Morning Commentary: Known Unknowns

Foreign Exchange - Morning Commentary
Known Unknowns 
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
Overnight, the Bank of Japan kept its rate unchanged, as expected, but expanded its special operations which demonstrated its “whatever-it-takes” stance.  In the US, the Fed announced that it would begin buying US corporate bonds.  Later this week, the Bank of England will meet and is also likely to increase its stimulus support.  

All of these actions reaffirmed what the markets already know—fiscal and monetary stimulus has been swift and strong.  In total, stimulus in the DM has been delivered much faster and much more decisively than after the 2009 global crisis.  Moreover, central bank promises of further support, if needed, appear to be credible.  

As economies continue to re-open there should be an acceleration of economic data to the upside with base effect helping this rebound (see retail sales).  However, what happens after this swift initial rebound still remains an unknown and that is what has led to the ebbs and flows in risk sentiment.  

A key unknown is how far away from the previous normal the global economy will be after the extreme lockdowns are over.  Even if one assumes that the worse is over, the fact that risk assets have move higher still seems inconsistent with fundamentals.  The global economy just came off the worst recession since the global depression.  In order to remain consistent with risk asset prices, the global economy not only has to have a “V” shaped recovery but it also has to have no permanent output loss and no sustained economic damage.  This seems unlikely.  Clearly the massive stimulus from governments around the world has helped but these are supposed to be temporary measures.  Even if these policies continue beyond what the weak economy would justify, it is not sustainable.  When this stimulus is removed, the adjustment is unlikely to be smooth.  

Near term, this Friday’s EU summit where the 750 billion euro Recovery Fund will be discussed is a key unknown.  The risk is that the proposed fund will be weakened during negotiations.  Germany has already expressed opposition to the proposal and a number of countries have expressed opposition to various elements such as grants instead of loans and the use of backward indicators to determine aid.  

Of course the risk of a second wave of infections is the most material variable of them all as most economies have re-opened without fully eliminating the virus.  To this point, there is evidence of an uptick in infections in some southern and western US states.  Beijing is also experiencing a reemergence of the virus and is moving towards limited lockdowns.  Without a vaccine, the ability for countries to keep the virus under control is paramount.  This makes the next couple of weeks critical in determining whether or not this is possible.
  • Market sentiment has reversed course back towards risk on due to central bank actions, talks of a $1 trillion US infrastructure program and optimism around Brexit.  Regarding central banks, it isn’t just DM banks that are stepping up.  In the EM, Brazil, Indonesia, and Taiwan are all expected to increase stimulus.  
  • Fed Chair Powell is scheduled to start his semi-annual testimony before the Senate Banking Committee at 10 am Eastern Time.  He is expected to reiterate his downbeat assessment of the economy, in line with what the FOMC expressed last week.  
  • US retail sales blew expectations out of the water.  Retail sales rose 17.7% in May against expectations for an 8.4% rise.  This print represented the largest gain on record.  
  • Positive COVID-19 treatment news came via a cheap and widely available anti-inflammatory drug.  In a UK study, dexamenthasone showed signs that it could help save the lives of seriously ill patients.  
  • Brexit talks took a positive turn after a phone call between UK PM Johnson and EU leaders showed signs that both sides were willing to compromise.  While cable is up on the day, history has shown many instances where optimistic headlines have led to little progress.  
  • RBA minutes showed that the bank is happy with how its policies are working but signaled that the economy could still need support for some time.  
  • Tensions around the world have ramped up with North Korea blowing up an inter-Korean liaison office and causalities resulting from a clash between India and China along an unmarked border in the Himalayas.    
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