Photo by Jason Leung on Unsplash 

The major central banks were slow to respond to price pressures as the economies emerged from the unprecedented depths of the Covid crisis. They have pivoted toward more aggressive rate hikes. 

The conversion at the Federal Reserve has been stark. In an unusual admission, Federal Reserve Chair Powell acknowledged that the high May CPI and the rise in the University of Michigan's consumer (inflation) expectations prompted the 75 bp hike rather than the 50 bp move that had been signaled. The last-minute change left the Kansas City Fed President George in a difficult position. This noted hawk dissented at the June meeting, favoring sticking with the 50 bp guidance (which hardly makes her a dove).

Powell pledged the Fed's "unconditional" commitment to reining in inflation. Even though he acknowledged that a 75 bp increase is unusual, Powell indicated another one of that magnitude or 50 bp was likely this month. Given the link to the CPI and household inflation surveys that Powell drew, those reports (July 13 and July 15, respectively) may overshadow the employment report. The "expeditious" move to neutrality (and beyond) seems to mean as fast as possible without surprising the market unnecessarily. That said, we expect the economic and price data to moderate, encouraging the Fed to signal a slower pace of rate hikes after the July hike.

The European Central Bank is widely expected to initiate its normalization cycle at its July 21 meeting. Although the meeting will not include updated forecasts, making it an unusual move, it has, without a doubt, signaled its intentions. Some are still making a case for a 50 bp move, but it seems unlikely. Still, the market will be looking for clues into how low a bar it is for a 50 bp hike at the September meeting. 

In addition to the forward guidance, the other important element of the ECB meeting is an update about the new tool to help combat an undesirable widening of the interest rate spreads among the members. The central bank argues that widening spreads interrupts the transmission of its monetary policy. In the previous sovereign debt crisis, the ECB unveiled a facility (Open Market Transaction) to do just that and neutralize the impact on the balance sheet. However, the strings attached, or what is euphemistically called "conditionality," proved sufficiently onerous as to deter any member requesting it. At the end of last year, talks revolved around similar issues, and the ECB secured extra flexibility (discretion) in reinvesting maturing proceeds.

The contrast between the US and Europe on one hand, and Japan and China on the other is stark. After many years of falling short, Japan's core measure of inflation has met the 2% target, but the BOJ insists it is "transitory." For the record, the market seems to agree with the BOJ's assessment. The BOJ's forecast sees core inflation finishing the year slightly below 2% and falling to 1.1% next year and in 2024. The median forecast in the Bloomberg survey puts Japan's core inflation at 1.7% this year, 1.2% next, and 0.7% in 2024.

The BOJ is committed to its current monetary stance and defending its 0.25% cap on the 10-year JGB, bought a record $80 bln of government bonds one day in mid-May. The divergence of monetary policy is the main driver of the yen's weakness, and as global rates rise and the yen weakens, there is upside pressure on the Japanese yields. The 30-year yield has increased by more than 20 bp over the past month to 1.24%. June was the seventh consecutive monthly increase, while the 10-year is flat near its cap and is net-net little changed over the past four months. As the BOJ defends its cap, it underscores the divergence in monetary policy, weighing on the yen and trapping policymakers and investors in a vicious cycle. It is not clear how Japan exits its policy, but others like the Swiss National Bank's cap on the Swiss franc or Australia's cap on the three-year yield proved very messy. We suspect it will exit its yield curve strategy after it is clear that US rates have peaked.

China's Covid experience and extreme policy response have disrupted the economy. Beijing prefers fiscal, regulatory, and moral suasion and has used monetary policy sparingly. China's economy is recovering from the extreme Covid-related lockdowns that had shut down areas that accounted for almost half of the country's GDP. Monetary policy has been brought to bear as much as one might be expected given the modest CPI (2.1% year-over-year in May). China's producer prices have fallen for seven consecutive months through May, and at 6.4%, the year-over-year pace is less than half of its peak (13.5% in October 2021). Fiscal and regulatory policy alongside moral suasion has been relied upon.

Few, if any, expect China to reach its growth target of around 5.5% this year. The World Bank's updated forecast dovetail with market expectations (median forecast in Bloomberg's survey) that see growth this GDP rising 4.3% this year and rising to 5.2% in 2023. More support for the economy may be forthcoming, and many observers expect a reduction in reserve requirements and/or another cut in administered rates. However, the zero-Covid policy continues, depressing economic activity and disrupting supply chains. Anticipating a recovery has seen Chinese stocks outperform in June. The CSI 300 rose by about 9.6%, recovering about half of what it lost in the first five months of the year. 

Toward the end of June, disappointing economic data, the dramatic cut in Russian gas shipments to Europe, and the tightening of financial conditions spurred concerns of a recession in most high-income countries. As a result, the markets shaved the extent of tightening the major central banks would deliver this year. While the tightening cycle is expected to extend into Q1 23, the futures markets have discounted a cut by the Federal Reserve and the Bank of Canada by the end of next year.

At the risk of burying the lede, this is the new new thing in the capital markets. For the first time since the onset of the pandemic, the fear of a recession is moving into the ascendancy, eclipsing inflation in all but the very short term. To be sure, the market continues to expect the major central banks (but Japan) and middle-income countries to continue to raise interest rates in the coming months. However, investors are strongly entertaining the possibility that the Federal Reserve's rate-hiking cycle lasts around a year, which is shorter than previously expected.

The US dollar trended higher against the euro and yen since bottoming on January 6, 2021 (yes, that January 6). the rates differential story and the trajectory of monetary policy were a big part of the story. In past cycles, short-term rate differentials often peak before the dollar. Although the news stream from Europe is poor, and the Bank of Japan appears committed to its extraordinary monetary policy, the dollar's 18-month rally may be coming to an end.

All of the constituents of Bannockburn's World Currency Index (BWCI) but the Russian rouble fell against the dollar in June. However, it appears to be forging a bottom, which coincides with a broad dollar top.

Interestingly, most of the emerging market currencies fared better than most of the major currencies. The Russian rouble was strongest with a nearly 15.5% gain against the greenback. We do not put much confidence in the price as a reflection of how the war is going or the domestic economy. By its official figures, the economy contracted by 4.8% in May after shrinking by 2.8% in April. It is experiencing positive terms of trade shock and appears to have found some offsets to the bans being implemented by Ukraine's allies. Capital controls forcing repatriating for earnings have been eased, but have not been removed and restrictions on sales by foreign investors remain in place. With a 2.1% weight in the BWCI, the rouble's appreciation was worth about 0.32 index points, but instead, the BWCI fell by almost 0.90 points in June.

The Chinese yuan (with a 21.7% weighting) slipped by 0.4%, the least, followed by the Indian rupee (3.8% weighting), which fell by almost 1.7%. The Mexican peso (1.5% ) was the third-best performer with a 2.3% loss. Among the emerging markets, that leaves the Brazilian real, which posted the- sharpest decline, almost 10.0%, and the South Korean won. It fell by about 4.7%.

It turns out that the won's decline largely matched Japan's yen's 5.1% loss. South Korea is maintaining export competitiveness. The won is the second weakest currency in Asia this year. It has depreciated by about 8.5% compared with the yen's 15% decline. On the other hand, China seems less reactive to the drop in the yen to 22-year lows. The yuan has fallen by about 5% this year.

Among the major currencies in the BWCI, the Australian dollar (1.9% weighting) was the second-worst performer after the yen, falling by about 3.7%. The euro (19.1% weighting) was of a 2.3% decline. The Canadian dollar (2.4% weighting) eased by around 1.7% and the sterling (4% weighting) depreciated by about 3.4%.
 

Dollar: The Federal Reserve has been explicit. It is determined to push inflation back to its target and hopes that a recession can be avoided. To do so, it aims at weakening demand to drive down price pressures through the tightening of financial conditions. It already seems to be having an impact. Fed officials emphasize the strength of the labor market as an indication of the ability of the economy to withstand the reduction of monetary support. However, cracks are already materializing. The foreign exchange market may be particularly sensitive to further deterioration. The four-week average of weekly initial jobless claims has risen by more than 30% over the past two months. Nonfarm payrolls are slowing. The 250k increase expected in June (July 8) would be the least since the end of 2020. The year-over-year increase in average hourly earnings is expected to have eased for the third consecutive month in June. Price pressures, more generally, may be coming off the boil. Core CPI has fallen for two months through May, and the core PCE deflator fell for the third month in May. The accumulation of disappointing economic data saw the market for the first time price in a rate cut in Q4 23. In the meantime, the market is pricing in a little more than a 70% chance of another 75 bp rate hike at the July 26-27 FOMC meeting. 
 

Euro: The European Central Bank meets on July 21. It will hike its key rate for the first time since 2011. A 25 bp rate has been signaled, but some officials still seem to be pushing for a 50 bp hike. The swaps market has about a 15% chance of a 50 bp move. By the end of the year, the market is pricing in about 140 bp in rate increases, down from 180 bp seen in mid-June. The ECB is expected to provide more details on the new tool it is devising to combat unwarranted widening of interest rate differentials that hamper the transmission of monetary policy. The tightening of financial conditions, the disruption from Russia's invasion of Ukraine, and the energy shock (Europe's natural gas benchmark rose nearly 60% in June) are leading to a sharp deceleration of growth. The risk of a recession appears to be increasing. The euro peaked in June near $1.0775 as the ECB's press conference following the June 9 meeting got underway. It fell to about $1.0360 on June 15 to approach the May low of $1.0350. After testing the $1.16 area it returned again and found good demand below $1.04. It needs to establish a foothold above $1.06 to improve the technical outlook and initially give potential toward $1.08 as a bottom-of-the-down move that began on January 6, 2021, is forged.

(June 30 indicative closing prices, previous in parentheses)

Spot: $1.0485 ($1.0780)

Median Bloomberg One-month Forecast $1.0525 ($1.0605)

One-month forward $1.0505 ($1.0800) One-month implied vol 9.4% (7.8%)
 

Japanese Yen: The dollar rose by 5.4% against the yen in June as the divergence in monetary policy and the relatively low credibility of intervention continues to drive the exchange rate. This brings the year-to-date loss to a little more than 15.1%. It is not just that the other central banks are tightening policy, but the Bank of Japan is still easing through its balance sheet. Moreover, to defend its 0.25% cap on the 10-year JGB, the BOJ was forced to buy over $80 bln in a single day last month. Foreign investors account for a significant amount (~$35 bln) of the sales. The cost of hedging US bonds for yen-based investors continues to rise and eat away at total returns, but reports suggest some insurers are boosting the non-hedged allocation. The BOJ has emphasized wage growth as a key component of a sustainable increase in inflation. This remains elusive. Despite the cost of living squeeze in Japan, the LDP enjoys the most support among the political parties ahead of the July 10 House of Councillors (upper house) election. 

Spot: JPY135.70 (JPY129.60)

Median Bloomberg One-month Forecast JPY134.35 (JPY129.90)

One-month forward JPY135.45 (JPY127.45) One-month implied vol 13.0% (9.4%)
 

British Pound: Sterling depreciated in each of the first four months of the year for a cumulative decline of about 7.3% before edging almost 0.25% higher in May. A deteriorating economy kept the sterling under pressure in June, driving it down nearly 3.5%. The economy unexpectedly contracted for the second month in a row in April as the consumers are getting hit with the largest cost-of-living squeeze in a generation. Economists surveyed by Bloomberg see more than twice the chance of a recession over the next 12 months as they did at the start of the year (now 35%). The Prime Minister survived a vote of confidence but remained weakened. Still, the government has successfully begun the legislative process to ditch the Northern Ireland Protocol. This can be expected to elicit a response from the EU. The Bank of England hiked rates in quarter-point increments, but the market expects the pace to accelerate to 50 bp starting with the next meeting (August 4) and probably extend for the subsequent meeting or two. The central bank warns inflation will reach 11% in Q4 as the gas cap is raised again.

Spot: $1.2180 ($1.2650)

Median Bloomberg One-month Forecast $1.2260 ($1.2500) 

One-month forward $1.2190 ($1.2655) One-month implied vol 10.8% (9.1%)
 

Canadian Dollar: The US dollar depreciated by around 4.5% against the Canadian dollar from about mid-May through early June. After approaching CAD1.25, the greenback recovered on the back of the equity market volatility and made a marginal new high by CAD1.3080. The correlation between the changes in the exchange rate and the S&P 500 (a proxy for risk appetites) continues to be broadly steady around the mid-0.70 area over the past 30- and 60-day. Some still depict the Canadian dollar as a petro-currency. The correlation is stable here, too but in the low 0.40 area. With the strong jobs market and robust consumption, with accelerating inflation, the swaps market favors a 75 bp hike on July 13 (to 1.50%) at the Bank of Canada meeting and has recently trimmed the likelihood of another in September. Still, the projected year-end rate has been moving lower in the second half of June. It eased by about 20 bp to 2.4%. The expected terminal rate fell from about 4.10% on the eve of the FOMC's decision to below 3.50% by the end of the month. Indeed, for the first time, the implied yield of the December 2023 BA futures contract is above the December 2024 contract, reflecting the risk of a rate cut in Q4 23.

Spot: CAD1.2875 (CAD 1.2655) 

Median Bloomberg One-month Forecast CAD1.2810 (CAD1.2800)

One-month forward CAD1.2880 (CAD1.2660) One-month implied vol 7.6% (6.9%) 
 

Australian Dollar: The Australian dollar extended its recovery off the nearly two-year low set in mid-May near $0.6830 and reached almost $0.7285 in early June. The pullback we expected was surprisingly deep, and by the middle of the month, it had fallen to around $0.6850. It enjoyed a two-day recovery, recouping about half of what it lost, but faded and remains in the trough. Recession fears in the US and Europe weigh on sentiment, and weaker commodity prices don't help. The futures market has a 50 bp rate hike at the July 5 meeting at a near 2-in-3 probability. It has and a little more than 230 bp of tightening discounted all told in H2 22. That would bring the cash target rate to about 3.20% at the end of the year. The terminal rate is seen closer to 3.75% by mid-2023. Australia's 10-year premium over the US is among the most it has been in the last six years, but the 2-year differential, which the exchange rate often seems more sensitive to, favors the US dollar by more than 30 bp. Re-establishing a foothold above the $0.7000 would help lift the tone. A break of May's two-year low near $0.6830 spurs another 1% decline toward $0.6760.

Spot: $0.6905 ($0.7195)

Median Bloomberg One-Month Forecast $0.7010 ($0.7200)

One-month forward $0.6910 ($0.7205) One-month implied vol 12.7% (11.1%)
 

Mexican Peso: The peso depreciated in the first half of June and appreciated in the second half, leaving it off about 2.0% against the dollar. That made it the best-performing currency in the region. The central bank hiked its target rate by 75 bp to 7.75% and signaled a move by the same magnitude at its next meeting (August 11). The swaps market has discounted about 200 bp of rate hikes in the second half. Banxico has seen inflation peaking at 8.1% in Q3 rather than 7.6% in Q2 as it previously did. The market seems to accept this and has the tightening cycle peaking this year. The dollar has spent the bulk of the time over the past three-and-a-half months between MXN19.50 and MXN20.50. It finished June near the middle of the range. Barring a significant negative shock, we expect the range to hold in July. There is scope for short-covering by speculators, who in the futures market had the largest net short position of the year in late June.

Spot: MXN20.11 (MXN19.5355)

Median Bloomberg One-Month Forecast MXN20.09(MXN20.2755)

One-month forward MXN20.2160 (MXN19.6375) One-month implied vol 11.6% (11.6%)
 

Chinese Yuan: From mid-April through mid-May, the US dollar appreciated by around 7.5% against the Chinese yuan but spent June consolidating in a CNY6.65-CNY6.73 trading range. China's economy is recovering from the lockdowns that had shuttered around half the economy. The composite PMI rose above the 50 boom/bust level in June for the first time since February. The CSI 300 rose 9.6% in June, its best monthly performance in two years. Its 9.2% year-to-date loss is among the least in the large markets. The US 10-year premium over China peaked near 65 bp in the middle of the month but fell below 20 bp as US yields retreated. A continuation of the consolidative phase is most likely. Meanwhile, the greenback had been pressing against the top of its range against the Hong Kong dollar, even spurring some intervention by the Hong Kong Monetary Authority. By the end of June, the market recognized that despite the changing circumstances, the peg would hold, and the dollar backed off.

Spot: CNY6.6995 (CNY6.6615)

Median Bloomberg One-month Forecast CNY6.7175 (CNY6.6700) 

One-month forward CNY6.6985 (CNY6.6675) One-month implied vol 6.6% (6.6%)