Last week, the European Council (EC) proposed an unprecedented response package to build on its first package and other measures taken on a national level. The EC’s most recent proposal more than doubles the amount of the first response. But the good news for the euro also comes from the EC breaking the taboo of fiscal transfers through debt mutualisation. If debt mutualisation leads to a deeper fiscal union, this would be a game changing moment for Europe. As would be expected, the euro has been well supported since the EC’s announcement.
In broad terms, the EC’s proposal builds on both the Franco-German and “frugal four” proposals. As such, there were few surprises but that doesn’t mean it isn’t an ambitious starting point. The EC’s proposal requires unanimous approval so we will likely see a period of intense negotiations.
Italy has expressed support for the proposal, but opposition remains from countries that oppose EU borrowing to finance direct transfers. Additionally, Eastern European countries, which may consider themselves relative losers to the proposal, are expected be in opposition.
Last month’s decision by the German Constitutional Court against the ECB serves as a strong reminder of the heterogeneity and diverse views within Europe as well as issues regarding the EU’s institutional setup. This backdrop suggests that the final deal will be different than the proposal, but it is unlikely that the proposal will be completely overhauled given the strong political back it has from some countries.
This means that the EC’s goal for an agreement by July is an ambitious goal due to divergent viewpoints and longstanding institutional inefficiencies that makes the road from proposal to EU law a very long one.
The euro moved higher on the week with the main drivers being optimism around economies re-opening and the European Commission’s (EC) rescue package. While there is potential for the EC package to be a game changing development, there are a couple factors that should cap near term gains. Unanimous approval is needed to pass the proposal. Many countries, including the frugal four, have expressed reservations so there will likely be many weeks of negotiations. Additionally, the upcoming ECB meeting flags the risk for further dovishness and Brexit risks still remain. While a hard Brexit will impact the GBP more, the euro will also have collateral damage. Expect further euro gains to be capped.
Brexit talks and progress, or the lack thereof, should continue to be the main theme for the currency. The end of June deadline to request an extension is fast approaching and both sides remain far apart. While there is the possibility of an extension of some sort, this likely doesn’t come until the last minute. As such, expect uncertainty to continue to weigh on the pound. With regards to monetary policy, BoE officials continue to be dovish. Over the past week, officials have acknowledged that it is better to err on too much stimulus rather than too little and conceded the bank is looking at negative rates. The bias remains bearish.
Economic data continues to be weak out of Japan and this has led to the Abe government announcing another round of stimulus. Japanese investors were net sellers of foreign bonds again and the trend of repatriation remains in place as Japanese investors have been net foreign bond sellers in 10 of the last 11 weeks. The yen has been range bound since the middle of May, and this is expected to continue. However, the bias for a breakout, if any, is to the downside as risk around US-China relations remains high.
The loonie, along with other currencies, have strengthened sharply as optimism around the re-opening of economies has weakened the USD. However, the CAD’s gains have lagged others in the G10 which reflects the uniquely vulnerable position the Canadian economy is in. Oil prices have rallied some but are still significantly lower than at the start of the year and Canada remains one of the highest cost producers. Additionally, Canada still relies on foreign financing for its deficits. Without a yield advantage, these inflows could fade and lead to a weakening of the CAD. Tiff Macklem takes over the governorship of the BoC and will preside over the next meeting. Based on past comments, the risk is for Macklem to be more dovish than the outgoing governor. Expect range bound trading.
Rapidly increasing tensions between the US and China represent upside risk to USDCNY. The yuan has weakened as markets price in non-tariff actions by the US. This leaves the yuan vulnerable should the US take tariffs actions and especially if the US pulls out of the Phase 1 deal (highly unlikely). The expectation remains for reciprocal action on both sides but using CNY depreciation as a measure appears counterproductive. The Chinese economy remains fragile and can do without capital flight pressures. Expectations remain for the PBoC to moderate CNY weakness and mute volatily, but CNY should continue to underperform.
The Aussie has remained true to its positive correlation with equities. There is a feeling that AUDUSD could be a bit toppish with a lot of good news already priced in and increasing headwinds building. US-China tensions clearly apply here, however Aussie-China tensions could be even more important. Rhetoric between Australia and China have turned hawkish ever since Australia called for an inquiry into the origins of COVID-19. Initially, actions from both sides were relatively benign but China’s recent signal that it could impose restrictions on coal imports represents a significant risk.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to remain unchanged at 0.25%
Expectations for rates to remain unchanged at 0.25%
Expectations for the deposit rate to remain unchanged at -0.50%
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
US ISM Manufacturing PMI
Expectations for 43.5 print
US Factory Orders
Expectations for -14.0% decline
US Initial Jobless Claims
Expectations for 1.8 million claims
US Non-farm Payroll
Expectations for a -7.6 million decline in employment
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