USD: Greenback on fire
In April, the USD appreciated right across the board, against G10, Asian and emerging market currencies. The USD rally was sudden and aggressive, the result of several factors.
First, front-end rates steepened aggressively to price in three consecutive 50-bps rate hikes in May, June and July; this pace of tightening has not been seen since 1994. Fed speakers did not try to talk down rate hike expectations; on the contrary, FOMC member James Bullard argued strongly for year-end rates of around 3%. Markets took note and the USD appreciated as a result.
Second, events in Europe led to increasing concerns of a eurozone recession over the coming quarters, and the USD attracted a strong safe-haven bid. This bid increased when rumours of an impending ban on Russian oil and gas exports to Europe made the rounds towards the end of the month.
Third, strong equity - FX hedge rebalancing at the end of April led to an accelerated downward move for EUR/USD, from around 1.07 to just below 1.05.
It is a mistake to view the USD’s appreciation purely through a EUR/USD-focussed lens. The USD outperformed against most other currencies and this outperformance sent traditional valuation measures skywards. The US Dollar Index broke higher and traded straight through strong multi-year resistance levels. Similar price action was seen in the likes of USD/JPY and GBP/USD, albeit for slightly different reasons.
The price action we have seen since the March rate hike is completely at odds with traditional price action. The USD normally depreciates modestly during the initial stages of Fed rate-hiking cycles. This is not the case at present, reflecting the more nuanced policy set-up, with rates pricing higher due to still-elevated inflation pressures. As we enter into May, we think that there are risks for further, albeit modest, USD appreciation.
EUR: Hiking into a recession?
In April, the EUR declined modestly on a trade-weighted basis, but it made significant losses against the USD in particular. Economic developments during the course of April were almost overwhelmingly negative. Headline eurozone inflation printed at 7.5% y/y for April – the highest on record. Leading indicators all pointed towards a contraction in activity: the IFO’s expectations print showed a large drop, which is not surprising in the context of events on the continent, but it does portend a slowdown in economic activity, which makes the European Central Bank’s (ECB) stance more complicated. At its April meeting, the ECB did not give any clarity on rate hikes, leading to an initial EUR/USD sell-off from 1.10 to 1.08.
However, the lack of guidance from the ECB did not deter speculation about further rate hikes. Markets moved to price in rising rates, with overnight index swaps (OIS) pricing in five rate hikes over the coming year. ECB Chief Economist, Philip Lane, subsequently noted that for the ECB the question is not if it raises rates, but how quickly. We believe that the ECB’s exit from its negative rate policy is an important development. We anticipate that the ECB will finish its QE tapering programme by June/July, opening the way for rate hikes as early as the July meeting, though we think that the ECB will probably wait until September.
Coming into May, there are explicit downside risks for EUR/USD. Technically, there is strong support at levels of around 1.0340 (the 2017 low), and thereafter it is open country towards parity. The catalyst for such a move could be an explicit ban on Russian oil and gas exports to the EU, which would presage a wider economic contraction, justifying the EUR’s weakness. The picture emerging now is that cyclical developments are weighing heavily on the EUR, even though the end of the ECB’s negative deposit rate policy is a game changer for the EUR in the medium term.
GBP: BoE stuck between a rock and a hard place
In April, GBP/USD fell from levels of around 1.32 to lows just below 1.25. The downward move was primarily due to the USD’s appreciation. There was little evidence of idiosyncratic GBP weakness; trade-weighted exchange rates were not massively weaker over the course of the month.
At its 5 May meeting, the BoE raised rates from 0.75% to 1.00%, a move which was well flagged ahead of the meeting. The MPC voted 6-3 to raise rates, with three members opting for a larger 50-bps rate hike. However, two MPC members opted to curtail forward guidance on rates, meaning that they estimated the BoE is close to the end of its tightening cycle.
GBP depreciated significantly following the meeting. GBP/USD fell below 1.23 and EUR/GBP rose to around 0.8550. Trade-weighted GBP exchange rates also fell materially. The pound’s volatility profile also showed a marked upward move - GBP/USD’s one-month implied volatility rose to around 11%. Even EUR/GBP volatility rose, with the one-month measure hitting highs of 8%, which is a significant upswing for EUR/GBP.
Our GBP/USD forecast assumes that it will rise modestly over the longer term, reflecting our anticipation of USD weakness once the Fed’s rate cycle is fully priced in, and markets then move to price in ECB rate hikes, pushing EUR/USD higher. This in turn will eventually also push GBP/USD higher, but only modestly so. In the short term, there are clearly downside risks for GBP/USD, reflecting the ongoing deterioration in almost every UK macroeconomic variable and a shallower-than-anticipated BoE rate-hiking cycle.
JPY: Getting cheaper
The Japanese yen has depreciated by around 20% over the last six months, which is a huge move considering that domestic inflation has barely made it above 2% during this period. As a result, JPY is now the cheapest currency among the advanced economies. In real effective exchange rate terms, it appears to be almost absurdly cheap. This does not mean that it will revert towards a more expensive profile, but the extent of short positioning does suggest that there is scope for a USD/JPY downward move if US long-end yields are close to topping out. This may manifest itself if US inflation dynamics begin to stabilise or even come in at lower levels, meaning that a downward move back to levels of around 125.00 is feasible over time. Currently, we see no reason to chase the move higher from current levels. Over time, we anticipate that JPY will appreciate, reflecting its low valuation profile and the Fed approaching the end of its rate-hiking cycle, but for the moment at least USD/JPY should continue to trade with a decent bid.