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GBP
Sterling continued to draw a lot of attention from the sell-side community yesterday, with the improvement in some analysts’ projections garnering a front page story in the Financial Times. The more constructive case for GBP is built upon the idea that the UK’s economy has proven more resilient than analysts had initially expected, external balances have improved, and most importantly that the Bank of England will be forced to take interest rates close or even to 5% whether policymakers like it or not. However, in what has become a relatively dull market in terms of directional conviction, the more positive calls have sparked quite a bit of pushback, and even we are dubious as to how far the sterling outperformance can run. Underpinning the recent leg higher in the pound has been a shakeout in net short positioning, not necessarily an accumulation of net long positions. In addition, we don’t believe the MPC will meet market expectations of up to three more rate hikes. While tomorrow’s decision may come too early for the BoE to pause and significantly push back on market pricing, we expect the Bank to move from a non-committal stance and pause its hiking cycle as early as June. In conjunction with our view that the ECB’s terminal rate is higher than markets are pricing, we think sterling should retrace against the euro specifically over the next month, especially as it currently trades at a five month high.
EUR
It was another busy day in terms of ECB commentary yesterday. The main takeaway from all of the speeches and interviews was that the ECB remains committed to its hiking cycle and that the deceleration in the pace of the hiking cycle was not a sign that it was about to imminently end. As we noted yesterday, this coincides with our view that the ECB’s terminal rate is higher than markets are currently pricing. However, it will likely require another round of robust core inflation data for markets to fully buy into the ECB’s more hawkish guidance and take the market implied terminal rate up closer to our projection of 3.75%. With headlines from ECB members having little impact on money market pricing, and amidst a broader risk-off backdrop, the euro struggled yesterday as it sank back towards the lower end of its recent trading range. Rate differentials are still a prominent driver for the single currency, and although eurozone rates are proving to be somewhat sticky, we could see some action this afternoon on the US side following April’s inflation data. Any significant slip in core inflation that inflates rate cut expectations will likely see EURUSD return to the upper end of its recent range, while a stronger reading will likely see yesterday’s lows broken. On the eurozone side, there is little in the economic calendar beyond comments from ECB member Madis Muller who is speaking on financial stability at 09:00 BST.
USD
The dollar broadly gained throughout yesterday’s session, even against fellow haven currencies, as equities tumbled and yields rallied. Underpinning the cross-asset price action were multiple ongoing stories. In equities, the real estate sector largely underperformed, especially within Europe, after one of Sweden’s largest commercial landlords delayed a dividend payment after suffering a ratings cut. With the transmission of monetary policy much swifter in Sweden, signs of commercial real estate weakness acted as a harbinger for European realtors. Also putting equities under pressure was the renewed rally in front-end yields. The US 2-year was back above 4%, lifted by continued concerns over the US debt ceiling and positioning ahead of today’s inflation report. On the former, despite talks between House Speaker Kevin McCarthy and Joe Biden, there remains no developments in terms of a deal. Meanwhile, driving broader risk aversion were the results of the NFIB measure of small business optimism. A consistent indicator of a recession over the past two decades, the continued decline in the index suggests that the probability of a US recession remains somewhat elevated, despite data on lending conditions and the US labour market pushing back on this narrative in recent days. After the swathe of economic headlines, focus then turned to New York Fed President John Williams, who is one of two influential Fed speakers scheduled this week. However, those looking for a more detailed discussion of how credit conditions are evolving and the impact that would have on monetary policy were left disappointed as Williams stuck to the script used by Powell last week.
Today, inflation comes back into view for markets with April CPI set to be released at 13:30 BST. Expectations have shifted ever so slightly from yesterday, with economists now looking for no change from March’s 0.4% MoM reading, which due to base effects would bring the year-on-year reading down just 0.1pp to 5.5%. With markets pricing in 63bp worth of cuts this year, down 7bps from this time yesterday, the reaction profile to today’s reading is relatively asymmetric. Any rapid decline in sequential core inflation is likely to firm up expectations of policy easing, meaning the threshold for a shock is fairly high at around 0.2% MoM. Conversely, a positive surprise of just 0.1pp (i.e. a 0.5% MoM reading) will likely result in fewer cuts being priced in. This should be a supportive factor for the dollar as it feeds into the Fed’s “higher for longer” messaging.
CAD
Little happened in USDCAD on Tuesday, as no major news nor data were released. Today, we anticipate that volatility will pick back up as US CPI is tabled for release, especially given CAD’s sensitivity to US rates.
Given the lack of volatility yesterday, we have decided to use the opportunity to take a deeper look back at the loonie’s strong performance since the start of the month. For disclosure’s sake, we revised our bullish CAD view at the start of the month in favour of a more neutral tactical stance, as growing two-sided risks and mixed data had considerably raised the uncertainty surrounding the macro outlook. The Canadian dollar has appreciated by 1.3% against the US dollar since the start of May, and has tracked fairly closely with other pro-cyclical G10 currencies. Most of the loonie’s cross-asset drivers supported the rally, with a neutral effect from a directionless equity market being the key exception. Broad US dollar depreciation offered modest support to CAD, with the DXY falling by -0.3%. Further supporting loonie strength, we found that Canadian yields narrowed the gap with US yields, by 8 and 6 bps at the 2Y and 10Y tenors. Over in the commodities space, crude oil rose by 1.2%, while base and precious metals also bounced. Finally, despite the lack of change in equities, the VIX index marginally eased. The correlation of daily returns shows that the loonie’s performance was most similar to that of the Norwegian krone, another petrocurrency. While the loonie began to turn around on May 3rd, when the Fed met expectations for a 25bp hike and hinted at a pause in its hiking cycle, the rally quickly accelerated the next day, which coincided with the turnaround in crude, as well as the bottom in regional bank stocks—key signs of rebounding risk sentiment. With risk appetite improving for the loonie, jobs data on Friday, May 5th also contributed to better sentiment, with prints in both Canada and the US roughly doubling expectations and pushing back on the widely-held view that North American economies will descend into a recession this year.
We’re clearly in an end-of-cycle market, with most G10 central banks preparing to shift stances from the last year of tighter policy. But considering that market participants hold a much wider range of opinions than usual on the macro outlook, forecast errors and revisions for economic data have been especially large, and insufficient information exists on the magnitude of credit tightening stemming from regional bank troubles in the US, it is still too difficult to call when USDCAD will break out of the 6-cent trading range that has held over the past 8 months. Until then, our expectation is that the pair will continue to mean-revert towards the midpoint of this range in the event that it reaches either extreme, although our view could change depending on the evolution of the macro data.