The tariff truce came to an abrupt end via presidential tweets on May 3. Until those tweets, U.S. officials had been indicating that progress was being made and there was hope that on the sidelines of the G20 meeting, Trump and Xi would agree on a trade deal. The end of the tariff truce marked a turning point in the markets. Risk appetites were reduced. Equities and yields fell. The dollar eased in the first half of May as renewed trade tensions were understood as increasing the likelihood that the Federal Reserve would cut interest rates. The greenback recovered in the second half of the month, with the notable exceptions of the Japanese yen and Swiss franc, as the wide interest-rate differentials and the idea that the U.S. is best prepared to weather escalating trade conflicts were pondered.
Ahead of the imposition of China's retaliatory tariffs on June 1 and just as the process seeking ratification of the new North American free-trade agreement has begun, President Trump surprised the world by claimed emergency powers, imposing a 5% tariff (effective June 10) that could gradually rise to 25% at the start of Q4 – unless Mexico tightens its border controls. There are likely to be far-reaching (even if unintended) consequences for Mexico – the outlook for monetary policy and for those seeking to move facilities from China, the U.S. economy and future trade negotiations. The current trajectory would put a 25% tariff on all the goods from the two countries that are the largest source of U.S. imports and a 25% tariff on all car imports. Shades of Smoot-Hawley.
The local elections proved disastrous for the UK Tories at the beginning of the month and their performance in the EU Parliament elections was not better. Prime Minister May finally succumbed to pressure, resigning before the results of the EU Parliament elections were announced. The risk-off environment that followed the end of the tariff truce plus the heightened risks that May's successor would increase the risk of a no-deal exit weighed on sterling, which fell nearly six cents over the course of the month and fell almost every day against the euro after Trump's twitter storm on May 5.
The June ECB (June 6) and Federal Reserve (June 19) meetings are among the month's highlights. Although neither central bank is expected to announce new initiatives, both will present updated forecasts The ECB will also provide more details of its new Targeted Long-Term Refinancing Operation (TLTRO). Meanwhile, the gap between the Fed's declaratory policy (patience, wait-and-see) and the market, which is aggressively pricing in a rate cut before the end of the year, has rarely been more stark.
The Chinese yuan's 2.6% decline against the dollar in May unwound the lion's share of its gains for the year. The fall, however, is not a reflection of officials seeking to offset the tariff effects. In word and deed, Chinese officials have been tempering the yuan's decline and warning against speculation. Owing to interdependency and limited alternatives, we argue that it is difficult for China to use the yuan's exchange rate, its holdings of U.S. Treasuries or its dominance in rare-earth minerals as leverage against the United States. Due to the costs involved, we identify them as possible measures at a much higher level of the escalation ladder.
Dollar: Backed by the highest interest rates among high-income economies, the U.S. dollar is higher against all the major currencies but the yen and Canadian dollar so far in the first half of 2019. There is little doubt among economists that the U.S. economy slowed markedly in Q2, but this follows the overshoot in Q1. At the same time, market-based measures of inflation expectations (e.g., the five-year/five-year forward and 10-year break-even) have fallen around 20 bp in May. Fed officials will likely see the tariffs as equivalent to a tax hike rather than focus on the resulting higher prices. We still only a slim chance that Trump and Xi will meet on the sidelines of the G20 meeting. The rhetoric was still rising as May ended. The U.S. has given Europe and Japan until late November to limit auto exports and that has cast a cloud over the bilateral negotiations. However, unlike the new NAFTA agreement, the negotiations with Japan and Europe are executive agreements, which do not need congressional approval.
Euro: Following the stronger-than-expected Q1 US GDP reported on April 26, the euro recorded a low of almost $1.11. Speculators sold into the euro's bounce and the single currency came back and made a marginal new low, drawing even closer to $1.11. The news has already been discounted. While real data are doing better than sentiment, the headwinds on EMU are well known. Several governments are being formed and that could take some time. Austria and Greece will likely hold national elections in July. Italy's Salvini, with a strong showing in the European Parliament elections, may flex his muscles and push to become Prime Minister. Banking woes and the public-debt issues remain worrisome and there's still a potential flashpoint between the EC and Italy. Toward the end of June, the new European Commission may begin taking shape and Draghi's successor at the ECB could be part of the negotiations.
(previous in parenthesis)
- Spot: $.1.1165 ($1.1225) Median Bloomberg Forecast $1.12 ($1.1215) One-month forward $1.1193 ($1.1255) One-month implied vol 4.85% (5.27%)
Yen: The Japanese economy and BoJ monetary policy does not appear to be driving the yen. The economy's apparent resilience in Q1 despite a decline in consumption, investment and exports, was owed to the fact of government spending and the fact that imports fell faster than exports. Upper house elections will be held in July and there is a reasonable chance of lower house elections as well. Since elections for the lower house are not required until October 2021, joint elections would require Abe to dissolve it in June. The end of the tariff truce between the U.S. and China has unleashed a wave de-risking that has strengthened the yen. Outside of the flash crash, that inexplicable sharp drop of the dollar on January 3 below JPY105 briefly, the dollar has traded for the most part in a four-yen band centered on JPY110.
- Spot: JPY108.85 (JPY111.40) Median Bloomberg Forecast JPY110 (JPY110.70) One-month forward JPY108.55 (JPY111.15) One-month implied vol 6.90% (5.30%)
Sterling: The Tory leadership challenge to replace Prime Minister May is likely to dominate the Brexit discussion for June and probably most of July as well. Sterling has fallen as the market fears that the next Tory leader will be willing to leave the EU without an agreement. However, such a position could alienate the Democratic Unionist Party from Northern Ireland. Northern Ireland voted for pro-European Parties in the recent EU Parliament elections. The withdrawal of the DUP's support could trigger national elections, which in turn could force the UK to seek another postponement for withdrawal or possibly revoke Article 50 and begin again.
- Spot: $1.2590 ($1.3065) Median Bloomberg Forecast $1.30 ($1.3180) One-month forward $1.2610 ($1.3085) One-month implied vol 7.0% (6.73%)
Canadian Dollar: The macro-economic climate has improved but by itself, that does not help the Canadian dollar very much. In terms of impact on the Canadain dollar, concerns about world growth, especially given the renewed tariff conflict between the world's largest two economies as expressed through reduced risk appetites, offset the narrowing of the two-year interest rate differential with the U.S. In a risk-off environment, it is difficult for the Canadian dollar to find good traction. The process that will lead to the Canadian Parliament's approval of the new trade agreement with the U.S. and Mexico has already begun.
- Spot: CAD1.3535 (CAD1.34) Median Bloomberg Forecast CAD1.34 (CAD1.3350) One-month forward CAD1.3520 (CAD1.3085) One-month implied vol 5.0% (5.15%)
Australian Dollar: The combination of the risk-off sentiment, the slowing of China's economy, trade tensions and the intensification of rate-cut speculation has weighed on the Australian dollar. The unexpected victory of the Liberal-National government in the middle of the month failed to offset the headwinds. The market is pricing aggressive easing by the Reserve Bank of Australia beginning with the June 4 meeting. A second cut has been fully discounted and pricing in the derivatives market suggests some are anticipating another one too. The current cash rate is 1.50% and the 2-year note yield has fallen 75 bp this year through the end of May to about 1.10%. The market may be at risk of getting ahead of itself and bears in the futures market have the largest gross short Aussie position in four years.
- Spot: $0.6915 ($0.7040) Median Bloomberg Forecast $0.7000 ($0.7070) One-month forward $0.6925 ($0.7045) One-month implied vol 7.25% (7.80%)
Mexican Peso: Mexico's high real and nominal rates protected the peso even as the economic backdrop weakened. The central bank cut its growth forecast for this year to 0.8%-1.8% from 1.1%-2.1%. The central bank is reluctant to cut interest rates because inflation is still above its 3% +/-1% CPI target. Banxico does not expect inflation to fall into the target range until late this year but the peso's decline in the face of U.S. tariffs keeps price pressure elevated. Optimism that Mexico was understood to be well positioned to benefit from reduced U.S.-Chinese trade may be questioned in light of new U.S. tariffs. Since March, Mexico exports more to the U.S. than does China.
- Spot: MXN 19.73 (MXN19.01) Median Bloomberg Forecast MXN 19.19 (MXN19.09) One-month forward MXN19.83 (MXN19.03) One-month implied vol 12.3% (9.22%)
Chinese Yuan: The yuan has been among the weakest currencies since the end of the tariff truce, falling about 2.5% against the dollar. However, this seems more like market forces that also took more than 5% off the value of companies that are part of the Shanghai Composite. Risk assets have underperformed broadly. In both word and deed, officials sought to counter the pressures on the yuan. After an initial decline, the yuan has steadied over the last couple of weeks even though the rhetoric remains escalated. The dollar has held below CNY6.92, though CNY7.0 is the critical level, primarily because it has been in the past. The lower end of the recent range is around CNY6.88. Unlike other observers, we see significant costs for China associated with weaponizing or using its Treasury holdings, its currency or its dominance in rare earths as leverage with the U.S. These costs imply that in the escalation ladder of the conflict, these measures are not for the lower rungs, which is where we would still assess the situation, despite the end of the tariff truce.
- Spot: CNY6.91 (CNY6.7350) Median Bloomberg Forecast CNY6.75 (CNY6.7140) One-month forward CNY6.91 (CNY6.7250) One-month implied vol 5.1% (3.65%)