G10 FX Week Ahead: Heat Waves

While heat waves are set to hit the UK and North America next week, second Covid-19 waves are set to keep hitting investor sentiment worldwide. This should result in limited upside for risk assets. We expect some broad consolidation in G10 FX, waiting for USD weakness to materialize in the longer-term.

DXY: Second wave challenges

• The dollar has gone into a consolidation phase as uncertainties over a second wave of the virus and the speed of the recovery have held the risk rally in check. We’d like to think that the market will come to terms with the daily swings in the new US virus cases, although the increase in total daily cases above the 25,000 mark does give cause for concern. The market will also be on the lookout for: i) news on US relations with China (Friday’s report of a pick-up in agricultural purchases looks encouraging) and ii) any news about a fourth US stimulus package – expected before unemployment benefits end in late July.
• On the US data side, our team notes a slight slowing in improvement in the employment situation – thus Thursday’s initial and continued claims will still be scrutinized. We’ll also see May existing home sales, May durable goods orders and a final reading of June consumer sentiment. We’ll also hear from the Federal Reserve's Charles Evans and James Bullard, expected to echo FOMC Chair Jerome Powell’s view that the recovery will be a hard-fought battle. We do note, however, that the financial system seems healthier – drawings on the Fed USD swap lines have dropped to $280 billion from $445 billion over the last couple of weeks – and our bias remains for the dollar to exit consolidation to the downside.

EUR: EU Recovery Fund and June business confidence in focus

• EUR/USD has been consolidating after its recent rally and the week ahead will determine whether it pushes ahead or hands back more of the early June gains. Important to that story will be the latest update on the EU Recovery Fund. If all is on track for progress into the July EU summit, the euro could gain a little upside momentum. If the Netherlands and Austria succeed in unpicking some of the plans made so far, the euro could suffer – especially since the ECB’s Christine Lagarde has highlighted that optimism over the recovery fund has been as important as monetary stimulus. 
• The European data calendar will focus on the flash June PMIs and the German Ifo. Our team looks for further modest improvement in the Ifo expectations index, but it will take some time to return to levels seen at the start of the year. Any manufacturing PMIs above the 50 level, however, would be great progress and could help the euro. Given the big take-up of the ECB TLTRO III, our team sees peripheral debt spreads (particular at the shorter end of the curve) staying contained.

JPY: Foreign bond buying on the rise?

• With the reflation trade on hold – at least until investors feel more confident about second wave risks – USD/JPY has sunk bank into a range. One month realized and implied volatility is just above 6%, compared to levels above 10% in early April. USD/JPY’s daily correlation with the S&P 500 is not particularly high right now (0.22 daily correlation, compared to e.g. -0.74 for USD/CAD), suggesting the JPY remains a story for the crosses.
• In the week ahead we’ll be looking at Japanese foreign bond buying. After a very quiet few months, Japanese purchases of foreign bonds have picked up over the last couple of weeks. This may owe more to greater confidence in the foreign debt story, rather than strategic buying of foreign bonds when USD/JPY nears 105 – but a consistent pick-up in purchases will start to attract greater market attention.

GBP: Staying on the soft side

• Despite the Bank of England delivering a tapered version of the QE extension (ie, the pace of asset purchases is set to decline in the reminder of the year) sterling failed to benefit as the market remains focused on the odds of negative rates. While not discussed at the BoE meeting, it was not ruled out by the Governor during the press conference. This is important for sterling's prospects as the stalling UK-EU trade negotiations suggest that the market will likely take a glass half empty approach and keep GBP risk premium in place (both from the economic side well as from the possibility of negative rates). This suggests GBP is to continue struggling, EUR/GBP to move to /above 0.91 this summer and GBP/USD in turn to underperform EUR/USD.
• On the data front, UK June PMIs (Tuesday) should continue their gradual recovery after the Covid-19 induced slump. Despite the increase, all forward-looking indicators should remain in contractionary territory. Given the volatility of PMI numbers, we don’t rule out an upside surprise, but this is unlikely to have a long-lasting effect on GBP. No key negotiations are scheduled on the UK-EU trade front.

AUD: China back in the driver's seat

• AUD/USD stayed mostly rangebound this week as risk sentiment failed to undertake a definitive path and retail sales overnight compensated for the grim jobs numbers earlier in the week. The calendar for next week does not show any key release in Australia, while some attention will be on remarks by the Reserve Bank of Australia's Philip Lowe on Monday. The two hot topics for the RBA now are a) tapering plans ; b) whether the strong AUD is becoming a factor in monetary policy decisions. The next RBA meeting will be on 7 July.   
• China-related sentiment has started to creep back as the main driver for AUD and this should continue to be the case. Despite some encouraging signals that the second wave in Beijing may have passed its peak, news of transport disruptions - following some new restrictions - may hit appetite on China-sensitive currencies. It will also be worth monitoring the People's Bank of China loan prime rate setting on Monday: there is a possibility the Bank will cut the 1Y and 5Y rates by 20 basis points. In our view, this would be an AUD-positive as markets should focus on the economic benefits to Chinese demand. Overall, we have a neutral bias for AUD/USD next week, in line with stable risk sentiment. 

NZD: RBNZ to show aversion to a strong NZD

• With equities and risk sentiment remaining quite rangebound, the Reserve Bank of New Zealand's meeting on Wednesday is set to be the key catalyst of the NZD's performance next week. While a cut appears to be unlikely now, the big question remains whether the Bank will signal the intention to use negative rates in the future. In our view, there is no evident need for New Zealand to leap into negative rates, but we suspect there is a growing interest in curbing the appreciation of the NZD, which could hinder the recovery in the country's export-oriented economy. 
• It remains to be seen whether the Bank is prepared to accept the adverse consequences of negative rates for the main purpose of currency depreciation. We think it more likely that Governor Orr will continue to fuel expectations for more rate cuts but eventually keep the floor at the current 0.25%. As such, we expect the RBNZ's tone to be very dovish this week, with the balance of risks for NZD tilted to the downside. Looking at other drivers, the NZD may face a spillover from China similar to AUD (details in the AUD section above).

CAD: Macklem’s first speech to confirm smooth transition

• The loonie still shows a more attractive risk-reward profile than other commodity currencies in the G10 thanks to the recent improvement in fundamentals (we do not see the April retail sales drop as too worrying) and the prospects for oil prices. Oil now appears to have a fairly solid floor thanks to improved compliance with OPEC+ cuts, which bodes well for a recovery in the battered Canadian energy sector, ultimately aiding the Canadian dollar's resilience.
• No data release is on the calendar this week but the spotlight will be on the first speech of the new BoC Governor, Tiff Macklem. Markets will likely search for hints at a divergence from the current BoC stance, but we have a strong suspicion that Macklem will aim to insure a smooth transition and will keep any changes for the autumn. We do not expect a significant impact on CAD, which may however be highly sensitive to any comments around negative rates– as is happening for many other central banks – even though we see such prospect as very remote. As such, CAD should remain driven mainly by the overall neutral risk sentiment this week and we expect it to prove more resilient to swings in sentiment compared to its peers, AUD and NZD.

CHF: Unimpressed by the SNB

• June's Swiss National Bank meeting provided no surprises and EUR/CHF took little notice of comments by the SNB’s Andrea Maechler, who said that the SNB would consider any measures to help the economy – e.g. starting a domestic asset purchase program. Instead it looks as though the SNB remains committed to negative rates and more FX buying – near 1.05 in EUR/CHF.
• The re-rating of the EUR on EU recovery fund news in early June has been the biggest driver of EUR/CHF this month. And this story looks like it will have much further to run over coming weeks and months. Providing support to EUR/CHF should be the recent large take-up of the ECB’s TLTRO III, which should help to underpin eurozone peripheral debt for the remainder of the year. We don’t see anything on the local Swiss calendar that will impact EUR/CHF this week.

NOK: The NB effect fading, the risk environment still matters the most

• It is a fairly quite week on the Norwegian data front. The Norges Bank meeting this week translated into a positive knee-jerk reaction for the krone as the central bank upgraded its growth outlook and revised the interest rate outlook higher from flat throughout the forecast horizon to a first full hike by 1Q23. While modestly positive for NOK, this on its own should not have a long-lasting effect on the currency as rate hike prospects still remain very remote.
• Rather, the prime NOK driver should remain the general risk environment. This was the case over the past few weeks and should remain the case in the months to come. For next week, our view of a neutral risk environment suggests stable / modestly lower EUR/NOK, as the currency remains the most undervalued in the G10 FX space. On the domestic data front, the April unemployment rate (Wednesday) and May retail sales (Friday) should have a muted impact on the krone.

SEK: Steady force in the cyclical G10 space

• The Swedish krona should remain a steady force in the cyclical G10 space, staying resilient during risk-off days while continuing to grind higher as the global U-shape recovery gains traction. Non-negative risk appetite next week suggests EUR/SEK staying rangebound around the 10.50 level.
• On the domestic data front, the focus turns to the June Economic Tendency Survey (Wednesday) and May retail sales (Friday). The data points are unlikely to rock the boat for the steady krona, which should remain stable in a non-negative risk environment. Equally, the effect on SEK of any upside surprises should be muted given the firmly cautious Riksbank bias.