Started by PocketOption, Jun 05, 2023, 09:09 am
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June is a pivotal month. The US debt-ceilingpolitical drama cast a pall over sentiment even if it did not prevent thedollar from rallying or the S&P 500 and NASDAQ from setting new highs forthe year. It is as if the two political parties in the US are playing a game of chickenand daring the other side to capitulate. Both sides are incentivized to take tothe brink to convince their constituents that they secured the best dealpossible. No side seems to really want to abolish the ceiling because it hasproven to be an effective lever for the opposition to win concessions over theyears. Still, a higher debt ceiling and some reduction in spending in the FY24budget are the middle ground.
Many think that this time is different. The partisanship, they say, is soextreme that a default is possible. They can point to severe distortions inthe T-bill market and the elevated prices to insure against a US default(credit default swaps). Neither side can be sure it will not be blamed for a default's expected and unexpected consequences. The risk of playingchicken is that neither driver swerves at the last minute. There are only downside scenarios in a default situation, even if it lasts for a shortterm and no bond payment is missed. On the other side of the debt ceiling, billissuance will rise, and the Treasury will rebuild its account held at theFederal Reserve. This could drive up short-term rates and reduce liquidity.
In additionto fiscal policy, a monetary policy drama is also playing out. TheFederal Reserve began hiking rates in March 2022, and at the May meeting, ChairPowell indicated that a pause was possible. Although he made it clear that itwas not a commitment, the markets saw the quarter-point move as the last. However, a combination of stronger economic data, sticky price pressures, and some hawkish comments saw the pendulum of expectation swing toward a hike at the June 13-14 meeting (60%). Moreover effective Fed funds rate (weighted average) is about 5.08%, and themarket-implied year-end effective rate is around 5.0%. It was near 4% as recently as May 4, which illustrates the extent of the interest rate adjustment. Even if the Fedstands pat in June, we expect Chair Powell to validate market expectations thatanother hike will likely be forthcoming (July).
Therecontinue to be worrisome economic signs in the US, including the inverted yieldcurves, the precipitous decline in the index of Leading Economic Indicators, anoutright contraction in M2 money supply, the tightening of lending standards,and a reduction in credit demand. However, at the same time, despite someslowing, the labor market is strong, with an improvement in prime working-ageparticipation. Consumption rose by 3.7% in Q1 and appears off to a good startin Q2, with stronger auto and retail sales in April. Supply chain disruptionshave improved, shipping costs have receded and are back within the 2019range. The Atlanta Fed's GDP tracker sees growth of 1.9% in Q2, near the Fed'snon-inflation speed limit of 1.8% and though a bit faster than Q1 (1.3%).
Anotherdrama that has unfolded is the stress on US banks. Banks with increasing low-yielding assets did not offer competitive interest rates withprime money market funds (only invest in US government/agency paper) and the USbill market itself. While the banking system lost deposits, several of thelargest banks reported increased net interest income. However, even afterthe deposits at small banks stabilized, pressure continued on their shares.That selling pressure seemed to be exhausting itself. June may be a pivotalperiod for this drama too. Still, many regional banks are exposed to thecommercial real estate market, which is under pressure.
Europeavoided a tragic winter energy crisis, but the drama is that inflation isproviding sticky, and the regional economy looks as if it stalled at the end ofQ1. Indeed, revisions show that the German economy contracted 0.3% in Q1after a 0.5% contraction in Q4 22. The eurozone and UK economies expanded by0.1% quarter-over-quarter in the year's first three months. The eurozoneand UK appear stuck in low gear, but the market is confident of quarter-pointhikes by the European Central Bank and the Bank of England in June.
Japan has adrama of its own. The Bank of Japan is under new management, but it turns outthat its extraordinary policy was not simply a function of former GovernorKuroda's idiosyncrasies. Several surveys of market participants saw June/Julyas the likely timing of an adjustment in the policy settings. However, GovernorUeda's call for patience suggests little sense of urgency, and someexpectations are being pushed out to the end of Q3. The recent history oflifting interest rates or currency caps suggests a dramatic market responseeven under the best circumstances. Still, the best time toadjust the cap on the 10-year bond is when it is not being challenged. The BOJis the last of the central banks with a negative policy rate. This isincreasingly difficult to justify. The swaps market is not pricing in apositive rate until early in the second half of the fiscal year, which beginson October 1.
Geopoliticsare always dramatic. It seems clear that US officials, including PresidentBiden, had recognized that bringing NATO to 's border was provocative.After relatively mild responses to 's invasion of Georgia and the takingof Crimea, the reaction to last year's invasion of e is a big shock to nearlyeveryone. The US has led a coalition that has stymied by arming e with weapons, training, money, and intelligence.
Initially, China appeared to be a net loser of 's invasion. NATO is stronger.US leadership was again demonstrated. Parallels between e and Taiwan weredrawn ubiquitously. There has been a rapprochement between South Korea and Japan,and both are boosting military spending. The US secured new bases in thePhilippines. However, China is finding its own opportunities.
Just as theUS thinks is in a quagmire, China may think it has the US in one.President Biden has cast the defense of e as the frontline of the battlebetween democracy and authoritarianism. However, American public support is notparticularly strong, and continued unlimited support may become a politicalissue in next year's election. Meanwhile, China has moved into the vacuumcreated by the US and European sanctions. China has secured into itssphere of influence, which Beijing could not have dreamed of before theinvasion. Using the swap lines with the PBOC has allowed several developing countries to pay for imports from China. It is similar toproducer-financed sales in market economies. China is exploiting niches that the US and Europe have created purposefully or otherwise. Even taking intoaccount the problematic debt that has arisen from the Belt Road Initiative, itis creating and solidifying a trade network that may be of increasingimportance to China going forward.
The sharprise in interest rates in May made for a challenging time for risk assets.Equity indices for developed and emerging market economies fell in May, butthere were notable exceptions. The S&P 500 and NASDAQ rallied to new highsfor the year. Germany's DAX and French CAC set record highs, while Japan'sTopix and Nikkei reached their best levels since 1990. Among emerging markets, Brazil (~6%), Chile (~4%), Poland (~3%), Hungary (~6%), Taiwan (~6%), andSouth Korea (~2.3%) are notable exceptions.
Emergingmarket currencies mostly fell in May. The JP Morgan Emerging Market CurrencyIndex fell by 1.3% after slipping about 0.35% in April. It is the firstback-to-back monthly decline since a four-month drop in June through September lastyear. It is essentially flat on the year. Latin American currencies continue tostand out. They accounted for four of the top five emerging market currenciesin May: Colombia (~5.1%), Mexico (~1.9%), Peruvian sol (~1.0%), and Chile (~0.4%). The South Korean won was the exception; its 1% gain put it inthe top five.
BWCI bottomed early last November near92.80, confirming the dollar's top. It rallied into early February to peak near98.15. The decline into March retraced about half of the rally, while theyear's low set in late May (~95.25) is within 0.75% of a critical area. This isconsistent with our base case that while there may be some scope for additionaldollar gains, it looks limited as the interest rate adjustment also appears to be complete or nearly so. In our analysis of the different currencies below, wehave tried to quantify where the base case breaks down.
Dollar: Theinterest rate adjustment, where the market converges to the Fed rather than vice versa, and the knock-on effect of supporting the US dollarunfolding broadly aligns with the view sketched here last month. The two-yearyield rose by around 65 bp in May to about 4.65%, the highest since mid-March.The year-end policy rate is near 5% rather than 4.5% at the end of April. Wesuspect that the interest rate adjustment is nearly complete, helped by whatwill likely be slower economic growth after the rebound in Q2. The growthprofile may be almost a mirror image of 2022. Then, the economy contracted inH1 and rebounded in H2. This year, the economy appears to have grown near trendin H1 and looks set to slow in H2. The odds of a Fed hike on June 14 were around 65% before the Memorial Day holiday (May 29), and it is fully discounted for the July meeting. The Fed's economic projectionswill be updated. The 0.4% median forecast for growth at the March meeting seemstoo low and will likely be increased. At the same time, the 4.5% year-endunemployment rate seems too high. Unemployment was at 3.4% in April. The median forecast bringit down a bit. The debt ceiling wrangling does not put the US in the bestlight, but barring an actual default, it will not have lasting impact. Outsideof the T-bill market and the credit-default swaps, investors took this peculiarAmerican political tradition in stride. Our working hypothesis has been thatthe dollar was going to "correct" the selloff that began in earlyMarch as the bank stress struck. In the last full week of May, the Dollar Indexexceeded the retracement target near 104.00. A move above the 104.70 area wouldsuggest potential back toward the 200-day moving average (~105.75) and theMarch high near 106.00. A break below the 103.00 area would suggest a high maybe in place.
Euro: Eurozonerates could not keep pace with the dramatic swing higher in the US. Germany'stwo-year yield rose by about 20 bp in May, less than half what the USexperienced. Yet, the euro's roughly 2.75% decline in May was not only a dollarstory. The proverbial bloom came off the rose. The fact that with a combinationof preparedness and good luck (low oil/gas prices and a mild winter), theeurozone avoided an energy crisis. The positive economic impulses carried intoFebruary, but by the end of March, economic growth stalled, or worse. After asecond look, Germany contracted by 0.3% in Q1 (initially estimated at zero)after a 0.5% decline in economic output in Q4 22. The European Central Bankstarted later than most G10 countries to begin adjusting monetary policy, andinstitutional rigidities may make price pressures more resistant. The ECB meetson June 15 and the market is confident of a quarter-point hike that would liftthe deposit rate to 3.50%. The staff will also update its economic forecasts. Theterminal rate is seen at 3.75% in late Q3 or early Q4. On June 28, Europeanbanks are due to pay back the ECB around 475 bln euros of loans (TargetedLong-Term Refinancing Operations). They account for around 6% of the assets onthe ECB's balance sheet and almost 45% of the outstanding TLTRO loans. Thesheer magnitude of the maturity could prove disruptive, and some banks may lookto find replacement funding. The ECB's balance sheet has been reduced by about3% this year and the repayment of the TLTRO would do more with a single blow. Recallthat end of the of last year, European banks returned almost 492 bln euros. Theeuro overshot our $1.0735 objective. We suspect the euro's downside correctionis nearly over, but a break of the $1.0680 area may signal losses back to theMarch low near $1.05. (May 26, indicative closing prices, previous in parentheses) Spot: $1.0725 ($1.1020)Median Bloomberg One-month Forecast $1.0890 ($1.0960)One-month forward$1.0740 ($1.1040) One-monthimplied vol 6.8% (7.5%) JapaneseYen: Rising US rates seemed to have dragged the greenback higheragainst the Japanese yen. The gains in May took it a little through JPY140, thehighest level since the end of November, and beyond the halfway marker of thedrop from last October's high near JPY152. Just as there may be some more roomfor the US 10-year yield to climb above 3.80%, there may be scope for thedollar to rise further against the yen. The next important chart area is aroundJPY142.50. Underlying price pressures in Japan continue to rise, and theweakness of the yen only adds to the pressure on the BOJ to adjust its monetarysettings. The economy expanded by 0.4% in Q1, well above expectations, and in lateMay, the government upgraded its monthly economic assessment for the first timein ten months. Several surveys found many see a window of opportunity in Juneor July for the BOJ to adjust monetary policy. Most of the speculation hasfocused on yield-curve-control (YCC), which caps the 10-year yield at0.50%. We do not think it will be abandoned entirely, and targeting ashorter-dated yield may be considered. It could lift the overnight target rateto zero from -0.10%. If experience is any guide, when it comes, the timing willlikely surprise, and it is bound to be disruptive. It will likely weaken thecorrelation between the exchange rate and US yields. Lastly, there is much talkabout a snap election in Japan over the summer as Prime Minister Kishida looksto secure his mandate and support for him, and the cabinet has risen recently.He hosted the G7 summit and brandished leadership. Politically, it may be themost opportune time before September 2024 LDP leadership contest, while theeconomy is relatively strong, the stock market is near 30-year highs, and he isperceived favorably.
Spot: JPY140.60 (JPY136.30) Median Bloomberg One-monthForecast JPY133.45 (JPY133.05)One-month forwardJPY139.95 (JPY135.75) One-month implied vol 10.8% (9.5%) BritishPound: May was a month of two halves for sterling. In the first half ofthe month, it extended its recovery off the for the year set on March 8 near$1.1800. Sterling peaked on May 10 at around $1.2680, its best level since June2022 and an impressive recovery from last September's record low of about $1.0350.In the second half of May, sterling trended lower and fell back to almost $1.2300.Our base case is that the move is nearly over, with the $1.2240 area likely tohold back steeper losses. However, if this area goes, another cent decline ispossible in this benign view. Stubborn inflation and a firm labor market haveproduced a dramatic interest rate adjustment in the UK that may lend sterlingsupport. The year-end policy rate is seen above 5.50%. This is a 70 bp increasesince the middle of May. The two-year and 10-year Gilt yields were mostly flatin the first half of May and soared around 75 bp in the second half. The10-year breakeven (the difference between the inflation-protected security andthe conventional bond) rose a little more than 10 bp in the last couple ofweeks. The Bank of England meets on June 22, the day after the May CPI ispublished. The market is debating whether a 25 bp or 50 bp hike will bedelivered. We lean toward the smaller move unless the incoming data surprises.
Spot:$1.2345 ($1.2565) Median Bloomberg One-monthForecast $1.2400 ($1.2480) One-month forward$1.2355 ($1.2575) One-month implied vol 8.0% (7.6%) CanadianDollar: The Canadian dollar fell by about 0.60% against the US dollar inMay, making it the best performer in the G10. The Swiss franc was second withtwice the loss. After testing April's low (~CAD1.3300) in early May, the USdollar recovered and set the month's high (~CAD1.3650) in late May. While interestrate developments can help explain the broader gains in the greenback, theexchange rate with Canada seems to be more sensitive lately to the general riskenvironment (for which we use the S&P 500 as a proxy) and oil. The price ofJuly WTI collapsed from around $76.60 at the end of April to a little below $64on May 4. It worked its way back up to almost $75 on May 24 before stalling.There has been a significant interest rate adjustment in Canada over the lastfew weeks. The 2-year yield rose by nearly 60 bp. At the end of April, themarket was pricing in a cut before the end of the year and now it is fullydiscounting a hike. The Bank of Canada meets on June 6. The swaps market has a 33% chance of a hike and a hike is fully discounted by the end of Q3. At the end of April, a June hike wasseen as less than a 10% risk. A move above CAD1.3700 could signal a return tothis year's high set in March near CAD1.3860.
Spot: CAD1.3615 (CAD 1.3550) Median Bloomberg One-monthForecast CAD1.3405 (CAD1.3475)One-month forward CAD1.3605 (CAD1.3540) One-month implied vol 6.0% (5.8%) AustralianDollar: The surprising quarter-point hike by the Reserve Bank ofAustralia saw the Australian dollar fray the upper end of the $0.6600-$0.6800range that has dominated since late February. Disappointing employment data,concerns about the pace of China's recovery, and the sharp selloff of the NewZealand dollar (following the central bank's hike that could be the last one)weighed on the Australian dollar. It recorded the lows for the year slightlybelow $0.6500. There is little meaningful chart support ahead of $0.6400, but amove back above $0.6600 would suggest a low is in place. The squeeze on households can e expected to increase in the coming months as mortgages taken on in the early days of the pandemic will begin to float at higher rates. The RBA meets on June6 and there seems to be little chance of a hike, though the market is notconvinced that the tightening cycle is finished. A small hike (~15 bp) ispossible in Q3. The first estimate of Q1 GDP is due the day after the RBA meeting, but we assume officials will have some inkling. Although there is some talk of the risk of a contraction, it likely grew slowly.
Spot:$0.6515 ($0.6615) Median Bloomberg One-monthForecast $0.6785 ($0.6710) One-month forward$0.6525 ($0.6625) One-month implied vol10.3% (10.1%)
MexicanPeso: Between the central bank's pause and the broader dollar'sstrength, the peso fell on profit-taking after it reached a new seven-yearhigh in the middle of May. However, the considerations that have driven ithigher remain intact, suggesting its high is not in place. Those forces includethe attractive carry (11.25% policy rate) and a relatively low vol currency(especially among the high-yielders), the near-shoring and friend-shoring thathas seen portfolio and direct investment inflows, and, partly related, thehealthy international position, with record exports and stronger workerremittances. The dollar fell to almost MXN17.42 in mid-May and its bouncestalled near MXN18.00. A break of the MXN17.60 area may signal a retest of thelows, but in the medium term, there is potential toward MXN17.00. WhileMexico's government has not facilitated an investor-friendly environment, themarket appears to be rewarding the strong and independent central bank andSupreme Court.
MedianBloomberg One-Month Forecast MXN18.1675 (MXN18.26)
Spot: CNY7.0645 (CNY6.9185)Median Bloomberg One-month Forecast CNY6.8625 (CNY6.8570) One-month forward CNY7.0500 (CNY6.9060) One-month implied vol 5.4% (4.9%)
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