its core measure that the central bank targets, drove the core CPI back below zero in April. The BOJ expanded its corporate bond and commercial support efforts, but the gradual rise in equities allowed it to slow its ETF purchases in May. Interest rate differentials are also low and stable, leaving the broad risk appetites to be the main driver of the exchange rate.

Spot: JPY107.85 (JPY107.20)
Median Bloomberg One-month Forecast JPY107.60 (JPY107.10)
One-month forward JPY107.80 (JPY107.15) One-month implied vol 5.4% (7.1%)

Sterling

Nothing seemed to go in the UK’s favor in May, and sterling was dragged lower. Although sterling recouped some of its earlier losses that carried it to six-week lows in the middle of May (~$1.2075), it was still the weakest of the majors, depreciating nearly 2.75% against the dollar. The virus has hit the UK hard, and it is slower than many other countries to re-open. Several Bank of England officials have played up the possibility of adopting a negative target rate. It seems neither imminent nor inevitable. At the June 18 meeting, the BOE is more likely to increases is the bond-buying program by GBP100-GBP200 bln. Trade talks with the EU do not appear to be going particularly well, and this may also weigh on sterling.

Spot: $1.2345 ($1.2590)
Median Bloomberg One-month Forecast $1.2355 ($1.2375)
One-month forward $1.2345 ($1.2590) One-month implied vol 8.9% (8.6%)

Canadian Dollar

The combination of the risk-on attitude, reflected in the continued recovery of equities and the better supply/demand factor that lifted oil prices by 60% in May, underpinned the Canadian dollar. The US dollar fell to two-month lows in late-May near CAD1.3725. The Bank of Canada meets on June 3. There seems to be no urgency to adjust policy at Governor Poloz’s last meeting. Macklem will succeed him, but there is a strong sense of continuity. Headline CPI fell below zero in April for the first time since 2009, but this was driven by the drop in oil prices and exaggerates the deflationary pressure. Underlying measures remain steady. There appears potential toward CAD1.3500-CAD1.3600 if risk appetites remain strong.

Spot: CAD1.3780 (CAD 1.3945)
Median Bloomberg One-month Forecast CAD1.3810 (CAD1.4140)
One-month forward CAD1.3800 (CAD1.3945) One-month implied vol 6.9% (7.4%)

Australian Dollar

Since the end of March, the Australian dollar has been the best performing major currency, appreciating about 8.5% against the US dollar. Australian equities were also a significant beneficiary of the reflation-trade with the main benchmark up nearly 5% in May. The Federal Reserve had greater scope to approach the zero-bound than the Reserve Bank of Australia and this has resulted in the return of a normal relationship, where Australia offers an interest rate premium over the US.

Meanwhile, Australia’s push for an independent investigation of the origins of the coronavirus have earned it the ire of Beijing, with a high tariff (80%) levied on Australia’s barley exports to China and a ban on some beef. While China can find alternative supplies, the same cannot be said Australian’s iron ore (at least in the short-run), which may limit the fallout.

Spot: $0.6665 ($0.6510)
Median Bloomberg One-Month Forecast $.0.6575 ($0.6460)
One-month forward $0.6665 ($0.6510) One-month implied vol 10.8% (11.6%)

Mexican Peso

The Mexican peso was the world’s strongest currency in May, gaining nearly 9% against the US dollar. It still is off almost 15% year-to-date, making it the third-weakest behind the Brazilian real (~ -24.5%) and the South African rand (~- 19.5%). The shift in the peso’s fortunes is more the result of the broader risk environment than an improvement in Mexico’s economic or political outlook.

The calmer markets and the global liquidity encourages asset managers to re-establish positions to benefit from Mexico’s high real and nominal rates that they were forced to cut in the dark days in March. The peso also serves a proxy for many less liquid or accessible emerging markets currencies. The JP Morgan Emerging Market Currency Index rose about 3.7% in May, the best monthly performance in more than four years. The dollar has surrendered around half of this year’s gains against the peso. The momentum could carry toward MXN21.00-MXN21.50, depending on the broader environment.

Spot: MXN22.18 (MXN24.15)
Median Bloomberg One-Month Forecast MXN22.38 (MXN 24.10)
One-month forward MXN22.28 (MXN24.20) One-month implied vol 18.5% (19.6%)

Chinese Yuan

At the risk of taking Chinese macroeconomic data at face value, it does appear the economy is recovering. Nevertheless, more fiscal and monetary stimulus has been signaled. The year-over-year decline in producer prices warns that a profit squeeze is still materializing. As US-China tensions escalated, the dollar trended higher against the yuan. The dollar appreciated against the yuan for four consecutive weeks through the end of May. It is difficult to see how the tensions will ease in the coming months, especially given the US political cycle. In late 2019, the dollar rose to nearly CNY7.1850 and stopped just shy in late May.

However, given the tensions, the risk is for additional dollar gains, though tempered by China’s other objectives, such as deter capital flight and spur import substitution. In April, the Hong Kong Monetary Authority was intervening to stop the Hong Kong dollar from appreciating, which appeared to be in demand, given the interest rate pick-up. However, by the end of May, investors had become more concerned about the future of the peg that the forward points widened to the most in two decades.

Spot: CNY7.1365 (CNY7.0630)
Median Bloomberg One-month Forecast CNY7.1150 (CNY7.0620)
One-month forward CNY7.1350 (CNY7.0760) One-month implied vol 4.7% (4.3%)

For a look at all of today’s economic events, check out our economic calendar.

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