Three Questions: Week of July 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'll be watching:

Question 1: Could yesterday’s market rally hold?

The dollar fell and risk-sensitive currencies climbed sharply during Friday’s session as US monetary tightening expectations cooled slightly and the growth outlook brightened. We think the deep contradictions embedded in the world’s biggest economy could give the move some staying power.

To sum up the last month:

- Central bankers committed to raising short-term interest rates aggressively - even at the risk of sending the economy into recession. This led to a drop in long-term interest rates.

- Oil and gasoline prices fell as tighter monetary policy weighed on global demand forecasts. This lowered household inflation expectations, and reduced the need for tighter monetary policy.

- Businesses became more worried about a coming collapse in demand, but also brought the unemployment rate to record lows as they continued to hire the workers who provide the demand.

- Consumers turned so pessimistic about the economy’s growth prospects that they indulged in a heavy dose of retail therapy, driving a surge in store receipts and raising the economy’s growth prospects.

It’s a little like when the Simpson’s Montgomery Burns visited the doctor:

Doctor: “Mr. Burns, I'm afraid you are the sickest man in the United States. You have everything.”

Mr. Burns: “You mean I have pneumonia?”

Doctor: “Yes.”

Mr. Burns: “Juvenile diabetes?”

Doctor: “Yes.”

Mr. Burns: “Hysterical pregnancy?”

Doctor: “Uh, a little bit, yes! You also have several diseases that have just been discovered - in you.”

Mr. Burns: “I see. You sure you haven't just made thousands of mistakes?”

Doctor: “Uh, no, no, I'm afraid not.”

Mr. Burns: “This sounds like bad news.”

Doctor: “Well, you'd think so, but - all of your diseases are in perfect balance.”

…

Mr. Burns: “So, what you're saying is... I'm indestructible!”

Doctor: “Oh, no, no. In fact, even a slight breeze could...”

Mr. Burns: [leaves the office, muttering to himself] “Indestructible!”

The American economy is almost certainly headed into a slowdown, but until something shifts more dramatically, counter-balancing forces could give central bankers, investors, and currency traders some breathing room.

Indestructible?

No.

Alive for now?

Very much so.

- KARL SCHAMOTTA, CHIEF MARKET STRATEGIST

Question 2: Will the ECB decision boost the euro?

The European Central Bank has an overflowing in-box: a deepening energy-supply shock; a market clamouring for clarity on its spread-control tool; and a possible Italian political crisis. Against this backdrop, it would make little sense to spring an outsized rate hike in the hope it might bolster the euro. We believe policymakers will hike rates by 25 basis points on Thursday, while setting the stage for a 50 basis point move in September.

Markets are in a stagflation funk and a hawkish surprise doesn’t guarantee lasting support for a currency (just ask the Bank of Canada). The trade-weighted euro is not especially weak; the dollar is exceptionally strong. With most commodity prices cooling rapidly, exchange-rate-driven inflation is no longer a major issue.

The Eurozone’s dilemma stems from the geopolitics of Russian gas supply, and a stoppage may increase short-term inflationary pressures but would also crush demand and the euro. Ironically, Gazprom has shut off a major pipeline for scheduled maintenance and an announcement on reopening is expected the very day the central bank meets.

The Bank has also promised details about its tool to control “unwarranted” widening of bond spreads amid German grousing that it will not condone fiscal laxity. But overly stringent conditionality overseen by the European Stability Mechanism and the International Monetary Fund would make the tool politically toxic. One way to compromise is via oversight by the European Commission and the Eurogroup of finance ministers—more politically pliable venues.

This would be enough for markets in the abstract, but if Italian Prime Minister Mario Draghi cannot find a new parliamentary majority next week, Italian bonds and the euro will be in trouble. This is another issue hikes cannot fix.

This will be a busy week for the euro, yet the big decisions affecting its value are not going to be made in Frankfurt, but in Moscow, Rome, and Washington.

- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

Question 3: Will we see a respite for commodities and commodity-linked currencies?

Raw materials rallied mightily in late February as traders bet sanctions on Russia would shrink global supply. But by the end of April, prices had begun a steep descent, succumbing to worries about high costs and aggressive Fed rate hikes destroying demand. China’s “covid-zero” slowdown only compounded the problem. Oil, wheat, and industrial metals are now at or below levels they reached soon after the invasion, with many Antipodean and South American currencies trading near recent - and in some cases, all-time - lows.

But a return to relative macroeconomic calm could bring a spell of good news.

The Fed will have a lot more tightening under its belt by the end of the month and recent data should help allay its fears about a spiral connecting headline inflation and expectations. At the same time, there is little that suggests an overly tight policy is leading the US inexorably toward imminent recession. And China looks like it will respond to its growth collapse in early 2022 by once again throwing money at infrastructure.

Political developments in Chile, Colombia and Brazil have not helped sentiment, but a more benign global inflation, rate, and growth backdrop could help investors overlook domestic issues. And central banks in these countries have boosted rates aggressively to fight inflation. As for Australia, the domestic economy is booming, and central bankers are in a hurry to catch up with their peers.

This corner of the currency markets does tend to behave like a roller coaster, but the screaming descent section of the ride might be done. For now.

- KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

CATALYSTS

MONDAY

CAD Housing Starts, June

AUD Reserve Bank of Australia, Minutes of July Meeting

TUESDAY

GBP Claimant Count Rate, June

EUR Consumer Price Indices, June (Final)

WEDNESDAY

GBP Consumer Price Indices, June

CAD Consumer Price Indices, June

USD Department of Energy Weekly Inventories

JPY Bank of Japan Rate Decision

THURSDAY

EUR European Central Bank Rate Decision

USD Weekly Jobless Claims

FRIDAY

CAD Retail Sales, May

USD Baker Hughes Weekly Rig Count

COUNTERPARTIES

Some of this week’s most interesting, insightful and off-beat reads on the state of the global economy:

“Earlier this year, strategists and investors came out in droves to embrace commodities to weather surging inflation. This looked like a brilliant move at first as oil, metals and grains all rallied, but investors who held on to those positions are seeing their winnings largely eviscerated by a brutal snapback. In reality, most individual investors had no business investing in commodities in the first place.” Bloomberg: Commodities Never Belonged in Your Portfolio

“The European Commission plan, due to be published on July 20, will suggest countries launch financial incentives for companies to cut gas use, use state aid to encourage industries and power plants to switch to other fuels, and roll out information campaigns to nudge consumers to use less heating and cooling." Reuters: EU to Urge Countries to Curb Gas Use to Buffer Against Russian Cuts

“Runaway inflation, on the other hand, would leave a darker legacy. Jerome Powell, Christine Lagarde and others would be joining Arthur Burns on university syllabuses for the semester on “historical monetary failures”. In 40 years’ time, economists would still be discussing how they “let IT (the 1970s) happen again”. No central banker wants to become a case-study in how to fail.” TS Lombard: The Nightmare Scenario For Central Banks

“If you wanted to tell the story of how the United States became one the world’s largest exporters of fossil fuels, you could start in the Middle Devonian period, around 400 million years ago, when a warm inland sea dense with primitive aquatic organisms covered parts of the northeastern United States and Appalachia; you could explain that as these creatures lived, reproduced and died, their remains settled on the ocean floor and were compressed beneath layers of sedimentary rock, until eventually they transformed into a gas trapped thousands of feet below what is now Pennsylvania. Or you could start with the murder of Nicole Brown Simpson." New York Times Magazine: How One Restaurateur Transformed America’s Energy Industry

“Some homebuyers are backing out of deals as a slowing housing market gives them more room to negotiate. Others are being forced to renege on contracts because higher mortgage rates mean some homes are no longer affordable." Redfin: The Deal Is Off: Home Sales Are Getting Canceled at the Highest Rate Since the Start of the Pandemic

“Chips are in short supply. Chips are over-supplied. Chip manufacturing has expanded too fast and surpassed demand, but also can’t scale up fast enough to meet demand. The chip business is booming. Chip stocks are falling. It’s a confusing time to figure out what’s going on in the semiconductor industry." Quartz: It’s the Best and Worst of Times for Semiconductor Supply Chains

“The industry’s enthusiasts and sceptics agree on one thing: they saw this coming. Perhaps they didn’t predict the precise contours of the crash, or the fact that so many seemingly reputable companies would flame out, but there was a sense that the cryptocurrency bull would run out of road. The sector was too hot, too loaded with bad-faith actors, scammers, credulous investors and amateurs feigning expertise in Telegram groups, YouTube videos and Twitter threads. When internet jokes such as PooCoin and Dogecoin surged in popularity, it ought to have been apparent that a market correction was coming. Such stupidity cannot be sustained for long.” The Guardian: The Amateur Investors Ruined by the Crypto Crash

“Big shifts in relative prices — large currency depreciation, for example — spread swiftly across the economy, as people struggle to protect themselves against the shocks to real incomes. The mechanism behind this spread is price-price and wage-price spirals. Moreover, the greater the worry, the more pre-emptive efforts become. Expectations are crucial. When people cease to know what to expect, they become even more urgently defensive.” Financial Times: Inflation Is A Political Challenge As Well As An Economic One