FX Compass: US Employment Report Unleashes the Big Debate
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US Employment Report Unleashes the Big Debate
We know that this comes out as we are into the evening of Mother’s Day. We hope all the moms out there had a great day and what is left of it. And as markets tend to invade all parts of our lives, Julia Allegretto found some very interesting global market dynamics going on with Mother’s Day flowers, and it involves cannabis. Yes, it is very intriguing and you should listen to find out what she found.
Julia and I are then joined by head trader Rich Pontius, and to be honest the plan for this was to talk about global commodity prices and how that is fitting in with a global reflation story. Then a Molotov cocktail got thrown into the economic data mix with Friday’s Non-farm payrolls report. This report will be fodder for weeks of arguing in the capital markets as to why this happened and what to do about it – the first of many conversations we will have on the topic.
One- to two-week view: The overall bias for euro bearishness remains despite euro area first quarter gross domestic product (GDP) contracting slightly less than market consensus, as second quarter growth should remain weak and as COVID-19 trends and fiscal and monetary policy differences favor the U.S. Given this, it should be noted that vaccination rates are accelerating in Europe but decelerating in the U.S., and progress has been made on the European recovery fund. Additionally, the disappointing U.S. jobs number will keep the U.S. dollar under pressure for longer as it hits the narrative of U.S. tapering. As such, the near-term EUR/USD view is biased to range trading. More generally, there remains good reason to think that the U.S. recovery is still going strong. On the geopolitical front, the EU-China Comprehensive Agreement on Investment is also running into trouble, as EU countries step up sanctions against China and China retaliates. China is a bigger EU trading partner than the U.S., so downgraded trade prospects are not a good thing. On the monetary front, the ECB reiterated that it will keep its accommodative stance for a long period.
Three- to six-month view: The start of the second quarter has gone better for the euro relative to the first quarter, but this move higher lacks a convincing fundamental basis, so it should be seen as more technical than the start of a durable reversal. Whether or not the euro is close to bottoming out in a durable way will depend on whether the fundamentals that have pulled the euro down (growth expectation and yield gaps between the U.S. and Europe) are close to reversing. While much of the good news on U.S. fiscal policy has been priced in and Europe is catching up on vaccines, it isn’t certain that growth expectations will shift in the euro’s favor. A material recovery in the euro will require not only a reopening of the European economy but a growth bounce that exceeds expectations. It also likely requires U.S. growth to disappoint in outright terms. Moreover, USD/EUR interest rate differentials also remain a headwind. This is due not only to divergent growth momentum but also divergent inflation expectations. It is difficult to paint a positive euro picture when markets can only price in one 25-basis-point hike by 2025 in Europe versus one hike by late 2022 in the U.S.
One- to two-week view: The pound should receive support and grind higher as a result of the U.K.’s better economic momentum, as well as a poor U.S. jobs report that puts the U.S. exceptionalism story, and thus U.S. dollar strength, on the back foot for some time longer. Additionally, Prime Minister Johnson indicated that COVID-19-related lockdown rules will be scrapped in seven weeks’ time. On monetary policy, the Bank of England (BoE) met this past week and kept rates unchanged at 0.1% while revising up its forecast for 2021 growth. The bank also slowed the pace of its bond buying and expects its QE program to end around the end of this year. Also keep an eye on the BoE composition, which will change this summer, with Andy Haldane and possibly Gertjan Vlieghe leaving. Regarding Scotland, significant political and constitutional hurdles will remain in the way of achieving another independence referendum. Consequently, it is more of a long-term risk, and any pound weakness triggered by elections should have faded.
Three- to six-month view: The pound has been supported by the U.K.’s vaccination lead, but this has always been viewed as transitory support. To this point, the U.S. has started to catch up with the U.K., and even Europe is making progress. As such, the pound’s vaccine premium should start to fade and inform a modestly bearish pound outlook. Focus should now increasingly shift to the sustainability of economic growth after reopening. With the U.K. facing stiff fiscal headwinds and continued elevated uncertainty from a relatively hard Brexit, there is justified skepticism on the U.K.’s ability to sustain economic outperformance. The pound rate markets paint a similar picture, with near-term pricing aligned with the Fed but closer to the ECB after that, representing the structural drag that could constrain the U.K. economy over multiple quarters. Moreover, events in Scotland raise the possibility of another independence referendum. This would justify a risk premium being placed on the pound, albeit smaller than the Brexit premium.
One- to two-week view: Increased COVID-19 numbers have forced the Japanese government to declare a third state of emergency (SOE) from April 25 to May 11, a period that covers the Golden Week holiday. Reports indicate that lockdowns could be extended. This SOE has weighed on Japanese equities while sustaining yen strength on safe haven demand and stabilization of U.S. yields. With new measures stricter than those taken before, the hit to consumption is likely to be greater than under prior SOEs. At the Bank of Japan’s (BoJ) last meeting, the bank delivered a dovish hold as it kept policy settings unchanged, signaling a prolonged accommodative stance. Eventually the Japanese economy should benefit as vaccinations catch up with peers. Until then, expect U.S. yields to remain a key driver.
Three- to six-month view: The rise in year-to-date U.S. rates justifies a shift higher in USD/JPY’s forecasted path through the end of the year, as USD/JPY’s relationship with nominal yield spreads has remained extremely tight. However, this correlation isn’t something that normally persists over the course of several months and is unlikely to remain high into the second quarter. A pullback in speculative positioning, more orderly moves in U.S. yields and the re-emergence of two-way Japanese investment flows should give the yen support versus the dollar. Valuations over the medium term also support a stronger yen. Nevertheless, the yen remains vulnerable should there be another sharp repricing higher in U.S. yields. Direct investment flow should also increase in importance, as several large merger and acquisition deals are in the pipeline. As for vaccinations, Japan lags its G-10 peers and is unlikely to reach herd immunity until late 2021. This puts the country at increased risk of further emergency measures and restrictions.
One- to two-week view: Vaccinations in Canada have picked up in recent weeks and will be further supported by Pfizer’s exports from the U.S. The employment report last week disappointed markets, but it should be noted that this report reflects the impact of the third COVID-19 wave and increased restrictions on the labor market. As such, there is comfort in looking to the future, as expectations for a post-lockdown rebound keep the Bank of Canada (BoC) on its current path. Overall, the view remains bullish due to continued vaccine progress reducing the impact of subsequent COVID-19 waves and historical evidence showing the Canadian economy’s ability to bounce back once the restrictions are over. A lot of economic optimism has been priced in but strong fiscal support, economic resilience, the pickup in vaccine rollouts and a dovish Fed supporting positive risk sentiment argue for continued Canadian dollar (CAD) strength.
Three- to six-month view: The CAD has been one of the best-performing currencies year to date, with a constructive medium-term outlook. The CAD’s performance represents a healthy, solid medium-term local outlook that is complemented by a strong global reflationary backdrop. This positive mix should continue to support further CAD appreciation over the rest of the year, albeit at a more moderate pace compared to the first quarter. The CAD is also supported by the BoC, which has started its tapering. While the Canadian economy is dealing with a renewed COVID-19 wave, it has shown resilience to lockdowns, and vaccinations are picking up. So on net, the CAD should continue to benefit from global reflationary forces and meaningful spillovers from fiscally led U.S. growth.
One- to two-week view: On the margin, the Chinese economy is losing some momentum, and growing U.S. exceptionalism has shifted the balance of major rate differentials toward U.S. dollar strength, although this is more of a medium-term consideration. In the near term, continued economic performance (the latest PMIs improved), a current account surplus and relatively high yields still form the base for a constructive yuan view. With the stabilization in U.S. yields, the yuan has recovered all of its March losses and continues to perform. On the geopolitical front, U.S./U.S. allies’ tensions with China remain but are unlikely to lead to disruptive actions.
Three- to six-month view: The shift in U.S. dollar momentum gives fewer reasons to be bullish about the yuan, but the outlook remains modestly constructive. This is because recent yuan weakness represents a bullish U.S. dollar outlook and not a rethink of the Chinese macro environment. Since last year, China’s strong balance-of-payment backdrop has been a key driving force behind a bullish yuan view. Equity inflows have remained resilient despite some softness in onshore sentiment. This marks a contrast with substantial drawdowns in other North Asia stock markets. Bond inflows have moderated some, but this appears more reflective of large maturities and a small pullback in inflows rather than broad-based selling by global asset managers, as structural asset allocation demand remains in place. Overall, a solid balance-of-payment backdrop, including a current account surplus and foreign investment inflows, should remain supportive of the yuan. U.S. dollar dynamics could move the yuan weaker, but absent a meaningful deterioration in U.S.–China relations, including resumed tariff hikes, the bias still remains for modest yuan appreciation in the second half of the year.
One- to two-week view: The Reserve Bank of Australia (RBA) met this past week and held all policy settings unchanged and signaled that rate hikes won’t be seen until 2024 “at the earliest.” While the overall tone was more positive than in April, the bank remains concerned about slack in the labor markets and is still very much dovish. A reduction in government COVID-19-related support measures, still-low global yields and a lack of inflationary pressures mean the RBA will be slow to taper its stimulus even as it continues to acknowledge better than expected data, and this should weigh on the Australian dollar (AUD), especially if global equity markets retain a weak tone. On the geopolitical front, tensions with China remain. Recently, a top Chinese diplomat blamed Australia for deteriorating ties between the nations as a result of Australia’s decision to cancel some investments from the Belt and Road Initiative. Should relations between the two countries deteriorate sharply, Australian exports, among other things, would be at risk. However, China does not have many alternatives to Australian iron ore, and this likely will prevent a complete deterioration of the relationship.
Three- to six-month view: The AUD outlook remains bearish. Much of the AUD strength seen in 2020 was a function of the rally in iron ore due to China’s real GDP recovery on the demand side and disruptions among major Brazilian producers on the supply side. However, Chinese real GDP growth has started to moderate back to pre-COVID-19 levels, meaning steel production is also likely to slow and contribute to lower iron ore prices. Overall, the combination of the RBA’s relative dovishness, negative carry and already elevated iron ore prices makes it hard for the AUD to outperform during the anticipated global recovery. Looking ahead, Australian data likely faces headwinds as fiscal stimulus fades. The government’s JobKeeper program expired on March 31, with enhanced unemployment also scaled back. The bulk of government support came through these programs, meaning fiscal tailwinds should be sharply lower in the second quarter. This contrasts with the U.S. scaling up its massive fiscal spend, supporting the view for AUD/USD to move lower.
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