For much of May and June, broad moves in risk sentiment have dominated major FX pairs, with the US dollar strengthening during risk-off periods and weakening as risk appetite improved. As a result, the broad dollar’s performance has traded with an inverse relationship to US equities.
This week’s price action has offered some modest divergence from this theme, with G10 FX performances differing amid concerns about continued growth in covid-19 cases in the US, and fresh restrictions in China. The Bloomberg dollar index closed the week higher, as has the S&P 500, which for now has shrugged off these broader global concerns. The question for FX is now if the binary risk on/risk off dynamic will return, or if idiosyncratic drivers such as macro data and monetary policy will take on increased importance. This week’s calendar offers several interesting tests for which way markets will trade. Flash Purchasing Managers’ Indices will give investors a look at how tentative re-opening has affected major economies, while Banxico is poised to offer another cautious rate cut at Thursday’s meeting, which may end up supporting MXN given conducive general risk appetite. Additionally, Bank of Canada Governor Tiff Macklem is due to give his first speech on Monday, while the Hong Kong Monetary Authority may continue to ease intervention in FX markets.
S&P500 and broad US dollar trade in tandem as currencies dominated by risk sentiment
PURCHASING MANAGERS’ INDICES LIKE CATNIP FOR MARKETS DESPITE NOISE
As diffusion indices, PMIs measure the balance between respondents reporting their business is contracting, and those reporting it is expanding. Obviously, the base for the level of activity businesses are reporting changes from matters greatly. A PMI reading of 60 is less impressive if it follows the biggest macro shock recorded in peacetime, when activity is extremely depressed. This is likely to be a significant confounding factor for Tuesday’s purchasing managers indices, which for many regions will reflect modest re-opening and therefore will see a level up improvement as a matter of course. Inferring just how bad the Q2 shock was will be a difficult task before official data is released, but as limited as the PMIs are they are among the most timely means of doing so, and for this reason markets are likely to view Tuesday’s releases as a major barometer for risk in general.
- US: May’s Purchasing Managers Indices correctly alluded to the sustained rate of job losses seen in the US in recent weeks, when the manufacturing employment index constructed from survey responses remained below 40. The signal was validated by incoming jobless claims data, which remained elevated and topped 1.5m this week. With the headline Manufacturing PMI expected to rise as high as 47.8 according to forecasts submitted to Bloomberg, the performance of the employment sub index may once again offer a glimpse at if the rate of job losses in the US is beginning to stabilize. In a general sense, June has seen further disruption for US businesses from large-scale protests, which may show up in the survey data.
- UK: The Bank of England noted in its most recent meeting minutes that the initial shock to the economy from covid-19 containment measures may not prove as sharp as originally feared, and this week’s PMIs will be the first major test of this conclusion. Nationwide re-opening of non-essential businesses occurred in the middle of June in the UK, and so broad business sentiment is indeed likely to pick up, and support the MPC’s cautious optimism. The composite PMI is expected to rise 10 points to 40, reflecting ongoing contraction in the economy but at a reduced rate.
- EU: As with the UK and US, Eurozone PMIS are generally expected to pick up. With several parts of Europe seeing relatively contained covid-19 outbreaks and expectations for Tuesday’s PMIs prints all well below the 50 level, there seems some potential for some upside surprises in the releases.
MACKLEM UNLIKELY TO STRAY FROM PRAGMATIC AND CONSERVATIVE APPROACH, BUT Q&A COULD PROVIDE MORE FORWARD GUIDANCE FOR MARKETS
Next week marks the first speech by newly appointed Bank of Canada Governor Tiff Macklem. While Macklem has already hosted one rate decision and stood in front of the House of Commons finance refcommittee, this week’s event marks his first free standing speech on monetary policy since taking the role as the head of the central bank at the beginning of June. The speech is entitled “Monetary Policy in the Context of COVID” and is due to take place virtually on Monday at 11:00ET/ 16:00BST.
Since taking the role of Governor at the beginning of the month, Tiff Macklem has hit the ground running. Thus far in his first few weeks, the governor has been getting to grips with the new role by reading from the same playbook left behind by his predecessor Stephen Poloz. It won’t take long for the 10th Governor of the BoC to cut his teeth and create his own legacy though, with a long career already at the central bank, albeit at lower positions. The early signs of the Governing Council’s united stance under Macklem’s tenure are already starting to take shape, however. Both Macklem’s testimony to the House Finance Committee and Schembri’s to the Greater Saskatoon Chamber of Commerce struck a very cautious and pragmatic tone, a stark contrast to Poloz’s previously upbeat outlook. After outlining a strong defence for Poloz’s reaction to the pandemic, Macklem stated that the Bank is unlikely to revert back from a scenario based monetary policy report in July due to the high level of uncertainty.
While the Bank stands ready to intervene when necessary and has a few remaining tools up its sleeve to expand its stimulus measures, the latest comments suggests that pragmatic conservatism will be the dominating theme in the coming months.
The longer the MPR remains in a scenario style format, the more important the rhetoric by board members will become to dictate the tone of the Bank’s core outlook. However, with the economy still in the early stages of recovery and Governor Macklem not jumping at the chance to highlight strong improvements in the labour and housing markets, we don’t expect the Governing Council’s public stance to deviate too much from its current trend. The open Q&A session in Monday’s speech offers an opportunity for further insight into the Bank’s current outlook, with markets desperately trying to decipher what metrics policy makers are watching to judge whether the recovery is “well under-way”.
Building out monetary policy expectations will be a key focus for investors ahead of the July MPR as the preliminary signs of forward guidance begin to seep from developed market central banks. It is widely considered that the flow and level of asset purchases by central banks will be the best metric to gauge the timing of marginal tightening, especially after the Bank of England’s decision last week to reduce the frequency and sizing of weekly purchases. Any discussion on the path for LSAP’s going forward by Macklem on Monday, or in central bank communications going forward, is likely to cause heightened volatility for the loonie for this reason.
Pace and level of central bank balance sheet will be key for markets which crave forward guidance on stimulus measures
USDHKD REMAINS AT BOTTOM OF RANGE AS INTERVENTION SLOWS
The Hong Kong Monetary Authority slowed their intervention in FX markets last week but capital inflows kept the pair at the bottom of its range as Hong Kong’s spread over US rates remains elevated. The one-month HIBOR premium over USD LIBOR has prompted currency traders to flood into the Hong Kong dollar over the last few months, pushing USDHKD to its lower bound as the Hong Kong dollar strengthens. HKD continues to trade at the lower bound of its trading regime implemented in 2005 even after the latest rounds of intervention take effect. However, with HIBOR rates falling and forward points elevated the HKMA are beginning to slow the pace of intervention.
USDHKD hits the bottom of its trading range for the first time since 2015 as carry conditions and equity opportunities outweigh downside risks
Last week, the monetary authority sold HK$3.007bn on Tuesday and Wednesday compared to HK$19.097bn the week prior. This brings the overall level of intervention to HK$63.113bn since the beginning of April. However, calls from some market participants for the peg as a whole to come under serious pressure remain premature, in our view. The size of the central bank’s FX reserves dwarfs the level of intervention seen over the last few months and with swap lines to the PBoC, the currency breaking below the HK$7.75 level remains a long-shot in the near-term.
Given the multitude of downside risks in play, the HKD rally is somewhat mesmerizing. Its surge to the top of its trading range comes in spite of deteriorating economic fundamentals caused by the impact of the coronavirus on migrant and capital flows, while the impending redaction of its special trading status by the US also poses a major downside risk.
While the backlash from the national security law remains vague at present, it could relieve pressure on the HKMA to protect its currency regime. With these downside risks to the economy so prominent, capital inflows continue to outstrip outflows according to Financial Secretary Paul Chan, as Chinese companies sell shares in the city and existing stocks offer value. The recent developments on Chinese ADRs de-listing from the US imply more IPO’s and capital inflows to the Hong Kong equity market should they choose to re-list on the Hang Seng.
This week, the pace of intervention by the HKMA is likely to persist at lower levels compared to that seen two weeks ago as HIBOR continues its trend towards the US LIBOR rate. After declining for 15 consecutive trading days, its longest downtrend in 3-years, and with forward points supported at the 200 level, the Hong Kong dollar’s bullish appeal may begin to dissipate.
HKD forward points supported at 200 while HIBOR premium over USD LIBOR continues to close
BANXICO BATTLES WITH GLOBAL RISK-OFF SENTIMENT INTO ASSISTING THE MEXICAN PESO
The Bank of Mexico announces its next monetary policy decision on Thursday June 25th and is expected to cut another 50 basis points as per the Bloomberg median consensus. This also runs in line with our forecast. Banxico has already slashed rates by 150 basis points since the pandemic’s outbreak in March, on top of 125 basis points trimmed since the beginning of the easing cycle in August. The benchmark rate currently sits at 5.50%, its lowest level in over three years. Even so, Banxico holds ample room to ease further given the comfortable inflation outlook and the still restrictive position of the policy rate. The neutral level of interest rates is estimated at around 4.25%. Cutting to such a level would nearly double the pandemic policy response to date. Option markets currently price in a rate cut of 35 basis points for the policy announcement next week, leaving a slight margin of surprise should Banxico cut rates in line with our expectations. However, we would expect options pricing to adjust to a half point cut ahead of the announcement, as Banxico is likely to continue its pace of easing seen in response to the pandemic thus far.
The outlook for Mexico’s economy is bleak at present. According to Banxico’s latest projections, the Mexican economy could plunge by as much as 9% this year, with 1.4 million job losses.
The estimate was revised down sharply from a previous forecast of GDP growth between 0.5% and 1.5% in 2020, after accounting for the massive economic damage triggered by the pandemic. In Q1 alone, GDP shrank by 1.9% on an annual basis, with domestic activity only being affected in the last week of the quarter by the implementation of social distancing measures. With lockdown measures in place for most of the second quarter, the median estimate for the GDP contraction in Q2 hovers around 11.6%. The inflation outlook by the end of the year is also expected to be weighed down in balance by a widening output gap. However, the high level of uncertainty in the trajectory of price growth is set to keep Banxico in a cautious stance. The potential recovery in energy prices, along with likely pass-through effects from currency depreciation and supply-side constraints could derail the inflation outlook and market inflation expectations. Annual inflation pivoted from a drop of 2.15% in April to a 2.84% rebound in May, following the recovery in oil prices. As per the unprecedented uncertainty facing the economy, Banxico is likely to remain in a rather cautious yet accommodative stance compared to other major central banks.
MXN remains far from pre-virus levels especially after breaking its rally on shifting risk sentiment
Another main concern shaping Banxico’s conservative policy path relates to potentially high capital outflows. In the first quarter, Mexico registered a $5.5 billion outflow in the bond market, outpacing any capital losses sustained since 1995. The move reflects the increased risks from fragile debt profiles, both from the sovereign and state-run oil company Pemex, which was downgraded into further junk territory by all major rating agencies. Even though currency moves from capital account pressures are not central in the policy setting, high peso volatility is poised to influence Banxico’s prudent stance amid increasing risks to financial stability. So far, the bank has managed sharp market volatility by means of unprecedented liquidity-boosting measures worth 3.3% of last year’s GDP. However, any further major market turmoil is poised to prevent Banxico from easing monetary policy via interest rates, while also souring prospects for medium-term peso appreciation.
The Mexican currency has broadly taken Banxico’s cuts as an element of support, since monetary accommodation improves Mexico’s chances in overcoming the impending recession. Considering all major central banks have aggressively eased policy tools as well, the Mexican peso still bears an attractive carry for traders, especially since policy rates remain as one of the highest in the EM space. Looking ahead, further gradual interest rate cuts should add currency strength in this vein, helping the peso to trend towards its pre-virus levels by year-end. However, this argument is particularly contingent on broad market sentiment. Even with relatively high yield spreads, the Mexican peso has proven to be extremely sensitive to market´s risk-off mood and global economic uncertainty. While monetary policy decisions still play as a factor into MXN volatility, the currency has turned increasingly more sensitive to sentiment waves amid the current panorama.
Ranko Berich, Head of Market Analysis
Simon Harvey, FX Market Analyst
Olivia Alvarez, FX Market Analyst