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How Many Interventions Does it Take? - Global Exchanges

FICC Podcasts Podcasts October 27, 2022
FICC Podcasts Podcasts October 27, 2022


In this week's episode, we discuss recent developments related to the yen, the renminbi, the euro, and the Canadian dollar.


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About Global Exchanges

BMO’s FX Strategists, Greg Anderson and Stephen Gallo, offer perspectives from strategy, sales and trading on the foreign exchange market, related financial markets, and the global economy.

Podcast Disclaimer

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Greg Anderson:

 

Hi, welcome to episode 55 of Global Exchanges, a podcast about foreign exchange markets and related issues.

In this week's episode, my co-host Stephen Gallo, and I discuss recent developments related to the yen, the renminbi, the euro, and the Canadian Dollar. The title of this episode is How Many Interventions Does It Take?

Stephen Gallo:

 

Hi, I'm Stephen Gallo, a London based FX strategist. Welcome to Global Exchanges presented by BMO Capital Markets.

Greg Anderson:

 

Hi, I'm Greg Anderson, a New York based FX strategist. I'm Stephen's co-host.

Stephen Gallo:

 

In each weekly podcast like today's, we discuss our perspectives on the global economy and the foreign exchange market. We also bring in guests from the FX industry and from related financial markets like commodities.

Greg Anderson:

 

We strive to make this show as interactive as possible, so don't hesitate to reach out by going to bmocom.com/globalexchanges. Thanks for joining us.

Stephen Gallo:

 

Okay, it's October 27th, 2022. Thanks for tuning into Global Exchanges, again.

Greg, let's not start off with the dollar this time and just launch right in with a key currency pair dollar/yen. What are the facts? It has stabilized below 150 reportedly due to multiple rounds of MOF BOJ intervention. And, as we speak, it's trading 145.90, give or take. But before we bring you in, Greg, on dollar/yen, I just want to take stock of where we are relative to our April 19th podcast we titled Does the FX Market need an intervention? And during that podcast, we basically said that coordinated intervention in a seamless fashion amongst global central banks and finance ministries was a very low probability risk.

But we also noted that both the yen and the euro might need some form of intervention in the coming months due to the strength of the dollar. So we got that in the yen. And my question, Greg, to bring you in, is what do you make of the effect of this intervention in dollar/yen in terms of the magnitude of the yen's strength it produced, and what do you think the global ramifications have been, or what will those ramifications be?

Greg Anderson:

 

Great question, Stephen. And since we were amateur virologists during 2020 and 2021, we might as well continue with the theme of being amateur psychologists in 2022. Because in markets that have faced as many shocks, as we've encountered this year, market psychology takes on inordinate importance.

So just to expound a little bit on the Japanese interventions, the MOF ordered one big intervention in September. And then, issued a press release confirming what it had done. A month-end intervention summary gave markets the [inaudible 00:03:03].

In October, presumably after consultations with the US and others at the G7 and G20 meetings, Japan changed tactics. Over the past week, it has conducted so-called stealth interventions in dollar/yen, which means that Japanese officials aren't confirming with certainty that they have intervened, but they also aren't denying it. While the BOJ's checking account balance, which is visible online basically suggests that a lot of money has been spent on intervention.

Looking at the price action, it seems that the intervention has been a lot more successful in October than it was in September. Some of that may simply be due to the broad US dollar receding, which has made turning the tide in dollar/yen a lot easier for Japanese officials.

It may also be the case that intervention effects are somewhat cumulative. It seems like there was still an unsatisfied demand for US dollars coming out of the first intervention. But this second round of intervention has sprinkled enough dollars on the market to satisfy the USD demand overhang. So now, we no longer have Japanese institutions seemingly almost panic buying dollar/yen on any dip. It looks like now, that these key market players have largely squared their positions. And, if that is the case, then I think it is reasonably likely that dollar/yen can just die off into a 145 to 150 range. I wouldn't rule out that that range could last through the end of the year, particularly if US bond prices stabilize.

And just kind of to reiterate the mechanics there, following us, bond prices have been a key part of the yen's decline because Japanese investors FX hedge their US bond portfolios. So as bond prices go down, their short dollar/yen hedges need to be reduced i.e., the system buys dollar/yen. If you take that factor away, then you take away a lot of the upward impetus in dollar/yen. Although, with Japan's ongoing core flows deficit, it maybe doesn't take all the upside pressure away.

So Stephen, you asked about implications for the rest of the world. And this is where I mostly want to turn it back to you. I'll just note that the never ending upward spiral in dollar/yen put upward pressure on dollar Korea, dollar Taiwan, and ultimately dollar RMB. So to the extent that Japan's FX intervention campaign succeeds in drawing the line into the sand at 150 in dollar/yen that should relieve a lot of the pressure on the ADXY currencies. Of course, you know the biggest ADXY currency is the renminbi, which seems to have seen some intervention of its own this week. What can you tell us about that, Stephen?

Stephen Gallo:

 

Yeah, absolutely, Greg. There has been physical intervention to sell dollars in dollar RMB by state banks. So, we've been told. But there are important differences between the RMB and the Japanese yen, which I think are worth discussing, worth mentioning.

Firstly, PBOC has been easing policy, monetary policy all year and not artificially propping up the RMB. Basically, what it's been doing is managing it lower. Secondly, very important I think, PBOC has not been fighting against a negative core flows dynamic like the BOJ has. So until we get another impetus higher from the dollar, if we get one, I think 740 in dollar RMB is the near term line in the sand which PBOC has drawn. And PBOC has a strong enough balance of payments where it can maintain that for the time being.

I mean, where do we go from here? It's now, really all about the dollar and The Fed, I think, Greg. And so I'm inclined to think that 720, 730 that range in dollar RMB is the sweet spot for the currency pair near term. But here's the thing, Greg, If The Fed pivots forcefully sooner than maybe even the rates market has priced in, China will say, "Thank you very much. We'll have some of those capital flows back, so to speak, and accept a bit of RMB appreciation," maybe with the knowledge that the global recession might not be as severe as previously thought because The Fed's pivoting.

But on the other hand, if The Fed is not quick to pivot and we get a run of bad news for the global economy, including more weakness in other ADXY currencies, I don't think the PBOC will have any problem letting dollar RMB go above 740. This has not been a distress move in the RMB lower. Now, that doesn't mean it can't happen. But I think the threshold for pain, so to speak, for China, given its balance of payments and other factors, is higher than that threshold is for other currencies in the ADXY. The critical, and I do mean critical difference between China and many of its ADXY counterparts so far, is that China is not tightening monetary policy to defend its currency. It's letting the currency reflect the stance of monetary policy which, of course, is looser than The Fed's.

Greg Anderson:

 

Good point about core flows being more favorable for China than for many other Asian currencies, Stephen.

It should make Chinese officials more confident that they can pull out of a spiral at the time and level of their choosing than is the case for many others. But still, I would argue that there is this ongoing risk that the yen spiraling weaker leads to non-China ADXY currencies spiraling weaker, which leads to the RMB weakening and maybe by choice, which leads to these other currencies spiraling weaker not by choice. And then, you just have this concert of multiple spirals acting in parallel that creates uncontrollable feedback loops for everyone.

But if the biggest Asian economies, Japan and China, are both trying to short circuit the multiple spiral through FX intervention, while some of the others are trying to short circuit this multiple spiral through rate hikes, then this sort of multifaceted intervention coming from many different angles, maybe that's enough to cure market psychology in all of these currencies.

But now, let's talk about Europe. Today, the ECB hiked by 75 basis points as expected. It is such a 180 from where we were not that long ago when ECB President Lagarde boldly declared, "The lady will not taper," and acted like she would never hike rates either. But even with this massive 180 degrees swing by the ECB, which I would argue is ECB's way of intervening to try to steer the euro higher, the knee-jerk response in the euro that we've gotten today is euro down 1.3% against Aussie, euro down 1.2% against CAD, euro down 1.1% against yen, euro down 0.6% against sterling. So what's going on here, Stephen? Please walk us through the ECB's communications and the FX markets response.

Stephen Gallo:

 

Greg, long story short, it looks to me like a portion of the FX market had the longs trade for QT on the table today, and when they didn't get it, they exited their euro longs, which had been put on in anticipation of a pop higher in the euro. I mean, that's what it looks like to me.

Lagarde effectively kicked the QT issue into the long grass, so to speak, and she put December on the table for a potential decision, but there was zero pre-commitment to do anything at that point. And to complement this vagueness on qt, she also left the December policy announcement completely open-ended. So the December decision is clearly going to depend on a number of different outcomes. Inflation is one of them, but also global factors as well.

But going back to the percentage changes in the euro, you mentioned Greg, here's the intriguing aspect of today's price action in euro dollar and in the euro crosses, when Lagarde downplayed the prospect of balance sheet runoff, the euro dribbled lower against the dollar to the point where it was down over a percent, I think, on that axis for the day. But then it retraced the portion of that loss after the press conference with Lagarde ended, or towards the end of it, as peripheral credit markets rallied and spreads compressed.

Now, don't get me wrong Greg, I'm not screaming euro bull here, but I do think that the net decline in the euro could have been much more severe if a QT launch date were set in stone by the ECB today as the euro area heads into a difficult winter and, quite likely, an economic recession, potentially a deep one. So I think if they had done that, I think you would've had a brief pop higher in the euro on the announcement effect of QT, followed by a full retracement lower in the euro and then some.

And I'll justify that by saying the more the ECB tightens, the more governments will be pressured to do more work on the fiscal side. And that risk causing significant dislocations in the euro area's credit markets as a result of the financial and fiscal architecture of the block. So it surprises me a bit that a larger portion of the FX market didn't see QT being announced today as a bigger outlier risk, but that's what the price action suggests.

So what's the main point here I want to make? The main point is that a reduction in financial stretch due to slower ECB tightening is partly a euro positive factor because it supports asset prices and slows the pace of asset price deflation in the euro area. And the best analogy I can think of, Greg, is that this is a bit like reverse psychology. True, the ECB mirroring The Fed to a degree with rate hikes probably turned what could have been a 25% decline in the euro dollar year to date into just a 12% decline.

But you can't argue yet that rate hikes reduced the euro's negative core flows dynamic or that it caused FX investors to start buying the euro. And I would blame that euro weakness versus the dollar all year long on financial stress and fragility in European credit markets, or the risk of those things. And that's your reverse psychology angle, I think. By slowing the pace of tightening, the ECB is actually reducing the risks of a more chaotic fall in the euro due to financial stress or fragmentation. Unlike the BOJ or the PBOC, the ECB knew it could not intervene in the FX market due to the size of the market and the degree of flexibility in the exchange rate. And it also found out, over time, that rate hikes weren't much of a hindrance to euro depreciation. So the other option is to just signal that you're willing to stop hammering the real economy and tightening financial conditions at the same pace. And that's what I think we saw from the ECB today.

Greg Anderson:

 

So Stephen, with the next ECB now seven weeks away and them, seemingly, turning more dovish, what is the top euro risk in your view?

Stephen Gallo:

 

Well, to be honest with you Greg, I think this risk is something that's gonna be a factor over the course of the next seven weeks, but it may persist as a risk into next year too. And that is the risk that core inflation doesn't roll over as quickly given the demand destruction that the ECB is expecting its policy to have. I mean, maybe it will and maybe it won't. It's not my job to forecast inflation, and I'm thankful I don't have that job.

But the downside risk for the euro and potentially European credit markets is that inflation pressures aren't as well behaved as the ECB would like it, and particularly core inflation. And then, we're back to square one again. What does the ECB do? Does it do nothing as inflation remains stubbornly high, higher than expected with little sign of a deceleration, or does it tighten more? I don't think either one of those scenarios is particularly euro bullish, Greg. And to be honest, again being frank, in the scenario where inflation is not well behaved at all for the ECB, I think you want to add exposure to commodity linked currencies against the euro. But we'll see what happens.

I mean, one thing I also didn't mention, which I have to just get in here at the end, is this is assuming nothing happens with escalation in the war in Ukraine. In other words, Russia does not escalate. If Russia does escalate, then that risk of inflation remaining high for longer becomes even more palpable, more likely to materialize. So they may, for some reason, have a lot of confidence on the inflation outlook, but there's a lot that could go wrong here, Greg.

Greg Anderson:

 

That restrained hawkishness that you noted by the ECB, Stephen, it's actually a continuation of a theme that the RBA kicked off earlier this month and then, the BOC continued yesterday. And like with analyzing the impact of the ECB on FX today, you need to look at yesterday's action and cross exchange rates to tease out the real FX responses because the US dollar has been receding so much this week. And that receding US dollar means that dollar CAD, it's actually a bit lower since the BOC seemingly disappointed the market by only hiking 50 basis points. But look, crosses like sterling/CAD, Aussie/CAD, they saw big jumps on the knee-jerk yesterday that are more consistent with a traditional response to the BOC disappointing markets with less aggressive than expected policy.

With those loony setbacks on crosses, I guess, I'd be inclined to feed them because I don't think that the BOC's deceleration to a 50 basis point rate hike was all that dovish. Rather, I think it was a shrewd calculation by the BOC about the timing of rate hikes rather than an actual adjustment to their intended terminal rate.

On that note, I will point out that our economics team did not adjust down their call for the BOC's terminal rate. They have kept it at 425 and done that by simply adding a 25 basis point rate hike to their outlook curve for the BOC's January meeting. This completely matches Macklem's rhetoric in the press conference. He talked about the BOC pretty much for sure hiking in December. But when talking about the potential for a downshift to normal 25 basis point rate hikes, he made sure to put a big S on the end of that word hikes, implying that if there is a downshift to 25, there will be more than 1, 25. The interest rate announcement, the printed version also had that big S, and I'm pretty sure it was by design.

On inflation, things obviously went from post pandemic bad to much worse in March of this year due to Russia's invasion of Ukraine. Monthly inflation numbers in March were extremely high in Canada in pretty much all other OECD countries. But that surge, that March surge is going to drop out of the year over year inflation prints in March of 2023. I think the BOC made a shrewd calculation that it would rather keep tightening until that happens, until the market can see the whites of the eyes of inflation shifting sharply lower. So they didn't want to spend all of their bullets in 2022.

So look, the BOC tightened before The Fed. And now, I would argue, it has better set itself up to get the last hike in, so to speak. So what does this mean for the loonie? Let me just reiterate what I said a second ago. I like the loonie crosses. It does not have the core flows problems like we've been talking about for euro and yen. It doesn't have the easy monetary policy, like we mentioned for the RMB. It doesn't have the fiscal problems that are underneath sterling, so the BOC just gave markets an entry point, buy CAD on crosses.

Stephen Gallo:

 

I like it, Greg, I continue to like it. And I also liked your point about the BOC strategy, downshifting the pace of hikes, but still aiming for the same target as before. In other words, it's about where you're headed of course, but it's also how you get there.

Always good to hear your thoughts on the CAD, Greg. I think it's that time again in the episode. I've heard enough of myself, and I'm sure listeners have too. Shall we end it here, Greg?

Greg Anderson:

 

Yeah. Let's cut ourselves off here before someone else has to intervene.

Stephen Gallo:

 

You may get a few LOLs with that one, Greg. Thanks for listening. Bye for now.

Greg Anderson:

 

Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts at bmocom.com/globalexchanges.

Stephen Gallo:

 

We'd love to hear what you thought of today's episode. You can send us an email or reach out to us on Bloomberg. You can listen to this show and subscribe on Apple Podcasts, Spotify, or your favorite podcast provider.

Greg Anderson:

 

This show and resources are supported by our team here at BMO, including the FICC Macro Strategy Group and BMO's Marketing team. This show is produced and edited by Puddle Creative.

Announcer:

 

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates, or subsidiaries. For full legal disclosure, visit bmocm.com/macrohorizons/legal.

Greg Anderson Global Head of FX Strategy
Stephen Gallo European Head of FX Strategy

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