Three Questions: Week of May 02

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: 

Question 1: Will the Reserve Bank of Australia hike rates?

Yes, but.

Although a minority of central bank watchers expect a decision to punt - or an outsized 40 basis point increase - Australia’s central bank will likely kick off its tightening cycle on Tuesday with a 15 basis point hike, meeting the predictions of most economists. However, the post-meeting communique and Friday’s quarterly monetary policy statement could push back against the futures curve, where more than 250 basis points in tightening have been priced in by the end of 2022. 

Perhaps reflecting the RBA’s more-flexible inflation target, officials still sound less hawkish than their counterparts at other developed market central banks. The minutes of the April meeting noted that “a further strengthening of aggregate wages growth … was expected” but qualified that “the pick-up was still expected to be only gradual”.

Political considerations ahead of the May 21 elections might also compel policymakers to tread carefully. Although a decision not to respond to the most recent inflation print of 5.1 percent could be misconstrued, the bank has historically refrained from changing rates during campaign season, and is likely to feel some pressure to avoid making dramatic moves. 

And global developments have provided another reason to convey that - although rates are headed higher - incoming data will determine the speed and magnitude of the move. War in Ukraine, Chinese Covid-Zero lockdowns, and spillovers from US dollar strength into world growth and commodity prices will all impact the Australian inflation outlook.

Ultimately, we suspect the Aussie’s near-term fortunes will be driven more by global events than by changes in domestic monetary policy settings. 

-  KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

2. Could dollar-related global spillover risks soften the Fed’s hawkish tone? 

There are few certainties in today’s economic landscape, but investors are sure the Federal Reserve will set out a more detailed balance sheet drawdown plan and raise rates by a half-percentage point on Wednesday. During the post-decision press conference, most expect Jerome Powell to repeat recent statements acknowledging the need to move quickly and aggressively to counter growing inflation risks. He will likely signal a level of comfort with current market pricing, keeping jumbo-sized rate hikes on the table for the next two or three meetings. 

What Mr. Powell will say about the complex and unintended consequences for the global economy as the central bank embarks on one of the most audacious tightening campaigns in post-Bretton Woods history is less certain. In particular, after last week’s surprisingly-weak gross domestic product release, awkward questions could be raised about the soaring greenback’s impact on the United States itself. 

Experience has shown that episodes of dollar strength often act like a wrecking ball hitting the global financial system, driving bond yields higher, hammering cross-border capital flows, smashing stock indices, and triggering violent dislocations in foreign exchange markets. The real economy also suffers. When businesses and consumers in the rest of the world face a deterioration in financial conditions, growth slows, demand crumbles, and dollar-denominated supply chains break. This feeds back into domestic fundamentals as US export revenues drop, corporate investment slumps, and sentiment worsens.

Fed officials have demonstrated greater awareness of these effects in recent years, and have worked assiduously to ensure that policy shifts are well-telegraphed and understood.

But because the rapid recovery in post-pandemic global financial conditions was engineered in no small part by the central bank itself, there are reasons to think vulnerabilities still exist. After policymakers deployed swap lines and flooded the system with liquidity in early 2020, fears of “dollar scarcity” faded, and greenback’s role as a global funding currency became even more deeply entrenched. When the Fed committed to keeping interest rates low and stable under its “average inflation targeting” framework, global banks, corporates, and asset managers allowed balance sheet mismatches to expand. Dollar invoicing in trade has only grown.

It is difficult to extricate the consequences of the dollar’s rally from the fallout over Russia’s invasion of Ukraine and the Chinese demand shock - but global bond yields surged in sympathy with their US equivalents in the first quarter, capital flows reversed, international stock markets fell, and major currencies - including the yen and euro - came under extreme selling pressure. US multinationals began issuing more downbeat earnings forecasts, and foreign demand for American products fell, with a 5.9 percent drop in net exports helping to drag growth into negative territory.

These spillover effects could eventually limit the Fed’s room for manoeuvre, putting the brakes on aggressive tightening plans. But when Mr. Powell speaks on Wednesday, he is likely to give short shrift to risks that may or may not materialize, instead choosing to focus on high prices, rising wage pressures, and superheated consumer demand as he maintains a hawkish approach to setting policy. 

For now, the words that Treasury Secretary John Connally uttered in 1971 remain true: “The dollar may be our currency, but it's your problem”. 

-  KARL SCHAMOTTA, CHIEF MARKET STRATEGIST

3: Will the Brazilian central bank signal that is almost done tightening?

Contrary to market hopes, we think Brazilian policymakers are likely to leave their options open. The central bank will almost certainly announce a 100 basis point increase - a move that will lift the benchmark rate to 12.75 percent. Since this is the unanimous expectation among polled economists, investors will look for hints as to where the cycle might peak. The futures curve has the Selic rate topping out soon at around 13.25 percent, but the bank might consider it premature to communicate an imminent end to tightening. The last meeting on March 16 delivered a 100 basis-point hike and conveyed a sense that not much more would be required to bring inflation to down to target in 2023. In a dynamic that contrasts with developed-economy markets, this helped both interest rate futures and the Brazilian real rally: the country’s large stocks of floating-rate, inflation-linked and currency-linked debt tend to increase the economy’s sensitivity to rising rates - meaning that when interest rates are expected to fall in the future, growth forecasts rise and traders turn more bullish on the currency.

However, tailwinds have turned to headwinds, driven by worries about the impact of China’s “Covid-zero” strategy on global growth and commodity prices.  And mildly dovish comments from BCB head Roberto Campos at the IMF meetings in mid-April ago led to a sharp selloff in the currency, Meanwhile, the most recent inflation print was slightly lower than expected, but prices are still rising 12 percent year-on-year and show little sign of flagging. In the face of an aggressive Fed, a broad dollar move higher, and the real losing close to 7 percent last week, central bankers may want to avoid delivering the ‘all-clear’ message on inflation, preferring to maintain a degree of hawkish optionality instead. Under current conditions, this could help stabilize the real, reducing downside in the currency - but it might take more benign global conditions to get the rally going again.

-  KARTHIK SANKARAN, SENIOR MARKET STRATEGIST

CATALYSTS

TUESDAY

AUD    Reserve Bank of Australia, Rate Decision

EUR    Unemployment, March

USD    Factory Orders, March

USD    Job Openings and Labor Turnover Survey, March

WEDNESDAY

USD    Trade Balance, March

USD    Department of Energy, Weekly Inventories

USD    Federal Reserve, Rate Decision

BRL    Central Bank of Brazil Rate Decision

THURSDAY

GBP    Bank of England Rate Decision

USD    Weekly Jobless Claims

AUD    Statement on Monetary Policy

CNY    Current Account Balance, Q1

FRIDAY

USD    Nonfarm Payrolls, April

CAD    Employment, April

USD    Baker Hughes Weekly Rig Count

COUNTERPARTIES

“So, you know, X tokens [are] being given out each day, all these like sophisticated firms are like, huh, that's interesting. Like if the total amount of money in the box is a hundred million dollars, then it's going to yield $16 million this year in X tokens being given out for it. That's a 16% return. That's pretty good. We'll put a little bit more in, right? And maybe that happens until there are $200 million dollars in the box. So, you know, sophisticated traders and/or people on Crypto Twitter, or other sort of similar parties, go and put $200 million in the box collectively and they start getting these X tokens for it.”

Bloomberg: Sam Bankman-Fried Described Yield Farming and Left Matt Levine Stunned

“As the contours of the post-pandemic landscape come into focus, a lost decade—a period of slow growth, recurring financial crises and social unrest—for the world’s poorer countries looks increasingly plausible.”

The Economist: Are Emerging Economies On the Verge of Another Lost Decade?

“Derivatives exchanges and clearing houses have raised the amount of initial margin that companies must stump up on futures positions because of the elevated levels of volatility, increasing the amount of capital they must have locked up permanently to keep positions open. The EFET said in March the amount of money needed to maintain a position in gas futures had multiplied six-fold from a year before as a result. That has led to a decline in the amount of outstanding contracts in several futures markets. The open interest in Brent crude oil futures has declined from over 426,000 contracts at the end of March to about 179,000 contracts, according to Refinitiv.”

International Finance Review: Commodity Traders Seek to Ride Out Liquidity Squeeze

“Private and official economic forecasts have recently started to highlight growing regional risks, but perhaps understate the extent to which they multiply each other. Widespread lockdowns in China, for example, will wreak havoc with global supply chains in the short run, raising inflation in the US and lowering demand in Europe. Normally, these problems might be attenuated by lower commodity prices. But with no clear end in sight in Ukraine, global food and energy prices are likely to remain high in any scenario.”

Project Syndicate: The Growing Threat of Global Recession

“Whatever the causes, there is no denying that China has accumulated an excessive volume of foreign-exchange reserves. As I have been arguing for decades, there are two big reasons why it should reduce these holdings. First, with more than $2 trillion of net international assets, China’s net investment income has been negative for almost 20 years, because its holdings are disproportionately in low-yield US treasuries. This is a grotesque misallocation of resources. Second, the US dollar eventually may fall significantly, because America has been running huge net foreign and national debts for decades, and this shows no signs of changing. Moreover, the US Federal Reserve’s expansionary monetary policy (in the form of quantitative easing) may continue to create inflationary pressure in the future.”

Project Syndicate: America Has Stopped Playing by the Monetary Rules