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Revisiting the USD Peak - Global Exchanges

FICC Podcasts May 31, 2022
FICC Podcasts May 31, 2022

 

In this week's episode, we discuss the pullback in the US dollar over the past two weeks and go through the macro stories behind it before looking at a few key exchange rates.


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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.

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Greg Anderson:

Hi. Welcome to episode 44 of Global Exchanges, a podcast about foreign exchange markets and related issues. In this week's episode, my cohost, Stephen Gallo, and I will be talking about the pullback in the U.S. dollar over the past two weeks. We'll go through the macro stories behind it before looking at a few key exchange rates. The title for this week's episode is, Revisiting the U.S. Dollar Peak.

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 cohost.

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 bmocm.com/globalexchanges. Thanks for joining us.

Speaker 3:

The views expressed here are those of the participants and not those of BMO Capital Markets, it's affiliates, or subsidiaries.

Stephen Gallo:

Okay, Greg, let's get the episode rolling. It's the last day of May, as we record. And I guess we owe listeners a brief explanation for why we're revisiting the dollar peak discussion, which we addressed last, in episode 42. That was back in late April. The first reason is price action. In late May, dollar negative. Dollar China turned after touching 683 and Euro dollar hit a low of 103.50, both on May 13th. So, the dollar index peaked on that day. And I think importantly, that was after the May 4th FOMC.

Stephen Gallo:

So, we're looking at a 3.9% drop in the BBDXY since that peak as we end the month of May. But it is still up 3% on the quarter and up a little under 5% year to date. So, let me toss it over to you. Let's get your thoughts. Let's get you to weigh in on a U.S. perspective for the dollar decline. Let's start there.

Greg Anderson:

Okay, so I'm going to give you two or three answers there. First, Fed hike expectations backed off a bit. On May 3rd, so that's the day before the last FOMC, the FFZ2 Fed fund's future contract implied an end of year Fed rate of 2.78%. And that's where it peaked because the next day Powell ruled out 75 basis point increments. By May 13th, so the date you identified as the USDD index peak, we were about 15 basis points lower with an implied Fed funds rate of 2.63%. Last week, we got down to 2.53% on Thursday and Friday. And I would say that's probably the result of Fed speakers like George and Brainard talking up the possibility of a so-called, strategic pause, or at least a deceleration after the Fed gets to quote, unquote, neutral. And I'd point out the minutes published Wednesday last week mentioned extreme uncertainty, so that supported it.

Greg Anderson:

The second thing, Stephen, and I would argue that this is even more important, equities just simply stopped following. And why, I'm not entirely sure, but I'll point out that the spillover from the crypto shock abated. And then maybe there was just a little ebbing of the general negative tone of earnings news. But if equities have hit a bottom, then risk off as a driver for U.S. dollar strength should go away.

Greg Anderson:

The last thing that I'll say is that I think there may have been some type of an alignment in official comments and actions coming out of the G20 finance officials and central bankers meeting that was held about 11 days ago. Seems like there's kind of been a coordinated effort to ease U.S. dollar strength with the Fed scaling back on hawkish rhetoric, while the ECB has escalated its hawkish rhetoric. So, I think that's where I'll turn it back over to you, Stephen. From a Euro fundamentals angle, what changed to support the bounce from 103 to 107? And does 103 now look like it was the bottom?

Stephen Gallo:

I think that last point about loose coordination, Greg, is definitely an interesting angle. Here's my take on an extension sort of that view. After the Fed seemed to soothe market expectations for rate hikes a bit, those expectations got pulled out of the curve. Risk assets like equities benefited from that move. And it seems to me that the reduction in risk aversion, partly instigated by the Fed, gave ECB officials some wiggle room to solidify rate hike expectations without causing major dislocations in European credit markets. I mean, we are seeing credit spreads and longer term yields adjust, but so far, it's not having a dramatic impact on risk appetite.

Stephen Gallo:

I admit that I was very uncertain about how things would play out with the ECB. But I did flag two important ECB issues earlier in the year. One was that the ECB could signal [inaudible 00:05:49] exit to mitigate fundamentally-driven weakness in the Euro. And clearly, this weakness in the currency was causing concern within the ECB.

Stephen Gallo:

Also important, the positioning data has suggested that FX leverage funds were only partly responsible for your weakness. So, the ECB had to act to lean against this type of fundamentally-driven your weakness. But it was also unclear to me how the ECB could start to signal normalization without severely disrupting financial conditions in credit markets at this stage. The Fed may have given them that opportunity, at least that's what I personally think.

Stephen Gallo:

So to answer your question, rate differentials and risk appetite supported Euro dollar in the bounce from 103 that you mentioned. If we're past peak Fed in terms of positive dollar impact, the ECB effect will certainly help. I think we can probably conclude that the ECB wants 103 to be the low. But I also think the timing of the peak in inflation in Europe, the coming fluctuations in energy prices, depending on how that plays out, balance of payments weakness and geopolitical risk, all of these are probably beyond the ECB short term control, and still factors that can hold back Euro appreciation in the short term.

Stephen Gallo:

I think what concerns me is that risk aversion episodes, which can feed off those issues I mentioned, are very difficult to predict. So, that's where I am in terms of thinking about this.

Stephen Gallo:

Now, let's move to Asia. Give us your thoughts, Greg, on dollar yen. Where do you think it's headed? What do you think the key issues are? And I guess the final question, Greg, is, do you think the top in dollar yen is in?

Greg Anderson:

This year's dollar yen rally from seemingly stable around 115 for most of Q1 to a high of 131 on May 9th, I mean, what was that about? I think most people would tell you that it was about the FX market price in yen aggressive Fed rate hikes. And that theory certainly matches the price action of the past two weeks because as 25 basis points or so of Fed tightening has come out of the curve during the back half of May, dollar yen, it backed off from 131 to 127.

Greg Anderson:

I would argue though that there's another variable at play that's just as important for dollar yen, and that's the price of Japan's number one import, energy, AKA oil. Because of high energy prices, Japan has reverted to running a trade deficit. And that deficit could get a lot worse if we have an oil price spike over the next few months. Given the tight inventories in the oil market, and that's even with all the lockdowns in China taking away some of the demand, I think that an oil price spike at some point this summer, is a fairly high likelihood.

Greg Anderson:

I mean, we haven't even reached hurricane and air conditioning season yet in North America. Whenever we get a major hurricane in the Gulf, I think we may well see oil go past the $130 a barrel price we saw in the first few days of the Ukraine War. And if oil goes back above 130, so does dollar yen, I think.

Greg Anderson:

So, I guess I would tend to think that the dollar yen peak is not in yet, although I'm not super high conviction with that view. But that brings us to dollar China, Stephen, the rapid move in dollar yen was followed a few weeks later by a similarly rapid move higher in dollar China. We moved from 640 to 683 in a hurry. But over the last two weeks, things have calmed. So Stephen, is it over with 683 the high? Or what if we get an oil-induced dollar yen spike? Does dollar China follow?

Stephen Gallo:

Greg, I think if the stimulus measures to support domestic demand in China don't pass through and feed into better economic data, then I think there is a risk dollar China's permitted to push higher, as policy makers lean on the export sector of the economy, again. Which by the way, this is what they seem to be doing initially, after the BOJ permitted the yen to weaken, and Chinese policy makers were being more reticent with new stimulus measures. They let the RMB follow the yen lower and there was a clear widening of the gap between RMB yen yields on the one hand and dollar yields on the other hand. So to sum up, limited traction in terms of the effect of new stimulus in China and or another bout of Fed on boosting the dollar, I think the RMB follows the end lower in an orderly fashion with PBOC managing the move on the way down.

Stephen Gallo:

But on the other hand, if we do get a big energy price-induced selloff in the yen, so energy price is a lot higher, yen lower, I'm not sure the PBOC would tolerate significant RMB depreciation in that environment. Because of the degree to which that could complicate managing the domestic inflation picture, potentially impacting the trade balance negatively. With those inflation risks increasing, I think the PBOC might be more likely to park dollar China for a while anyway, and wait things out.

Stephen Gallo:

So a move to seven, not out of the question, but the benefits to China have to outweigh the costs. And that's a very fine balancing act. I guess this is the way that the balancing act that most central banks face is reflected for the PBOC.

Greg Anderson:

Thanks for those thoughts, Stephen. So, we're winding down here and just to summarize for our listeners, what we are saying is that we flat out do not know if the dollar has peaked. We don't have a lot of conviction either way. The thing we have the most conviction on is that European policy makers want 103 to be the floor in Euro dollar. Although to quote the Rolling Stones, "You can't always get what you want." We tend to have the least amount of confidence that the top is in dollar yen at 131. And for dollar China and correlated emerging currencies, we're somewhere in the middle. It's just really hard to say. Did I get all that right, Stephen?

Stephen Gallo:

That's a common theme, Greg, lack of conviction. And I don't think it's unique to us. The only thing I would add, just pulling in the commentary from episode 42, when we first addressed the dollar peak issue, still very much believe the peak in the dollar, the timing of it depends a great deal on dollar China. And of course, there's that all important seven level in dollar China. If we get there, if the benefits to policy makers outweigh the costs, it's probably going to have a broad effect on all currencies versus the dollar. But we just don't know what the global environment exactly is going to look like. What will be the variables that are moving most, where will the volatility be, is very uncertain.

Stephen Gallo:

But anyway, let's wrap it up here. Listeners who stuck it out until the end, thanks for tuning in. We'll be doing our monthly podcast with our colleagues from U.S. Rates, U.S. Credit, and Canadian Rate Strategy next week. But Global Exchanges will be back later in June. Thanks again.

Greg Anderson:

Thanks for listening to Global Exchanges. Listen to past episodes and find transcripts at bmocm.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.

Speaker 3:

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Speaker 3:

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

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