The Week Ahead: Promises Made But Are Promises Kept?
Promises Made But Are Promises Kept?
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Andrew Kositkun Foreign Exchange Head Trader
Last week, the ECB came through and exceeded market expectations by expanding its bond buying program more than expected. Focus now shifts to the Fed which meets this week.
In the immediate term, the Fed is unlikely to make any major changes to its policy toolkit as it is focused on underpinning the markets, making sure credit flows freely and markets are functioning properly. However by mid to late summer, the Fed should be able to gauge the economy better. By then, there should be enough economic data to better assess whether or not the initial re-opening bounce will fade, what the actual damage to the economy is and what needs to be done to close the output gap and bring the economy back to full employment.
What then are the triggers for the Fed to step up with additional easing measures? Three key check points are a rise in deflation risks, a deterioration in financial conditions and a fading of the reopening bounce that leaves the economy stabilizing at a level significantly below pre-COVID-19 levels. Should the Fed decide it needs to provide more support, expect it to turn to stronger forward guidance and yield curve control (YCC).
The Fed has been very clear that when rates are at zero, the most critical tool thereafter is forward guidance. There are two main benefits. The first is that it reduces uncertainty around the future policy path. Secondly, forward guidance, to the extent that markets believe in its credibility, serves as a guarantee and helps the central bank achieve its goals. Research has shown strong forward guidance effectively acts as easing even with the constraint of the zero lower bound.
YCC is also a likely tool as it has come up in speeches by two well-known Fed mouthpieces. It also came up in the May FOMC minutes which is important as the Fed has a history of floating policy changes in its minutes. The primary purpose of YCC would be to reinforce forward guidance as it keeps rates low even after the recovery starts and prevents markets from pricing in rate hikes. In essence, strong forward guidance paired with YCC helps the Fed keep the promises it makes.
The view was for stimulus hopes to support the euro but for uncertainty around the negotiation period to keep gains capped. The euro was indeed supported by stimulus hopes with additional German stimulus and the ECB’s upsizing of its Pandemic Emergency Purchase Program adding to the tailwinds from the EC’s rescue package. Markets are clearly in risk on mode due to stimulus and the strong jobs report in the US supports this. I still think there is a material risk for a second wave/pull back in stimulus to disrupt the reopening process and for markets to realize that approving the EC’s package won’t be easy. However, the trend should continue to be for optimism which lends to USD weakness and support for the euro.
The GBP was up this past week but this likely is more a function of USD weakness than progress on Brexit. This past week also marked the last round of negotiations before the end of June deadline to request an extension and ended without material progress, leaving both sides far apart. The UK government remains stanch in its position that it won’t request an extension which flags continued hard Brexit risks. However, price action indicates the markets still think an extension will ultimately be requested. Despite this, expect the GBP to be increasingly under pressure as the extension deadline approaches but for USD weakness to mask some of the downward pressure on sterling.
USDJPY has drifted higher along with US interest rates. The theme here is similar to other currencies as hopes around a re-opening has sapped safe haven demand and weakened the USD. Over the past couple of weeks, Japanese investors have been net sellers of foreign bonds. With markets settling down, outbound investments could pick up again and support a weaker yen. Expect the yen to continue to trade with risk sentiment which remains positive.
The BoC meeting came and went with the bank leaving rates unchanged and striking a slightly more optimistic tone on growth and effects from COVID-19. As with other commodity currencies, the CAD has strengthened with the markets taking a positive view on reopening and the positive jobs report in Canada supports this. For now, the short term trend is for risk on and there doesn’t appear to be any catalysts to change that.
The yuan actually finds itself stronger despite continued tensions between the US and China. The relatively benign actions announced by President Trump at his press conference on Hong Kong has supported the yuan as markets moved to price out stronger action and CNY roughly where it was at the end of March. Economic data continues to show a pickup in activity as China continues to reopen and this, combined with investment inflows, should continue to support the currency. Expect continued currency stability, which the PBoC strives for. However, longer term election dynamics flag the risk for increased rhetoric and tougher action as bipartisan support for tougher measures against China continues to rise.
The Aussie has had a strong run of late with the AUD trade-weighted index hitting a 1-year high. Certainly, the factors that have driven the AUD higher remain in place but appear overbought as iron ore prices have only seen a limited uptick. The AUD also continues to face a challenged backdrop with both the domestic economy weak and external risks coming through via weak global growth and higher geopolitical tensions. This includes both US-China and Australia-China. Near term, further upward momentum is possible, but with the Aussie’s valuation inconsistent with its backdrop, risks of correction are growing.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to remain unchanged at 0.25%
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
US CPI MoM
Expectations for a 0.0% print
US Initial Jobless Claims
Expectations for 1.55 million jobless claims
Canadian Housing Starts
Expectations for 160K starts
EZ G1 GDP QoQ
Expectations for a -3.8% decline
UK April GDP
Expectations for a -18.0% decline
UK Industrial Production MoM
Expectations for a -15.0% decline
Asia/Japan, and New Zealand
Chinese Trade Data YoY
Expectations for imports and exports to fall -7.9% and -6.5%, respectively
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