May will likely feature rate hikes by the Federal Reserve, the European Central Bank, and the Bank of England. The banking stress that erupted in March appears contained, though one regional bank's dramatic loss of deposits saw it rekindle at the end of April. What makes the May rate hikes important is that the derivatives markets are confident (again) this is the last hike for the Fed.

The swaps market anticipates two more hikes from the BOE and the ECB. Headline CPI in the UK has been above 10% for seven consecutive months through March. The ECB, which was slower than the others to initiate the tightening cycle, is understood not to be quite finished either.

Before the bank stress emerged, the market had priced in a peak Fed funds rate of nearly 5.75%. Now, the May hike to 5.25% is expected to be the top. Similarly, the swaps market had the ECB's target rate rising to 4.0% by the end of September, and now it sees the peak between 3.50% and 3.75%.

The market thought the Bank of England's base rate would top between 4.75% and 5.0% in Q4 22. After pulling back to 4% in late March, the swaps market finished April back near its pre-stress levels. 

We suspect the market is under-appreciating the risk of a Fed hike after May. Indeed, the futures market has moved dramatically in the other direction, pricing in a cut in Q3 and for the year-end rate to be about 4.50%.

That implies 75 bp in cuts over five FOMC meetings that remain after this month, which seems unreasonably aggressive. It would likely take more than a quarterly contraction to deter the Fed. It would imply some kind of shock. The economy was contracting when the Fed began the tightening cycle. 

The median Fed forecast in December was for the economy to slow to 0.5% year-over-year this year. This was shaved to 0.4% in March. Those are downbeat numbers and may be about as close as the central bank gets to projecting a recession.

In March, the Fed's staff warned that a mild downturn is likely later this year. The preliminary official estimate was that the US economy expanded by 1.1%, almost meeting this year's Fed growth forecast in the first quarter.

China's economy expanded by 2.2% in Q1 23 after stagnating in Q4 22, before its pivot from zero-COVID-19. Even though this was above expectations, many seem disappointed with the reopening of the economy and see the price weakness as a sign of weak demand.

In some sectors, like autos, falling prices seem to be a function of excess capacity in the industry and intense price competition. The IMFs updated forecasts see China growing by 5.8% this year, and the median estimates in Bloomberg's survey project a 5.3% expansion. After the GDP figures, some economists revised their forecasts for above 6%.

Economic activity in the Eurozone and Great Britain has fared better than expected. The periphery has done well in the Eurozone, and the banking stress did not spur widening in the intra-EMU yield differentials.

The relatively higher German inflation can bolster the competitiveness of the periphery. Ironically, the German center-left coalition government appears to show more strain than the rightist Italian coalition. The UK economy is defying recession calls, including previously by the central bank, and appears to have expanded in Q1.

Japan's economy is expanding slowly. Industrial production has been held back by weaker exports. However, the spring pay raise and government energy subsidies have bolstered consumption while lowering inflation.

Still, the underlying picture is unsettled as the CPI measure that excludes fresh food and energy reached a new cyclical high in March. Surveys show the majority expect the new leadership of the Bank of Japan to adjust policy in the June-July period.

The Bank of Canada acknowledged that growth was stronger than expected this year, but not enough to move it from its "conditional pause" in its tightening cycle. It expects the economy to slow for the rest of the year.

The Reserve Bank of Australia joined the Bank of Canada, pausing its hikes. Despite improving trade ties with China, the economy is struggling. Governor Lowe's term ends in September, and it is still being determined whether he will be granted a three-year extension like his two predecessors. 

As a topic for discussion, the dollar's future is always lurking in the background. In the mid-to-late 1980s, some thought the large Asian country with a chronic trade surplus was the challenger, but the Japanese yen never took hold.

Then some thought that if Europe had a common currency, it could rival the dollar. The euro is the second largest reserve currency, but it is hardly larger than the sum of its parts (the legacy currencies, like the Deutschemark, French franc, Italian lira, etc.). Now, the Chinese yuan is suggested as the dollar's replacement. 

The issue resurfaced following the meeting between Saudi Arabia and China late last year and again in interviews with French President Macron after returning home from a visit to Beijing and meetings with President Xi. Within a fortnight of Macron's visit, Brazil President Lula visited Xi and repeated his interest in reducing the reliance on the dollar.

Technological advances in payment systems have lowered barriers to entry. The sanctions on Russia and Iran have also spurred the use of alternatives to the dollar, including the Chinese yuan and the UAE dirham (pegged to the dollar). 

The US dollar continues to be overwhelmingly used for trade and investment. Yet, a yuan bloc could form. Russia and Iran are the obvious initial members. There could be a few more members over time, but ultimately if this club forms, China would draw not the countries that wanted to dump the dollar but those who were kicked out, as it were, via sanctions.

Moreover, given the interest rate differentials, Chinese exporters are in no hurry to sell the dollars they earn. Ultimately, the key to the dollar's role is a store of value (the depth, liquidity, and transparency of the US Treasury market), not a means of exchange (trade settlement).

Last September, investors struck against the attempt by a new UK government to fund its proposed fiscal stimulus in the face of a recession forecast with debt. As a result, the Bank of England took measures to support the Gilt market. As sterling was sold to record lows, pundits said the UK was an "emerging market," and the Economists called it "Britaly."

We recognized it as a reflection of extreme market sentiment. In a similar vein, we suspect that the deluge of articles in the social and mainstream media about the demise of the greenback is more a reflection of psychology than substance.

The G7 Summit (May 19-21) will be held in Japan's Prime Minister Kishida's home city, Hiroshima. The opposition to Russia's invasion of Ukraine has been a galvanizing principle. French President Macron is preparing a peace proposal with China as mediator, but we suspect this will not garner broad support.

The US will shortly announce new limits on American business investment (broadly conceived) in China, especially high-tech (e.g., semiconductors, artificial intelligence, and quantum computing.

Yet, even though the Biden administration couches its actions on the elastic national security umbrella, it looks to many as an attempt to hold back the development of a rival superpower. Other G7 members may be reluctant to fully embrace the American position without greater provocation.

Greece holds its parliament election on May 21. Greece is one of the fastest-growing European economies in the post-COVID-19 period, has lower inflation than Germany, and is likely to record a primary budget surplus (excludes debt servicing costs). The New Democratic Party is expected to retain its majority.

The UK has local elections on May 4. In the previous contest in 2019, the Tories lost around 1000 council seats, and the party chair now warns of losses of similar magnitude. Labour also lost seats and councils in 2019 as the Liberal Democrats performed best. On a national level, the Tories have narrowed the gap with Labour, but it remains wide. A general election is likely next year.

Turkey's national elections (parliament and president) are on May 14. A run-off will likely be necessary on May 28. Erodgan has drawn on his power of incumbency. In the run-up to the election, he has raised the minimum wage, offered subsidized loans, and eliminated the age requirement for retirement benefits (based on years of work rather than age).

There will be significant economic and geopolitical implications if Erodgan loses. Chile (May 7) and Thailand (May 14) also have general elections.

In April, emerging markets as an asset class were little changed. The JP Morgan Emerging Market Currency Index was slightly softer (~0.3%), while the EMBI spread over Treasuries was virtually unchanged, a little above 400 bp. A year ago, it was closer to 380 bp. The MSCI Emerging Markets equity index eased by around 1.8% in April, while the MSCI index of developed equities rose by about 1.5%. 

Bannockburn's World Currency Index, a GDP-weighted index of the 12 largest economies, eased slightly (~0.1%) in April after rising 1% in March. It has been alternating between monthly gains and losses this year. It traded quietly in April between roughly 96.40 and 97.05. Year-to-date, it is up almost 0.5%. 

Leaving aside the dollar itself, seven of the remaining 11 currencies were higher and lower than 1%. Sterling was the strongest, with a little more than a 1.8% gain. It reached its best level since last June at the end of April ($1.2585). After hitting its record low near $1.03 in the turmoil last September, sterling recovered to nearly $1.2450 in the middle of December. 

The euro was second, rising 1.6% last month. It approached $1.1100 in the last week of April, its highest level since last April. It first breached the $1.10-level in early February and has been chiefly in a four-cent range in the three months through April.

After hitting its record low near $1.03 in the turmoil last September, sterling had recovered to nearly $1.2450 in the middle of December. The Brazilian real was the only other currency in the index that rose by more than 1%.

Outside of the Russian rouble, which fell by 3.1% as sanctions bit and the external balance deteriorated, the yen and the South Korean won were the weakest performers in the index, shedding about 2.5% and 2.7%, respectively. Around half of the yen's losses were recorded on the last trading day in April after the Bank of Japan left policy unchanged.

There was no strong sense of urgency, though stronger than expected, Tokyo April CPI was disconcerting. The deterioration of South Korea's external balance and low policy rate (3.5%) weighed on the won. Four currencies in the index (the Canadian dollar, Chinese yuan, Indian rupee, and Mexico peso) were little changed (+/- 0.5%).

Dollar

The dollar was mixed in April. It was stronger against most G10 currencies, but not the Swiss franc, euro, or British pound. The Swiss franc (~2.4%) led the advancing European currencies, except the Norwegian krone, that depreciated by 2.5% and was the worst G10 performer last month. Year-to-date, it is off 8.1%.

In the race to the top this year, sterling has edged ahead of the Swiss franc (~4.0% vs. 3.5%). Last year, the Swiss franc's 1.25% loss was the least in the G10. After a quarter-point hike in early May, the derivatives market is discounting three quarter-point rate cuts before the end of the year. 

There is a clear consensus favoring a weaker dollar and lower Fed funds. Because we are suspicious of the latter, we see the risk that when market views converge with the Fed's (rather than the other way around), it will buoy the dollar. Indeed, we suspect another rate hike after May's move is more likely than 75 bp of cuts the market is discounting.

The labor market is slowing, and price pressures are easing, though not fast enough from the Fed's perspective. The base effect suggests price pressures can continue to ease through Q2, but the second half of the year may prove more difficult. Meanwhile, the debt ceiling continues to loom, distorting the bill market and thinly traded credit-default swap market (provides insurance against default).

It is hard to know when the so-called "x-date" is, but after the recent tax revenues, the best guess now seems to be in in the first part of Q3. Assuming that the political brinkmanship does not take us over the brink, a resolution would likely see a rebuilding of the Treasury's General Account, which means cash balances at the Federal Reserve, and a jump in bill issuance, and a normalization of the money-market curve. 

Euro

The euro reached a new 12-month high in late April of almost $1.1100. The high in Q1 23 was set in early February near $1.1035. Before the bank stress hit, the euro had fallen to nearly $1.05. Its climb over the past six weeks has, at least in part, been fueled by the diverging rate expectations. The hawks have indicated they want to discuss a 50 bp increase at the May 4 meeting, but it seems unlikely.

The deposit rate is at 3.0% now, and the terminal rate is seen between 3.50% and 3.75%. The ECB's balance sheet contracted by around 3% in the year's first four months. On the other hand, the Federal Reserve and Bank of Japan's balance sheets expanded (for different reasons: the Fed is making collateralized loans to banks, while its holdings of government and agency bonds are falling, while the BOJ continues to buy bonds as quantitative easing).

The euro has appreciated by about 7.5% on a trade-weighted basis since it bottomed last August (about a month before the euro recorded its low against the dollar). Much of the good news for the euro has been discounted. Trend followers and momentum traders seem to be long or overweight, and the speculators in the futures market have amassed the largest net long position since 2020.

There may be two signals to watch for a change in trend. First, the euro has been finding support ahead of the 20-day moving average, which begins May near $1.0950. The second, when the five-day moving average falls the below the 20-day moving average, may also signal a change in trend. 

Indicative closing prices as of April 28 are listed below. Previous numbers are provided in parentheses.

• Spot: $1.1020 ($1.0840)
• Median Bloomberg one-month forecast: $1.0960 ($1.0825)
• One-month forward: $1.1040 ($1.0860), one-month implied vol: 7.5% (7.7%)  

Japanese Yen

With two shallow and brief exceptions, the dollar had been confined to a JPY130-JPY135 trading range from mid-March through April. It surged at the end of the month as the new leadership at the central bank signaled no sense of urgency to adjust monetary policy. The new Bank of Japan forecasts continue to show price pressures easing shortly after the Tokyo CPI warned of upside risks to the national figure.

The dollar surged to JPY136.55 after the BOJ meeting, the highest level since March 10, to end the month. That was two days after what is so far the year's high (JPY137.90). A move above there targets JPY139.50-JPY140.00.That said, in order to sustain the move, we suspect that firmer US rates may be necessary.

The Bank of Japan's next meeting is June 16. Surveys and press accounts had suggested a strong expectation for a change in policy in the June-July period,. After Governor Ueda's endorsement of current policy settings in a more formal way, the markets appear somewhat less confident of that timeframe.

The yen's weakness is even more pronounced against the euro. The euro closed April at its best level against the yen since 2008 (above JPY150).

• Spot: JPY136.30 (JPY132.85)
• Median Bloomberg one-month forecast: JPY133.05 (JPY131.85)
• One-month forward: JPY135.75 (JPY132.20), one-month implied vol: 9.5% (13.0%)

British Pound

Sterling rose above the $1.2450 cap that had held it back since mid-December to approach the $1.2550 area twice in April before pushing to $1.2585 on the last trading day of April. The next important area is near $1.2670 and then the $1.2750 area. March consumer prices were more than 10% year-over-year for the seventh consecutive month. The core rate stands at 6.2% after peaking last year at 6.5%.

The economy has proved more resilient than expected, leaving scope for additional monetary tightening. The Bank of England meets on May 11, and a 25 bp in the base rate to 4.50% is widely expected. As the banking stress emerged, the swaps market implied year-end rate fell from about 4.85% to 4.0%. It trended back in April and reached 4.85%.

The two key high-frequency data points are the employment report (May 16) and the CPI (May 24). The results of the local elections on May 4 may pose headline risk but are unlikely to drive the markets.

• Spot: $1.2565 ($1.2335)  
• Median Bloomberg one-month forecast: $1.2480 ($1.2290) 
• One-month forward: $1.2575 ($1.2345), one-month implied vol: 7.6% (8.5%)

Canadian Dollar

The US dollar has been in a fairly clear trading range against the Canadian dollar since late Q3 22. The upper end of the range is around CAD1.3850-CAD1.3900, and the lower end of the range is in the CAD1.3225-50 area. The greenback trended higher in the second half of April and approached CAD1.3670. However, this move was greeted by strong selling pressure.

This leaves the US dollar vulnerable to a return toward the CAD1.3400-50 area in the coming weeks. The bank stress in March had spurred speculation of significant rate cuts this year. The target rate is set at 4.50%, and in late March, the swaps market had a 3.60% year-end rate discounted. The market corrected, and by mid-April, it briefly flirted with the idea of a rate hike.

However, renewed banking stress at the end of April saw the swap market price a cut again. The Bank of Canada meets next on June 7. Canada reports April CPI (May 16), and it might look like progress is stalling, but another lurch lower is likely when the May data is released in June. Still, most of this year's improvement will occur in H1. In H2 22, Canada's CPI was practically flat, making challenging comparisons.

• Spot: CAD1.3550 (CAD 1.3515) 
• Median Bloomberg one-month forecast: CAD1.3475 (CAD1.3475)
• One-month forward: CAD1.3540 (CAD1.3510), one-month implied vol: 5.8% (6.7%)

Australian Dollar

Ironically, the central bank of New Zealand surprised the market with a 50 bp hike in early April, and while the Reserve Bank of Australia paused, still the Australian dollar outperformed. Nevertheless, the Australian dollar is weak and approached the March low (~$0.6565) in late April. A break could spur a move toward $0.6400.

The RBA meets on May 2, and a hike would catch the markets off-guard. After a benign Q1 CPI report, the market downgraded the chances of a hike from almost a 20% chance of a quarter-point to zero.

Meanwhile, the exchange rate's rolling 60-day correlation with gold and copper has risen after trending lower through the first quarter. The inverse correlation with short-term US rates has slackened. Its correlation to the S&P 500 is recovering after weakening to its lowest since March 2022.

The Labor government solidified its hold of nearly all the state governments and is taking two significant initiatives: Implementing central bank reforms proposed by the independent review. It may look like the Bank of England with a separate monetary policy committee and regular press conferences after the policy meeting.

The Labor government also is committed to significant changes in its military posture. It will operate new land-based missile systems. Australia will also boost its domestic capacity for defense manufacturing. Australia will extend the range of its weapons from around 25 miles (40 km) to about 185 miles and, with the acquisition of precision strike missiles, more than 300 miles.

• Spot: $0.6615 ($0.6685) 
• Median Bloomberg one-month forecast: $0.6710 ($0.6760)   
• One-month forward: $0.6625 ($0.6700), one-month implied vol: 10.1% (11.1%)

Mexican Peso

After appreciating in the first three months of 2023, the peso spent April consolidating. The dollar's high for the month was about MXN18.40, after peaking in March amid the bank-stress-induced risk-off near MXN19.23. The low was seen around the middle of April, slightly ahead of MXN17.93, holding above the five-year low set in March, slightly below MXN17.90.

Carry-trade strategies still seem popular, and it requires not only relatively high-interest rates, but also a low-volatility exchange rate. The peso's historical (actual) one-month volatility was about 6.6% in April, around half of the other Latam contenders for carry strategies, like the Chilean and Colombian pesos and the Brazilian real.

Mexico's central bank meets on May 18. It had been expected to match the Fed's move (25 bp), but comments by Governor Rodriguez on April 25, suggesting a pause will be considered, helped put a floor under the dollar. The greenback's loss of downside momentum and a "correction" in US interest rate expectations could see the dollar recover in May. The MXN18.25-MXN18.40 area may offer the initial target area and then around MXN18.60.

• Spot: MXN18.00 (MXN18.05)
• Median Bloomberg one-month forecast: MXN18.26 (MXN18.26)
• One-month forward: MXN18.1250 (MXN18.15), one-month implied vol: 10.3% (11.5%)

Chinese Yuan

China's Q1 expansion of 2.2% quarter-over-quarter was better than expected, and the stagnant Q4 22 GDP was revised to 0.6%. Still, even though retail sales (domestic consumption) were strong, and many economists revised growth projections this year to 6% or a little higher, others expressed disappointment.

The CSI 300 reached two-month highs a day after the GDP figures and proceeded to sell off sharply to its lowest level since early January. The slide of Chinese equities, whether they trade on the mainland, Hong Kong, or the US, weighed on the yuan. However, the strength of Q1 GDP seems to rule out solid near-term stimulus, and geopolitical concerns remain elevated.

We suspect that US sanctions and investment prohibitions will act only as a minor hindrance and will see China devote resources to develop its own capabilities. Moreover, Beijing may use areas where it enjoys a technological lead, such as silicon processing and solar panel manufacturing, to also limit exports on national security grounds.

If the market reassesses the likelihood of a Fed cut in Q3, a broad US dollar bounce may see the greenback re-challenge the February-March highs around CNY6.97-CNY6.98.

• Spot: CNY6.9185 (CNY6.8735)
• Median Bloomberg one-month forecast: CNY6.8570 (CNY6.8480) 
• One-month forward: CNY6.9060 (CNY6.8560), one-month implied vol: 4.9% (6.5%)

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