News & Analysis

USD

Even after projecting three rate cuts this year, the Fed still stands out as hawkish. This was the takeaway in markets yesterday, as the SNB cut rates unexpectedly, the hawks at the BoE fell on their sword, and weak German and French PMIs provided another supportive data point for the doves at the ECB. At the same time, the focus in US rates was on Fed easing expectations beyond this year. For example, 1-year forward OIS pricing bounced and stayed stable above 4%, suggesting that once the Fed cut rates three times this year, it would have to decelerate the pace of easing considerably in 2024. This outcome saw 2-year Treasury yields climb 4bps and the dollar firm across the board in a move that we had warned would be coming as yesterday we noted that the dollar sell-off was focusing on the wrong thing as the Fed sounded markedly more hawkish on the overall path for rates.

This morning, the dollar bid remains firm across the board, with the main development occurring in Asia overnight as the Chinese yuan slipped to a four month low after authorities fixed USDCNY above 7.10 for the first time since March 7th at a time when the market was focused on fewer rate cuts from the Fed beyond this year and a slew of disappointing earnings reports dragged on Chinese equities. This provided the perfect combination for traders to take USDCNY north of the 7.20 cap that had been in place all year, with the currency up 0.35% on the day at the time of writing. This is a significant move, namely for APAC FX where the soft peg in USDCNY had anchored a lot of the region’s currencies and dragged implied volatility much lower. It is therefore unsurprising to see AUD and NZD underperform against the dollar in the G10 space this morning, with the Korean won and the China-linked ZAR also leading losses in emerging markets. With Bloomberg already reporting that State banks are out in force to smooth the recent decline, the focus now turns towards Monday’s daily fixing to see whether the PBoC reinstates its intolerance for CNY weakness by placing it back below 7.10 and if it follows this up by squeezing funding conditions as last summer authorities drained liquidity to shake out short CNY positions from the market.

The move in USDCNY overnight doesn’t just have major implications in spot markets, however. The lack of volatility in the pair has dragged implied volatility in the region considerably lower in recent months, but this morning’s breakout has seen front-end implieds rise across the region. As we pointed out in a note a fortnight ago, near-term hedging costs in most USD-Asia pairs in options were incredibly cheap by historical standards due to soft pegs in USDCNY and USDJPY, but we expected that this wouldn’t last and likely wouldn’t need the Fed to change that with its first rate cut. Today’s moves in USDCNY and those in the yen over the past week have proven that point, making USD-Asia pairs more volatile and bringing life back into the options space.

EUR

March’s flash PMIs for the eurozone suggested that conditions in the eurozone may finally be improving, as the services measure rose further into expansionary territory, rising from 50.2 to 51.1 and printing well above expectations of 50.5. However, as we noted in our initial reaction, this glossed over some pivotal developments, both in terms of the distribution of growth and the implications this has for the ECB. While the eurozone services measure printed strong, March was another bleak month for the manufacturing sector, which considerably undershot expectations and dragged the eurozone composite reading lower such that it marginally undershot the no-change level at 49.9. Furthermore, the growth in services wasn’t reflected in the region’s two largest economies, as both France and Germany recorded no growth in that sector. Furthermore, while the ECB continues to stress about high wage growth and the PMIs also suggested input prices remained high in services, the reports noted that firms were taking this hit in their profit margins as they struggled to pass on higher wages to the final consumer due to weak demand levels. All told, while the data was positive at its most aggregate level, the details of yesterday’s reports favoured the doves more than the hawks within the Governing Council.

GBP

Softer than expected flash PMIs and unexpectedly dovish BoE commentary combined to see sterling take a nosedive on Thursday, dropping a full percent against the dollar and almost half a percent against the euro. Even so, sterling’s reaction feels a little overblown to us. PMIs continue to print in expansion, with hints that inflation pressures remain sticky under the surface. These details, all else equal, should be supportive for the pound, even if the headline print was modestly disappointing. Meanwhile, though the MPC did open the door to rate cuts yesterday, we continue to think that there is a high bar to easing policy in the first half of the year. Admittedly, a post-meeting intervention by BoE Governor Bailey saying “all our meetings are in play”, reads as dovish. But with uncertainties around the impact of April’s National living wage rise, we still think policymakers would need to see a string of favourable prints to be able to cut rates in June. Given the relatively low probability of such an outcome, we continue to see odds tilted in favour of a first rate cut in August for now. A high for longer Bank Rate profile under this scenario should also help lift sterling, and as such, we are inclined to see yesterday’s selloff as temporary weakness, rather than a more permanent retracement. For now though traders have continued to take sterling lower, even whilst retail sales data beat expectations to flatline in February. Coming on the back of January’s string print, this is another strong indicator that consumer demand should drag the UK economy out of recession. This is not a GBP negative signal in our minds, suggesting a retracement higher should be in store for the pound.

CAD

After initially threatening to continue Wednesday’s selloff, USDCAD reversed course yesterday’s morning to ultimately finish the day up 0.3%. The move higher for the pair largely reflected the broader rally for the dollar, coming as traders continued to digest Wednesday’s Fed meeting, and in particular, a series of interest rate projections that were less dovish than many had expected. With the dollar’s climb continuing to extend this morning on developments in Asia, USDCAD now finds itself trading close to pre-Fed levels once again as markets trade in a risk-off nature. In our view the current USDCAD level better reflects the divergence in fortunes playing out between the US and Canada. This narrative should be further reinforced later today by Canadian retail sales data, expected to show that consumer activity softened in January. If realised, this should add further weight to the view that the Canadian economy remains weak, weighing on inflation, an outcome that is likely to see a rapid pace of BoC easing later this year and setting up the loonie for what we expect to be a continued move higher.

 

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