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Russia's invasion of Ukraine and China's response to Covid continue to shape the broader investment climate. Europe is making efforts to reduce reliance on Russia's energy. Ultimately, the disruption to Ukrainian food shipments is a different story, and protectionism measures by India, Malaysia, and Indonesia do not help matters. An estimated 20%-30% of Ukrainian farmland is either unplanted or unharvested. At least two dozen countries depend on Russia/Ukraine for at least half their grains. 

China's policy response to Covid seems out-of-proportion to the threat given the mutations in a way that arguably was not the case two years ago. Still, the important takeaway is that it appears that the max lockdown is passed, which is not to say that it is over. With the re-opening of large swathes of the economy, Beijing has announced new fiscal measures to support the economy. That said, the May economic data may mark the trough. Moreover, the downward revisions to this year's growth forecasts last month may also mark the peak in pessimism.

George Soros has argued that Xi's third term is not assured, and some reporters have played up potential differences between President Xi and Premier Li. However, it has already been signaled that Li will not join Xi in another term. And it seems that by the 20th Party Congress in Q4, the economy will be in recovery mode, and possibly a robust one at that. 

Almost at the same time that President Biden indicated that the US would defend Taiwan from an attack, and the White House walked it back for at least the third time, the Biden administration unveiled its new regional initiative. Hal Brands, professor at Johns Hopkins and columnist for Bloomberg, piqued that "once is a gaffe, three times is policy. And yet an element of ambiguity remains. The signal is not to China. On the contrary, Beijing's war planning must assume that Taiwan's allies, including the US, come to its aid. Rather America's "strategic ambiguity" was directed at Taiwan to deter it from unilaterally dragging the US into a war with China by, for example, declaring independence.

Biden's new initiative, the Indo-Pacific Economic Framework (IPEF), includes 13 nations. If it is to fill the vacuum since the US withdrew from the Trans-Pacific Partnership, it is unambitious. No trade barriers are coming down. No tariffs are being cut. It is about clean energy/decarbonization, supply chain resilience, infrastructure, and taxation/corruption issues. It is vague and abstract.

Two other elements will be noted by Beijing for their absence. First, despite a letter signed by half of the Senate to include Taiwan in the IPEF, the Biden administration did not. Second, Biden's FY2023 budget proposal calls for a reduction of the size of the US navy to 280 ships in five years from 298 today. The Pentagon estimates that China has 355 vessels now and projects it to increase to 460 by 2030. In fairness, US allies in the region--Japan, South Korea, and Australia, have as many ships combined as China--and US tonnage is greater than China, meaning that it has bigger vessels.

Alongside the reverberations to shockwaves emanating from Russia's invasion of Ukraine and China's extreme reaction to Covid, countries must cope with the hawkish turn by the Federal Reserve and a strong US dollar as they wrestled with their own economic dynamics. Rising inflation was the driver of US rates and the Fed, which, in turn, underpinned the dollar. Last month, it looked like inflation may have peaked. Inflation expectations, measured by the 10-year breakeven or five-year five-year forward, peaked in late April and fell around 50 bp in May. The two-year breakeven peaked about a week after the first Fed hike in March near 5% and by mid-May had dropped to about 3.75% before consolidating.

In early May, the market toyed with the idea that the peak in the Fed funds rate in this cycle would be around 3.75%. That is well above the 2.25%-2.50% range that captures most Fed officials' estimate for the neutral rate. However, softer economic data and some official comments saw peak Fed funds hover near 3% for most of the May. The implied yield of the December 2022 Fed funds futures fell from a little more than 2.90% in early May to 2.50% in late May as the market ruled out a 75 bp move and began to think about a pause. 

The Federal Reserve has all but committed to lifting the Fed funds rate by 50 bp in both June and July, which would raise the target to 1.75%-2.00%. The balance sheet will begin shrinking in June as well. The Summary of Economic Projections ("dot plot") will draw much attention as two new governors have been confirmed (Cook and Jefferson), and the third (Barr) could be approved in time. Meanwhile, the Boston Fed has picked Collins to lead them, but she will not take the post until July 1, leaving the Philadelphia Fed President Harker voting in her stead.

The policy outlook for the European Central Bank has been evolving, and it has now crystalized with President Lagarde's essay on the central bank's website. At the end of last year, Lagarde did not expect to lift rates this year, but now she has strongly signaled 25 bp hikes at the July and September meetings. She acknowledged that the deflationary dynamics are ended and are unlikely to return. The July rate hike is unusual as the ECB has clearly preferred to change rates at meetings where the staff updates its forecasts. However, the bond-buying under the Asset Purchase Program is set to continue into early July. Still, Lagarde has repeatedly noted that the first hike can come quickly after the bond-buying stops. The forward guidance at the June meeting will most likely confirm this.

The swaps market has slightly more than one 25 bp hike discounted for Q4 22, with the year-end rate seen at 27 bp. The year-end rate was seen ibelow zero until early April and peaked slightly over 50 bp on May 23. While the Fed's tightening cycle is expected to peak next year, the ECB's cycle is seen stretching into 2024 and peaking between 1.25% and 1.50%. While many economists see US inflation peaking in Q2, eurozone inflation may not peak until Q3 or even possibly Q4.

Nevertheless, the 10-year German breakeven trended lower law month. It peaked at the start of May near 3.00% and dipped below 2.2% in late May. It is not just Germany. Consider Italy. Its 10-year breakeven peaked slightly lower than the German equivalent and fell nearly 100 bp to a slip below 2% briefly in late May. The five-year five-year forward for the eurozone fell by around 50 bp to lows than 2.05% last month.

The ECB has signaled it will adjust the Targeted Long-Term Refinancing Operations (TLTRO) rate. When the pandemic struck, the ECB cut the rate to 50 bp below the deposit rate (-50 bp). The TLTROs were a critical component of the monetary policy response (to the Great Financial Crisis and Covid). These long-term loans were a cheap source of funding and provided a risk-free arbitrage opportunity for the banks. Assuming certain lending targets were met, the banks could get funds from the ECB at -100 bp and deposit the same funds with the ECB at -50 bp. The TLTROs complemented the bond purchases and account for around a quarter of the ECB's 8.8. trillion-euro balance sheet.

With inflation and/or inflation expectations possibly peaking in the US and interest rates falling, the dollar appeared to be rolling over. The US 2-year yield peaked on May 4 near 2.85%. By the end of the month, it was around 40 bp lower. The US 10-year yield peaked on May 9 at about 3.2%. It appeared to be finding a base near 2.70% in late May. The dollar fell against the major currencies, with the Norwegian krone being the sole exception. The Japanese yen rose 2% to halt a nearly 15% slide over the previous two months and led the major currencies higher. The euro rose about 1.8% in May, its first monthly gain of the year and the largest since last April. Not coincidentally, the two-year premium the US offers fell by around 50 bp since peaking in early April near 2.55%.

Emerging market currencies were mixed. Capital controls, a positive terms-of-trade shock, a dramatic rate hike when it invaded Ukraine (to 20% from 8.5%), and the trade embargo limiting imports helped lift the Russian rouble by 8% in May. The currency appreciation has given the central bank the latitude to cut rates. The 600 bp cut in April was followed by a 300 bp cut in May to bring the key rate to 11%. In addition, some capital controls have been lifted or diluted.

After the bout of profit-taking in April, Latam currencies were back in favor in May. Leaving aside the rouble, Latam currencies, led by the 5.1% gain of the Brazilian real, were four of the next five emerging market currencies. Central European currencies also did well, aided by the euro's recovery. Hungary was a notable exception. The Turkish lira was the poorest performer, depreciating by almost 8.5% on the back of rising inflation, a deteriorating current account, and limited official ability to defend it. Its year-to-date loss is 18%, after falling 44% last year. An inter-meeting rate hike failed to prevent the Indian rupee from falling in May (~1.4%). This year, it has fallen every month for a cumulative decline of about 4.2%. The Chinese yuan fell for a third month (~1.3%) and is off a little more than 5% this year.

Bannockburn's World Currency Index, our GDP-weighted basket, edged up in May, reflecting the gains in the major currencies. The increase in the second half of the month more than recouped the losses from the first half. The emerging market currency component was weaker, reflecting the decline in the yuan, rupee, and South Korean won. The currencies from Brazil, Mexico, and Russia appreciated, but they account for only 6% of the index. The May gain pared the year's loss to around 2.2%. From a longer perspective, the BWCI peaked in June 2021 and has been trending lower since. At the May low, it had fallen by about 5.6%. That low may prove durable.
 

Dollar: Two contrarian indications seemed to signal the dollar's setback. First, the talk of a need for a Plaza-like agreement and/or intervention to check the greenback's rise seemed exaggerated. Second, the non-commercial (speculative) accounts in the futures market that had been net long euros since early this year, despite its persistent decline, capitulated and briefly flipped to a net short position in early May. Unlike other dollar setbacks seen over the past year, this one is backed by a critical fundamental development: the peak in inflation/inflation expectations weakened its interest rate support. To be sure, barring a significant negative shock, businesses and investors should expect the Fed to deliver 50 bp hikes at least at the next two FOMC meetings (June and July). This is unlikely to mark the peak in policy, but a return to 25 bp steps as the Fed funds' rate enters neutral territory seems likely. The Fed's balance sheet peaked in mid-April and has since fallen by more than $50 bln, which may sound large but is around 0.6%. However, going forward, the balance sheet will begin shrinking in earnest as the Fed will not fully reinvestment maturing proceeds of its Treasury and Agency holdings. The idea was that the Fed would tighten until something breaks, and to put it simply, the market sees something breaking on the horizon. The interest-rate-sensitive housing market is already showing signs of tightening financial conditions. On the other hand, the Fed may welcome some moderation in housing and the labor market and some unwinding of speculative excesses in other markets. May was the third consecutive month that the odds (median result in Bloomberg's survey) of a US recession rose over the next 12 months. At 30%, it is twice what it was at the end of last year.
 

Euro: Economic activity has proven resilient thus far in the face of the energy shock and disruption caused by Covid and the war. The May composite PMI stood at 54.9 compared with 53.3 at the end of last year. The acceleration and broadening of price pressures have spurred a significant change in rhetoric from ECB officials. President Lagarde's post on the ECB's website (May 23) was as explicit a statement imaginable but confirmed what the market had been anticipating, a 25 bp hike in July and September, though a few hawks are are reluctnant to rule out a 50 bp move. The swaps market sees the ECB exiting sub-zero rates in Q4 for the first time since 2014. The IG Metall clash with the German steel industry will be closely monitored, and Germany's minimum wage will rise to 12 euros an hour from a little less than 10. The ECB's chief economist Lane has unveiled a new wage tracker, and according to it, the pay deals since January are the strongest in a decade. The ECB meeting on June 9 may be among the most important of the year. Under the umbrella of new staff forecasts, the ECB will confirm the end of its net bond purchases and a rate hike in July.Counter-intuitively, more revealing of the medium-term outlook for the euro will be the pullback from the two-week rally that it carries into June. The $1.08-$1.10 area provides the immediate cap, and a break back below $1.05 would be disappointing.

(May 30 indicative closing prices, previous in parentheses)

Spot: $1.0780 ($1.0545)

Median Bloomberg One-month Forecast $1.0605 ($1.0730) 

One-month forward $1.0800 ($1.0565) One-month implied vol 7.8% (9.4%)
 

Japanese Yen: Japan has the fastest inflation in over a decade, but the central bank assures businesses and investors that it is not the right kind and will not be sustainable. That means that BOJ will continue to defend the 0.25% cap on the 10-year yield when necessary and expand its balance sheet. The fiscal package is expected to lower headline inflation by around 0.5%. The market accepts that disinflationary forces have not been fully defeated. The 5-year breakeven is slightly below 1.20%, and the 10-year is near 0.85%. With Covid pressures easing, the economy is gaining traction. The May composite PMI stands at 51.4, a five-month high. The correlation between changes in the exchange rate and the 10-year US yield remains strong. The 30-day correlation is finishing May at two-month highs (~0.57%). They both peaked on May 9. The dollar-yen exchange rate often appears to be rangebound, and trends occur as it moves from one range to another. If the JPY130 area marks the upper end of a possible new range, we suspect the lower end may be in the JPY124.50-JPY125.00 area.

Spot: JPY129.60 (JPY129.70)

Median Bloomberg One-month Forecast JPY129.90 (JPY126.70)

One-month forward JPY127.45 (JPY129.60) One-month implied vol 9.4% (11.9%)
 

British Pound: Sterling rallied by about 4.25% after bottoming in mid-May, but the market is not convinced. Speculators in the futures market have amassed the largest next short sterling position in three years. Of the G7 countries, economists (median, Bloomberg survey) see the highest risk of a UK recession in the next 12 months (35%). Still, the swaps market has 127 bp of hikes priced in for the next five Monetary Policy Committee meetings for the remainder of the year. The strength of the labor market and the unexpected strength of April retail sales offset the four-year low in consumer confidence. The first stab at addressing the cost-of-living crisis, which included easing the energy bill for households, and a tax on profits of oil companies (and utilities), is unlikely to prove sufficient given the hike in the energy price cap in October. Meanwhile, Gray's report stirred the political pot, but "partygate" is not going away. The next phase is the Committee of Privileges, on which the Tories have a majority, to determine whether the Prime Minister deliberately lied to Parliament. The $1.27-$1.28 area may offer formidable resistance, but if sterling bottomed, it should hold above $1.2350-$1.2400.

Spot: $1.2650 ($1.2575)

Median Bloomberg One-month Forecast $1.2500 ($1.2800) 

One-month forward $1.2655 ($1.2570) One-month implied vol 9.1% (9.7%)
 

Canadian Dollar: Near mid-May, the Canadian dollar had fallen to its lowest level since late 2020 but recovered smartly in the second half of the month. The US dollar finished may testing important support in the CAD1.2660-CAD1.2700 area. A convincing break targets CAD1.2400 initially. The swaps market sees the Bank of Canada lifting its target rate by 50 bp in June and July and then 25 bp at each of the last three meetings of the year. The expected terminal rate is now seen as around 3% in 2024. The peak was seen near 3.4% in mid-April. Canada's economic fundamentals are solid. It is expected to be the fastest-growing economy in the G7 this year. In addition, it is experiencing a positive terms-of-trade shock. An important drag on the currency, however, has been the sensitivity to the broader risk appetite. The correlation between the change in the exchange rate and the S&P 500 has been stable near 0.70% for the past 30 and 60 days.

Spot: CAD1.2655 (CAD 1.2850) 

Median Bloomberg One-month Forecast CAD1.2800 (CAD1.2665)

One-month forward CAD1.2660 (CAD1.2850) One-month implied vol 6.9% (8.2%) 
 

Australian Dollar: The newly elected Labor government inherits a relatively strong economy and a robust jobs market (3.9% unemployment rate in April vs. 5.1% at the end of 2019). The rise in commodity prices has seen the trade surplus swell from almost A$33 bln in the 12 months through Q1 2019 to A$123.5 bln in the 12 months through March 2022. The RBA began its tightening cycle with a larger than expected 25 bp move on May 3, which brought the cash rate target to 0.35%. The swaps market favors another 25 bp hike on June 7 and scope for a 50 bp move in H2 on its way to a year-end rate between 2.00% and 2.25%. The terminal rate is seen closer to 3.6% in the middle of next year. In early April, the Australian dollar peaked near $0.7660 and tumbled 10.8% into the May low of about $0.6830. The recovery in the second half of May saw it approach $0.7200. The $0.7245-$0.7265 area, which also houses the 200-day moving average, offers the nearby cap. If a significant low is in place, the Australian dollar should hold above $0.7000.

Spot: $0.7195 ($0.7060)

Median Bloomberg One-Month Forecast $0.7200 ($0.7240)

One-month forward $0.7205 ($0.7065) One-month implied vol 11.1% (10.0%)
 

Mexican Peso: The peso was among the strongest currencies in the world in May, appreciating by around 4.8%. The four-week rally lifted the peso to new two-year highs into the end of the month. In contrast, the JP Morgan Emerging Market Currency Index gained about 1.35% in May, leaving it fractionally higher on the year. Although there is little support ahead of the MXN19.20-MXN19.30 area, the dollar is stretched. Mexican price pressures may be peaking, and President AMLO's deal with a couple dozen businesses to limit price increases may help on the margins. Still, there has been speculation of a 75 bp hike at the June 23 Banxico meeting from 7.0% reached in May. With the Fed committed to 50 bp increases and the Mexican economy sluggish, a half-point move in June and August seems a more likely scenario. The market expects the terminal rate to be between 9.25% and 9.50% toward the middle of 2023. The peso is sensitive to the broader risk environment. Its correlation with the S&P 500 is near 0.6%, the most on a 60-day rolling basis since last July. Mexico holds six gubernatorial elections on June 1. Although the traditional parties have dominated, polls suggest the Ciudadano and Moreno (AMLO's party) are mounting a serious challenge. The PRI, PAN, and PRD have formed a coalition in four states to block the insurgency. 

Spot: MXN19.5355 (MXN20.4280)

Median Bloomberg One-Month Forecast MXN20.2755 (MXN20.3610)

One-month forward MXN19.6375 (MXN20.55) One-month implied vol 11.6% (12.3%)
 

Chinese Yuan: Since the end of February, the Chinese yuan has risen in only two of the 13 weeks through the end of May. The dollar rose by nearly 8%. However, the shifting view of the Federal Reserve and the re-opening of Shanghai and new stimulus measures announced seem to have capped the greenback around CNY6.80. As bottom pickers return to Chinese stocks, there is scope for the yuan to recover. As a result, the dollar may have scope to pull back toward CNY6.5400. Despite the new stimulus efforts, the official growth target of 5.5% this year is unlikely to be met. The median projection in Bloomberg's survey is for GDP to rise 4.5% this year, while many banks sub-4%. The pessimism stems from the zero-Covid policy, and although it is unlikely to be abandoned, the peak lockdown coverage has likely passed. May could very well mark the trough in the economy and sentiment. While there is scope for some additional monetary support, Beijing looks likely to rely more on fiscal efforts.

Spot: CNY6.6615 (CNY6.6085)

Median Bloomberg One-month Forecast CNY6.67(CNY6.5015) 

One-month forward CNY6.6675(CNY6.6380) One-month implied vol 6.6% (7.0%)