May Monthly

The US dollar rose against all the major currencies in April, encouraged by renewed economic divergence. The March jobs report in early April and the better than expected Chinese data lift the animal spirits. The S&P 500 gapped higher on April 1 and did not look back on its way to record closing highs. The better tone to the world’s two largest economies failed to be duplicated more broadly. Asia is lagging. South Korea, a regional bellwether, already reported Q1 GDP contracted. The Japanese economy, the world’s third largest, probably also contracted in Q1. While fears of an EMU recession have eased, German manufacturing has yet to recover. Germany, the world’s fourth-largest economy contracted in Q3 18 and barely grew in Q4 18. Its estimate for Q1 GDP will not be officially released until the middle of May, but the Eurostat put EMU growth at 0.4% in the quarter and 1.2% year-over-year.

We suspect the “divergence” hypothesis is now discounted or mostly so, for the time being, and this is underscored by the extreme speculative positioning in the futures market (which may be a proxy for the market segment that includes trend-followers and momentum players). Also, the macro story may be overstated somewhat. The preliminary estimate of Q1 US GDP of 3.2% was flattered by a surge in imports, which if confirmed, could cut into future output. Excluding trade, inventories and government, the final domestic private sales, which is seen as a better gauge of the underlying economy, grew by 1.3%, the least since 2013.

The UK will have to participate in European Parliament elections at the end of May if the Brexit debate lingers on and the government is unable to strike a deal with Labour. Precisely what it means to leave the EU was not decided by the 2016 referendum, and it serves as a sort of Rorschach Test. The EU Parliament Elections themselves at the end of May pose a political risk. Often small and extreme parties tend to do better than in national contests. Merkel appears more keen to protect and project German interests through the new European Commission than at the ECB, it could ostensibly be Germany’s turn, though French central banker who some see as a candidate, insists that nationality doesn’t matter

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Trade issues remain open. The end of the month could see the Presidents Trump and Xi sign a trade agreement. As an executive agreement, it does require congressional approval. The same is true of the US negotiations with Japan and the EU. Neither is likely to be resolved in short order, and the threat of US auto tariffs remain. The US-Mexico-Canada free-trade agreement has not been approved by any of the legislatures. Without the lifting of the steel and aluminum tariffs in the coming weeks, which seems unlikely, Canada’s parliament is unlikely to approve it before its recess, and the national elections in October crowd the agenda.

Dollar: Can the macro story get any better? Growth accelerated Q1, and price pressures eased. The S&P 500 and NASDAQ are at record highs. The unemployment rate is the lowest in a generation, and average hourly earnings continue to exceed inflation. The combination should help lift consumption after a soft first quarter. Market positioning appears extreme, but given the interest rate differentials, it is expensive to be short the dollar. This allows for a consolidative phase and some position churning as the primary macro picture is clear. The US economy is performing among the best, and the interest rate premium is sufficient, if not to attract large portfolio flows, according to Treasury data, then to keep US savings at home.

Euro: The eurozone economy continues to struggle to gain traction. The problem lies in the core. The near-stagnant Italian economy is not a surprise. It is that the German manufacturing sector does not appear to have stabilized. Several shocks have hit it, including uncertainty about Brexit, the slowdown in China, the weakness in Turkey, idiosyncratic and industry issues hitting the auto sector. At the same time, the strength of the German service sector is overlooked. The recent IFO survey put at four-month highs, while the April service PMI was at its best level since last September. The rally in oil prices and the euro’s weakness will likely lift measures of inflation in the coming months. The European Parliament election and the formation of the next European Commission will dominate the coming months. Italy will also hold the first round of local elections at the same time—May 26. Speculation of who will replace ECB President Draghi, whose turn expires in October. We suspect Finland’s former central bank governor, Erkki Liinkanen, is the most likely.

Spot: $1.1225     Median Bloomberg Forecast $1.1215        One-month forward $1.1255 

One-month implied vol 5.27%

Yen: The Japanese markets are closed for an extended period in the first part of May for the new Emperor. These thinner conditions that result could lead to erratic price action. The macroeconomic backdrop is poor. The Japanese economy contracted in Q3 18 before recovering Q4. However, the steep drop in industrial output, weak services, and contacting exports on a year-over-year basis for four months through March warns that growth remains elusive. The Americans are pushing for a modest agreement to grant the US the same access that has been given to the EU and the Trans-Pacific Partnership as early as the end of this month when Trump is set to visit Tokyo. However, with July upper house elections and the G20 meeting in Osaka in late-June, Prime Minister Abe is no rush, especially if the US is not offering to exempt it from any new auto tariffs.

Spot: JPY111.40     Median Bloomberg Forecast JPY110.70        One-month forward JPY111.15 One-month implied vol 5.30%

Sterling: Despite some fluctuations, sterling finished April little changed against both the dollar and euro. When the UK was given an extension to the end of October, short-dated volatility fell dramatically. Three-month implied volatility fell from 11% at the end of March to below 7% where traded quietly in the second half of April. A longer-dated measure that covers the end of October also is near multi-month lows. With Prime Minister May still ruling out a customs union arrangement talks with Labour do not appear to be progressing very far and the UK will have to participate in the EU parliament elections. Depending on the results of the local elections (May 4) and the EU elections, May will likely come under increasing pressure to step aside if talks with Labour fail. One of the reasons this may not have been seen more favorably for sterling is that May’s most successor comes from the most vocal wing of the party, which includes many of the most virulent anti-European members. That is understood to increase the risk of a no-deal exit after all. Although not much of a focus or driver at the moment, the UK economy appears fairly resilient and manufacturing and consumption appear to be bright spots at in the first part of the year.

Spot: $1.3065        Median Bloomberg Forecast $1.3180        One-month forward $1.3085 

One-month implied vol 6.73%

Canadian Dollar: The US dollar traded in a CAD1.33-CAD1.34 trading range for most of April. A day before the central bank meeting on April 24, it pushed above it and extended to rally after the somewhat softer neutral tone of the Governor Poloz. The US dollar peaked near CAD1.3520, the highest level since January 3. If the US dollar has moved into a new range, old resistance around CAD1.34 should now offer support. The next upside target would CAD1.3600-CAD1.3650. However, we are suspicious that the breakout was not the beginning of a new leg up for the US dollar, and expect it to consolidate in May, though expected it to still find support around CAD1.33. For the Bank of Canada to consider cutting rates we suspect the housing weakness would have to spill over into employment and consumption and/or inflation would have to fall sharply.

Spot: CAD1.3400   Median Bloomberg Forecast CAD1.3350   One-month forward CAD1.3390    One-month implied vol 5.15%

Australian Dollar: The labor market is strong, and sentiment surveys give reason to expect better economic traction going forward. However, the unexpected softness of Q1 CPI (1.3% vs. 1.8% in Q4 18) and the softening of the underlying measures fanned the ember of rate cut expectations. Before the inflation report, the derivative market appeared to price in a cut in Q4 18. It has been brought forward into early Q3. The Reserve Bank meets on May 7, followed by the Monetary Policy Statement on May 10. The Australian dollar has been in a $0.7000-$0.7200 range since mid-February. It began April poked above the top and slipped below the range briefly after the CPI. The range is proving resilient, and it may still dominate the price action in the coming weeks. We expect to eventually be to the downside.

Spot: $0.7040        Median Bloomberg Forecast $0.7070        One-month forward $0.7045 

One-month implied vol 7.80%

Mexican Peso: The Mexican peso remains the market’s darling. Its 2.25% gain in April led the world’s currencies. The 3.25% gain for the year is the most except for the Russian rouble, which seems to be an oil play. The high nominal real rates are attractive, and the high real rates mean that the central bank will have to cut interest rates eventually. Speculators in the futures market have amassed a record net and gross long peso position. A dollar spike late-April to almost MXN19.20 was sold quickly. Slower growth alone is insufficient to get the central bank to cut rates. It takes a further decline in price pressures. The year-over-year comparisons make it difficult to envision much improvement in April or May. If MXN19.20 is the upper end of the dollar’s near-term range than the MXN18.75 area has been a shelf.

Spot: MXN19.94       Median Bloomberg Forecast MXN19.09     One-month forward MXN19.03 One-month implied vol 9.22%

Chinese Yuan: Through the first four months of the year, the Chinese yuan is the fourth strongest currency in the world behind the Russian rouble, the Mexican peso, and the Chilean peso. The 2.1% gain was recorded in January and February. In March and April, the dollar traded between roughly CNY6.68 and CNY6.75. We thought we saw signals from Chinese officials suggesting no desire for the dollar to fall through CNY6.70 or above CNY7.0. To the extent that the exchange rate is managed, we suspect that a little strengthening of the dollar may be desirable. It may want to pare the yuan’s gains now that it has arguably demonstrated its capability and willingness to maintain stability, as the trade negotiations with the US appear to be entering their final stages. It would be a reminder of the importance of that an agreement is struck but also that like the embargo against Iran, and fighter jet sales to Taiwan, and trying to lead a boycott against Huawei and its Belt-Road Initiative that there are many dimensions to the US-China rivalry. If this assessment is correct, the US dollar could firm into the CNY6.78-CNY6.82 area.

Spot: CNY6.7350   Median Bloomberg Forecast CNY6.1740     One-month forward CNY6.7250 One-month implied vol 3.65%

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