Three Questions: Week of April 18

Good morning, and welcome to Three Questions - a look at the big uncertainties facing currency markets in the week ahead.

Here are some of the things we're watching: 

1. What will Sunday’s French presidential election mean for the euro?

The second round between President Emmanuel Macron and hard-right challenger Marine le Pen carries asymmetric risks for currency markets. A Macron win could give the single currency a modest boost, but an upset would see asset market volatility soar and the euro dive against the dollar, Swiss franc and British pound.

With Macron picking up support on the centre and left and polling 6 to 10 points above his opponent, betting markets put 90 percent odds on his regaining the presidency. 

But anything that moves the odds in le Pen’s favour will impact sentiment, making Wednesday’s debate a key signpost for financial markets. Her poor performance in 2017 helped lead to a 66-34 rout, so the barest appearance of competence could make investors jittery.

A second Macron term would mean relatively coherent leadership across Germany, France, and Italy and accelerate centralized responses to the European Union’s challenges on defence, energy, the environment, and technological competitiveness. A bigger role for targeted fiscal policy would give the bloc and markets confidence that monetary policy is not the sole support for Eurozone growth. But such changes would take time.

Conversely, even if le Pen longer wants France to leave the euro, her sovereigntist positions on the single market, free movement of labour, the Commission, and the European Court of Justice could make the EU’s governance structure unworkable. And once the consequences become apparent, the European Central Bank might  prove reluctant to calm bond markets, given that it has long said it will only act against unwarranted threats to monetary transmission.

In short, while not the base case, markets face a tail risk.

In couplet form:

Even short of Frexit,

Maybe le Pen still wrecks it.

-  KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

2. Could Japanese authorities step in to arrest the yen’s decline?

The Japanese yen fell to a twenty-year low against the dollar last week, generating hundreds of headlines in the financial press, driving pundits to issue near-apocalyptic forecasts, and drumming up chatter in markets about the need for government action to stabilize the currency. 

We think the currency's decline is well-justified and could extend further, given fundamental shifts in the Japanese economy and the yen’s changing role in global financial markets - but we also think the move will soon reach its logical limits, rendering official intervention unnecessary. 

With core price deflation stalking the economy, the Bank of Japan’s commitment to “yield curve control” - in which it keeps interest rates anchored near zero - stands in sharp contrast with central banks elsewhere. Rate differentials have widened, pulling capital into international markets. 

The country’s dependence on imported energy has grown since the 2011 Fukushima meltdown forced many reactors into shutdown. A spectacular post-pandemic rally in oil and natural gas prices has seen import costs climb at a historic rate, reversing net trade-related currency flows. 

Japan remains the world’s largest creditor, with a net international investment position other countries can only envy. But with household savings rates turning negative and the corporate sector showing an increasing unwillingness to liquidate foreign assets during recent crises - like the onset of the coronavirus pandemic - the yen’s reputation as a safe haven has suffered. During episodes of global turmoil, the dollar and euro have exhibited haven-like characteristics, and speculators have become less confident in following Japanese money home. 

A move down to 130 - or even 135 - is not out of the question, particularly if policymakers stay on the sidelines. Finance minister Shunichi Suzuki called the yen’s decline “very problematic” last week and yesterday, central bank governor Haruhiko Kuroda said the move had been “very rapid”, but jawboning efforts have been more subtle than those seen ahead of previous intervention cycles. Historically, policymakers prepared markets for action by claiming that exchange rate moves had become “one-sided” or “disorderly”, and that the yen’s value had become disconnected from fundamentals.

Although speculative pressure has increased, carry trade activity remains well below the levels that prevailed in the mythical Mrs. Watanabe’s heyday - when yield-hungry Japanese households placed huge bets on the Aussie, Brazilian real, and US dollar, among others. Margin trading at such scale has become more difficult, but to us, this also might reflect a lack of durable potential in today’s commodity rally - prices are already falling as heavily-discounted raw materials make their way out of Russia and Ukraine, and no long-term demand shock comparable to the emergence of China looks likely to unfold. 

If energy prices continue to fall, the country’s current account could swing back toward surplus. If global inflation fears subside in the coming months, long-term US rates could fall - narrowing interest differentials. If the financial cycle begins to turn, investors could once again prize Japan’s relative invulnerability to a funding crisis. 

And if we’re right, a deceleration in the yen’s slide could signal the emergence of a new regime in global markets - one in which participants begin to abandon the ‘strong growth, high inflation, long commodity, and short bond’ framework that has dominated activity since mid-2021. 

Tomorrow might dawn - as it so often does - in Japan first. 

-  KARL SCHAMOTTA, CHIEF MARKET STRATEGIST

3. Will Latin American currency outperformance continue?

Most likely not.

Defying the risk-off themes of rising interest rates and geopolitics, South America’s currencies have outperformed this year, boosted by perceptions of the region as a “safe” source of grain and metals that will benefit from supply outages in Russia and Ukraine.

However, shocks to supply have consequences for demand. A Fed bent on cooling an overheated US economy, wobbles in China, and the politics of inflation within the region are likely to halt or turn the currency trend. A reversal in performance this month suggests the process has already started.

The International Monetary has warned that its outlook due this week will project a sharp slowing of global growth, which does not bode well for broad commodity demand. Nor does a Fed determined to check inflation, hoping for a soft landing, but seemingly prepared to risk a hard one. The intensification of lockdowns under China’s Covid-zero strategy represents another threat to raw material demand.

While commodity price rises help South American exports, the region faces economic and political consequences from slowing growth and falling real incomes. Peru has seen urban riots that threaten President Pedro Castillo. Chile’s central bank has warned that a constitutional provision to allow accelerated pension fund withdrawals could exacerbate both price pressures and rate hikes. And in Brazil, hopes that inflation and the tightening cycle would peak soon are ebbing. Historically, the real has tended to do better when rates are high but falling - reflecting preoccupations about growth and debt dynamics.  

It was good while it lasted, but the contradictions in Latin American currency performance are about to come to the fore.

-  KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

CATALYSTS

MONDAY

AUD Reserve Bank of Australia, Meeting Minutes

WEDNESDAY

CAD Teranet Home Price Index, March

CAD Consumer Prices, March

USD Department of Energy Weekly Inventories

USD Federal Reserve Beige Book

THURSDAY

USD Weekly Jobless Claims

FRIDAY

CAD Retail Sales, February

USD Baker Hughes Weekly Rig Count

COUNTERPARTIES

“In 2010, the United States owed the rest of the world $2.5 trillion, a sum equal to 17 percent of U.S. GDP. By early 2020, those liabilities had risen to $12 trillion, or well over 50 percent of GDP—a threshold that has often triggered currency crises in the past. They now stand at $16 trillion, or 70 percent of GDP.”

Foreign Affairs: Emerging Markets Are the Next Comeback Nations

“China shows little interest in giving up the micromanagement of its economy by pegging its currency to commodities it cannot control. There is a reason the gold standard failed. Pegging a currency to a commodity ties one hand behind a central bank’s back in terms of supporting growth or leaning against inflation.”

Financial Times: King Dollar Is in No Danger of Losing its World Financial Crown

“Individual multiple-property owners hold a significant share of the residential property stock, despite accounting for a relatively small number of owners. In Nova Scotia, New Brunswick, Ontario, and British Columbia in 2020, these owners held between 29% (British Columbia) and 41% (Nova Scotia) of the property stock while accounting for 15% (British Columbia) to 22% (Nova Scotia) of owners.”

Statistics Canada: Canadian Housing Statistics Program, 2019 and 2020

“This pattern is so common, especially with gas prices, that economists have a pet name for it: rockets and feathers. When crude prices jump, pump prices tend to rise like a rocket. But when crude prices fall, pump prices tend to descend gently, like a feather.”

Chron: Why Gasoline Prices Remain High Even as Crude Oil Prices Fall

“Clean power generated in oceans and prairies needs some way to get to the urban areas where most Americans charge their phones and run their dishwashers. That journey often puts it in conflict with wildlife and landscape conservation goals, as well as with locals alarmed at the prospect of development encroaching into open spaces or on their property rights.”

Bloomberg: The Clean-Power Megaproject Held Hostage by a Ranch and a Bird

“India is perhaps the most inconvenient of the serial abstainers from the West’s campaign to punish Vladimir Putin, Russia’s president, for invading Ukraine. But it is far from alone. In Asia, the Middle East, Africa and Latin America, even longtime allies and clients of America are rebuffing its entreaties to impose sanctions on Russia or merely to criticise it”

The Economist: Why So Much of the World Won’t Stand Up to Russia