Three Questions: Week of April 25
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. Will currency market dislocations continue?
As the tectonic plates under the currency markets move, exchange rates are veering off in wildly divergent directions - and already-gaping fault lines between central banks look likely to widen further in the days ahead.
Facing broadening price pressures and rising consumer expectations, Jerome Powell and Tiff Macklem channeled Paul Volcker last week, expressing a willingness to tighten policy in the face of growing recession risks. Markets moved neutral rate forecasts higher and are now bracing for extremely aggressive - but short-lived - hiking cycles, with ever-larger increments coming under serious consideration. Real yields are finally moving into positive territory.
In contrast, with imported food and energy costs soaring while other prices rise more slowly, policymakers in Europe, the United Kingdom, China and Japan are struggling to strike a slightly different balance - maintaining inflation-fighting credibility while avoiding damage to the real economy.
Against this backdrop, the dollar continues to steamroll all of its major counterparts, moving higher with each hawkish word from a Federal Reserve official. If this Friday’s first quarter data release shows the personal consumption expenditure deflator and employee compensation - particularly wages and salaries - accelerating even faster, markets will lift terminal rate forecasts and raise bets on 50-basis point hikes at the coming four meetings.
A brief rally in the euro after Emmanuel Macron’s victory in yesterday’s second-round French election failed to shake the sense of gloom settling over the currency. April harmonized inflation data and first quarter gross domestic product numbers due later this week are unlikely to clear the way for a rapid rise in interest rates - or help kick the dollar exchange rate back above the psychologically-important 1.10 threshold.
The yen is suffering its longest losing streak since the eighties, and could fall farther if Governor Kuroda fails to signal any change in the Bank of Japan’s commitment to yield curve control during Wednesday’s press conference.
The yuan is in freefall as policymakers scramble to adapt (more on that below).
And investors are ignoring elevated commodity prices as they focus on the negative impact tighter financial conditions might have on over-indebted emerging market sovereigns or over-leveraged households in Australia and Canada.
Of course, if one thing is predictable about currency markets, it is that they will overdo it. Exchange rate trends tend to overshoot changes in economic and monetary conditions, and then experience violent reversals when momentum fades.
At some point, market participants might start worrying about how falling real incomes could intersect with deteriorating household balance sheets to crush consumption levels - and central bankers might decide growth risks are beginning to outweigh inflation risks. Upward movement in interest rates could reverse, the dollar could slump, and risk-taking could rebound.
But not yet.
For now, stress fractures are spreading across the financial markets, and we should all worry about where the aftershocks might hit next.
- KARL SCHAMOTTA, CHIEF MARKET STRATEGIST
2. Will the British pound find some respite this week?
Very likely not.
The British pound dropped to an 18-month low against the dollar on Friday following the release of March data that showed sharp drops in retail sales and in consumer confidence. The same day, Bank of England Governor Andrew Bailey described the UK as “walking a tightrope” between high inflation and the risk of a recession.
This means tough choices for divided institution facing a stagflation threat and suggests the policy-tightening path will be less aggressive than the 1.6 percent (by year-end) currently priced. The bank’s meeting on May 5 will likely a deliver a 25-basis point hike but the tone of the statement and the number of dissents favouring a bigger move will determine the shape of the curve. But even a hawkish outcome would provide limited support to the currency given the fragility of the economy.
Politics could add to the pressure. PM Boris Johnson has dodged many bullets in office, but there are growing signs of a rebellion within the ranks. His standing has rested on his delivering a huge parliamentary majority, but if local elections on May 5 show him to be a liability it could trigger a confidence vote by Tory MPs over the summer.
The pound has been resilient to Johnson’s troubles thus far, but there is an increasing risk that he will court a new conflict with the EU to cover his flanks with the hard-Eurosceptic right. He indicated last week that the government would soon submit legislation to dump the Northern Ireland protocol of the Brexit agreements – a step that would lead to economic retaliation.
US-style inflation dynamics, European recession threats and Italianesque political risks make for a nasty cocktail. The odds of a hangover are rising.
- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST
3. Could the Chinese yuan keep falling?
The offshore renminbi fell by more than 2 percent against the dollar last week and plunged further overnight, suffering some of its worst losses since the height of the coronavirus panic in early 2020.
Shanghai remains under brutal lockdown conditions, reports are surfacing of rising community infection rates in Beijing, and travel restrictions have been implemented in most major provinces. Many factories remain closed, ports are operating at reduced capacity, and shipping delays are mounting.
Deeper problems are surfacing, with property prices falling and municipal finances worsening as policymakers try to rein in history’s biggest real estate bubble. Equity bourses are underperforming as regulators continue their crackdown on activities Xi Jinping finds objectionable, and foreign capital is flowing out of the country as yields fall.
The falling exchange rate should help offset some of these factors, acting like a shock absorber to cushion the economy against undesired monetary tightening.
But policymakers may be equally motivated to guide the renminbi into closer alignment with the Japanese yen, which has come under intense selling pressure this year.
With the yen down almost 11.5 percent against the dollar this year and the yuan-yen pair trading near a 7-year high, the exchange rate could drop significantly before finding a new equilibrium.
We should also note that the global macroeconomic implications may be more benign than they appear: Although snarled supply chains could lift American consumer prices by making manufactured goods more expensive, slower credit creation and declining purchasing power in China should dampen the country’s voracious appetite for energy and industrial raw materials, knocking a significant hole in the secular “commodity supercycle” narrative that has raised worldwide inflation expectations. The world economy might suffer, but central bankers will welcome a rebalancing in supply and demand dynamics.
- KARL SCHAMOTTA, CHIEF MARKET STRATEGIST
USD Durable Goods Orders, March
USD Advance Goods Trade Balance, March
USD Department of Energy, Weekly Inventories
JPY Bank of Japan Rate Decision
EUR European Central Bank Economic Bulletin
CAD Employment Change, February
USD Gross Domestic Product, Q1
USD Weekly Jobless Claims
CNY Caixin Manufacturing Purchasing Manager Index, April
EUR Gross Domestic Product, Q1
EUR Consumer Price Index, April
USD Personal Consumption, March
CAD Gross Domestic Product, February
USD Baker Hughes Weekly Rig Count
CNY Manufacturing Purchasing Manager Index, April
“This profound change in the economics curriculum has resulted in a discipline that is sterile, tone-deaf, and lacking an emotional pulse—but also one that has proved ineffective in its explanatory and predictive capacities. Economists don’t exactly have a great track record at anticipating the pertinent developments of late: The discipline as a whole was caught off guard by the Great Recession in 2008 and has been late to recognize the skyrocketing rise of inequality.”
The Atlantic: Economics: The Discipline That Refuses to Change
“We find strong evidence that FX option volume negatively predicts future exchange rate returns, especially for the seven major currency pairs. In other words, higher option volume observed today indeed predicts a non-dollar currency depreciation (ie a US dollar appreciation) tomorrow.“
Bank Underground: Predicting Exchange Rates
“…Xi Jinping carried out a grand project to reorient the Communist Party’s mobilizational machinery away from the pursuit of economic growth and toward a broader set of goals, which can be summarized as the pursuit of “national greatness.” … But the shift to goals defined more by political and social values rather than quantitative measurements has led to economic management occurring through politicized campaigns.”
Andrew Batson: Why GDP Growth Targets are Underrated
“The game of markets is as interesting, challenging, and alive as it has ever been. Today’s players are more diverse, more online, more global. But they follow the same instincts and ambitions, and they wrestle with the same emotions, as previous generations. Perhaps their game has become too abstract and quiet for the big screen. Absent a crisis, scandal, or reckless exuberance it is not exciting enough for mass entertainment. But their work has become more challenging and interesting because the world is more complex and the game much more competitive.”
Insecurity Analysis: Does Wall Street Need New Storytelling?
“I have no recollection how it came up, but someone suggested making a 3D scrolling depth chart. The idea was pretty much identical to 2D chart mentioned above, but instead of using colour to represent size, we could use a 3D rendering. It was explained to me as follows: “It would look a bit like that scene in Star Wars where they are flying the x-wing through the death star”.
Machowski: The Death Star Depth Chart
“Amazon has transformed our expectations for how we buy things and how we interact with technology. It’s now intuitive for many of us to buy almost anything we want with a click — whether from Amazon or some other retailer — and to count on it being delivered within days, if not the same day. As Amazon has built the sprawling logistics and delivery empire that makes this possible, it has also begun to change the working lives of many Americans — in some ways for the better, and in some ways for the worse.”
Vox: The Amazonification of the American workforce
“If the revenues generated by rising exports are properly distributed domestically, as they normally are in a well-functioning economy, imports should rise just as quickly as exports. Instead, China had the highest first-quarter trade surplus in its history, the latest in a line of record-breaking trade surpluses. These surpluses are symptoms neither of manufacturing prowess nor of a culture of thrift, but are instead a consequence of the great difficulty China has had in rebalancing its domestic economy.”