In a piece written last year, Bloomberg’s Matt Levine said, “The weird thing about the coronavirus crisis is that it simultaneously (1) caused a stock market crash and (2) eliminated most forms of fun” – before suggesting that a tedium epidemic could play a big role in the financial markets. Under his ‘Boredom Markets Hypothesis’, people would – after losing access to large public venues, drinking establishments, and sports betting – seek alternative entertainment choices. Millions would engage in highly speculative investment activity – at least, until other, more salubrious forms of gambling were made available once again.
Mr. Levine’s theory proved prescient, describing market dynamics during the pandemic with remarkable accuracy.
Unable to place bets on athletic endeavours, Barstool Sports’ Dave Portnoy suddenly took an interest in day-trading, saying, “Stocks only go up” – and he was basically proven right. Legions of amateur investors, communicating over Reddit forums and using applications like Robinhood from the comfort of their living rooms, drove markets skyward. Bubble-like behaviour emerged in stocks, commodities, and cryptocurrencies. And an “endless bid” helped dampen volatility.
Events in the real economy looked uncannily similar: when people lost access to services and entertainment, they accelerated spending on things they could see – mainly tangible products and home improvement. With government stimulus supporting aggregate incomes in most developed countries, economic activity wasn’t destroyed so much as it was transformed.
As the New York Times’ Doug Irwin observed, shutdown-related losses in transportation and recreation services, restaurants and hotels amounted to “$430 billion in “missing” economic activity” last year, “largely equivalent… to the combined shift of economic activity toward durable goods and residential real estate”.
In-person services were put into suspended animation, while goods imports sprang above pre-pandemic levels in a matter of months. Housing prices soared, sales surged, and building materials stores did a roaring trade.
This had profound implications for foreign exchange markets: China’s manufacturing-focused economy was a direct beneficiary, recording enormous trade surpluses and unprecedented inward capital flows during the pandemic’s peak. Losses in Germany and Japan were cushioned. Huge increases in housing market activity boosted growth in small, open economies like Australia, Canada and the United Kingdom. Raw materials exporters in the emerging markets found that foreign investment levels remained far more stable than in prior crises. And the dollar fell as flows were directed into the rest of the world.
But with lockdowns easing, workplaces reopening and traffic patterns beginning to return to normal, this “boredom bubble” is now deflating. Over the last month, the biggest tech stocks, cryptocurrencies, and commodity prices have all collapsed from their peaks.
If a rebalancing process is underway – in which the pandemic’s winners switch places with the losers – the following outcomes are possible:
Export growth begins to weaken: As the preferences pendulum swings back toward in-person services, the share of consumption going to tangible goods tumbles – weighing on trade balances and exchange rates in the manufacturing superpowers.
Inflation fades more quickly than expected: With producers and logistics networks ramping up just as consumers shift buying patterns, today’s supply shortages and transportation bottlenecks suddenly give way and force prices downward.
Real estate market activity drops: Demand for detached housing, vacation properties, and building supplies wanes as workers begin returning to the office.
Foreign exchange volatility returns: Cross-border investment flows and exchange rates experience rapid reversals as monetary policy expectations switch signs and shift geographically.
Even as the world emerges, blinking, into the sunlight, currencies could be facing another round of turbulence. But this really shouldn’t come as a surprise – a thirst for entertainment has long plagued financial markets . As the French philosopher Blaise Pascal once observed, “All of humanity’s problems stem from man’s inability to sit quietly in a room alone”.
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The trade-weighted dollar is sitting near cycle lows as June begins, with last month’s soft payrolls report keeping yields and capital flows restrained.
The Federal Reserve is (finally) talking about talking about tapering: Minutes taken during the central bank’s April meeting show policymakers were considering whether “it might be appropriate… to begin discussing a plan for adjusting the pace of asset purchases”. Last week, both Vice Chairs – Randal Quarles and Richard Clarida – confirmed they could begin talking about tapering at “upcoming meetings.”
We think this is largely priced in: Data from the New York Fed’s Survey of Market Participants shows that markets have long expected policymakers to wind up their telegraphs this summer – potentially at the Jackson Hole symposium in August – with bond buying beginning to fall off in early 2022.
A 2013-style “taper tantrum” should be avoided: Financial conditions remain incredibly accommodative, and Jerome Powell has taken pains to communicate the timing differences that are likely to emerge between asset purchase reductions and rate hikes – setting out a phased withdrawal plan that reflects lessons learned during Ben Bernanke’s time at the helm.
But tomorrow’s jobs report matters: The Fed’s policy stance is unlikely to change until a string of consecutively solid non-farm payrolls reports has been recorded. An upside surprise – a number materially above the 650,000 threshold – could elicit serious dollar upside. Back-to-back disappointments might provoke a fall in interest rates and generate more weakness on the exchange rate front.
The June 15-16 Fed meeting could also trigger volatility: Markets currently see several policymakers beginning to bring lift-off forecasts forward, adjusting dot plot contributions to show the first hike coming in 2023. If officials prove more patient than expected (or are rattled by incoming data), this outlook could shift, forcing rebalancing in currency markets.
The dollar might continue to fall, but against what? Balance of payment gaps that have been propelling China’s renminbi higher are beginning to narrow, interest differentials remain firmly tilted against the yen, dovish voices are in the ascendant at the European Central Bank, and emerging markets are suffering a commodity-price hangover.
The trend is your friend, until the bend at the end: An upturn in economic surprise indices could push markets over the tipping point in the month ahead, convincing participants that US rates should move up in a sustained way. If so, the dollar’s performance could reverse direction – and background market volatility could rise sharply.
CALM AFTER THE STORM
Cambridge Flow-Weighted Implied Volatility Index: Turnover-Weighted 3-Month Implied Volatility: USDEUR, USDJPY, USDGBP, USDAUD, USDCAD, USDCNY, USDCHF, USDHKD, USDKRW, USDINR, USDSGD, USDNZD, EURGBP, EURJPY, EURCHF
2016 May – 2021 May
Sources: Bank for International Settlements, Bloomberg, Author Calculations
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The Canadian dollar has been the highest achieving major currency this year, rising 5.6 per cent against the dollar year-to-date, and 11.3 per cent against the worst performer – the Japanese yen.
Vaccinations are accelerating: On a per capita basis, Canada is jabbing more arms than Europe, the United Kingdom, or the United States. Lockdowns are set to begin easing in the country’s most populous province by mid-June, putting the conditions in place for a sustained economic recovery.
Oil prices remain supportive: Global demand continues to absorb OPEC production increases, and the prospect of a renewal in the Obama-era nuclear deal between the US and Iran hasn’t noticeably impacted either of the two major benchmarks.
Trade is providing a nice boost: Elevated commodity prices and feeble services imports helped the country record a rare trade surplus in the first quarter.
Real estate markets are superheated: Housing investment rose an astonishing 43 per cent relative to a year prior, in the first quarter, with residential investment contributing 8.6 per cent of overall gross domestic product – the highest on record.
Canadians continue to spend: Retail trade rose 3.7 per cent in March, following a 5.9 per cent rally in the prior month, as households splurged at furniture, clothing, and building materials stores.
The economy is on the cusp of full recovery: Output expanded at an annualised 5.6 per cent pace in the first three months of the year and is on course to rebound more strongly in the second half.
Employment fell in April but is poised to snap back: Friday’s jobs report is expected to show a 20,000-position loss for the month of May, but a sharp recovery is likely to come in June and July as social distancing restrictions are eased.
The Bank of Canada remains a global outlier: In beginning to taper asset purchases and telegraphing its first rate hike in 2022, the central bank has pushed two-year swap rates well above global counterparts. Another reduction in bond buying is expected at the Bank’s July meeting.
But competitiveness challenges have worsened: Echoing post-2008 “Dutch Disease” dynamics, an elevated loonie is interacting with spiralling costs in the real economy to inflict severe damage on the export sector.
Trade deficits are likely to return: Among the world’s 20 largest economies, Canada ranked dead last in growing exports over the last two decades, posting a performance three times worse than the global average – despite a sustained rise in commodity prices.
After leaping off the starting block, Canada’s run could lose momentum: The country’s credit impulse looks likely to roll over as the summer begins, with reopening providing a smaller boost as residential investment levels and tangible goods consumption begin to weaken.
We think the currency looks dangerously overbought: Speculative positioning remains heavily long, rivalling levels last seen in late 2019 – meaning that a rebound in the US dollar could trigger a swift unwind toward lower levels.
% Change in Goods and Services Exports
2000 – 2019
Sources: World Bank, Author Calculations
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The Mexican peso rose 0.9 per cent against the greenback in May, shrugging off losses sustained earlier in the year.
Domestic demand remains weak: Although consumption has recovered modestly, it remains well below pre-pandemic levels. With high unemployment and poor labour participation hobbling the economy, remittance flows and export receipts have been crucial in maintaining spending levels. Financing to the private sector has continued to decline, credit conditions have worsened, and survey data suggests that most managers do not believe that now is a good time for firms to invest.
Confidence is climbing: The economy expanded 0.4 per cent on a quarter-over-quarter basis in the first three months of the year, recovering from an 8.2 per cent contraction in 2020. Retail sales rose 1.8 per cent from a year before in March – ending a 13-month series of consecutive losses. Consumer and business sentiment indexes posted modest gains for April.
Extreme base effects are playing havoc with inflation numbers: Headline inflation increased 5.8 per cent in the first two weeks of May compared to a year earlier, while energy prices rocketed more than 25 per cent higher.
The Banco de México remains sidelined: The central bank held its key interest rate benchmark steady at 4 per cent in May, despite missing its 3 per cent objective at both core and headline levels. Deputy Governor Gerardo Esquivel said that he expects price spikes to be temporary, with inflation reaching target in the second quarter of 2022.
But crude prices are helping to fuel the peso’s rise: West Texas Intermediate prices jumped to two-and-a-half year highs this week, rising as the OPEC+ group of producing countries forecast continued tightness in global oil markets.
Spillover effects are growing: The reopening American economy should continue to generate dividends for Mexico. With service sector jobs returning, remittances are poised to rise in the weeks and months ahead. Exports should remain well-supported. And tourism flows are likely to rebound – in a dramatic fashion.
Traders are turning less bearish: Speculative positioning remains slightly short, but the number of bets against the peso has fallen over the last month. In the absence of a commodity price shock or reversal in US economic conditions, the currency could continue to defy its critics.
FUEL FOR INFLATION
Consumer Price Inflation Indices, % Change Year-over-Year
Banco de México Official Overnight Policy Rate
2019 January – April 2021
Sources: Bloomberg, Banco de México, Author Calculations
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The euro’s rally is losing momentum, with gains petering out well below levels reached in 2018.
Green shoots are appearing: After suffering a 6.2 per cent collapse in gross domestic product last year, the bloc has lagged most other major economies – but rapid progress in vaccination campaigns, the impending delivery of EU recovery funds, and expected spillovers from the Biden administration’s fiscal stimulus programme are combining to invigorate animal spirits. Business and consumer surveys are showing the biggest rebound in optimism ever recorded.
Headline inflation topped target in May: Price growth reached the European Central Bank’s 2 per cent objective for the first time since 2018 last month – but commodity prices were the main driver. A 13.2 per cent year-over-year increase in energy costs helped overstate overall inflation rates, with the central bank’s preferred core measure running at a far-more sedate 0.9 per cent pace.
Yields are rising: Interest rates on government bonds have climbed from their lows in March, supported by growing expectations of a tapering in ECB asset purchases.
In the near term, this euro bull case looks flawed: Fiscal stimulus efforts remain smaller in scale and ambition than those being attempted in the United States, and inflation rates are well below levels needed to sustainably revitalise long-term interest rates.
We expect the ECB to keep stimulus flowing for now: The central bank’s latest forecasts show consumer-price growth averaging 1.4% in 2023, motivating Governing Council member Francois Villeroy de Galhau to say: “Today there’s no risk of a return of lasting inflation in the euro area, and so there’s no doubt that the ECB’s monetary policy will remain very accommodative for a long time. I want to say that very clearly”. Policymakers seem likely to fall back on a “constructive ambiguity” strategy – avoiding sweeping changes in their quantitative easing programme while maintaining the flexibility to adjust purchases as needed.
But portfolio flow expectations could play an exchange rate role: Weak investment returns, excess savings and the ECB’s asset purchases generated some of the largest capital outflows ever recorded over the last year, outstripping – on a 12-month summed basis – the exodus that occurred during the euro crisis. If this reverses (as appears to be happening), capital flows that were weighing on US yields and propping up US equity markets may fade, while having offsetting effects on the euro area – putting renewed upward pressure on the common currency in the months ahead.
Net Portfolio Investment Flows
Billions Euro, 12-Month Moving Sums
APP: Asset Purchase Plan, PEPP: Pandemic Emergency Purchase Plan
2010 January – March 2021
Sources: European Central Bank, Author Calculations
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The pound turned in another strong performance last month, rising 1.8 per cent relative to the dollar, and 0.3 per cent against the euro. On a year to date basis, the currency is up 3.8 per cent and 3.3 per cent, respectively.
Political risks have subsided: Prime Minister Boris Johnson’s Tories solidified power in a series of midterm election victories in early May, and the Scottish National party’s failure to win an overall majority lowered the odds on an independence referendum that might fracture the country further.
Herd immunity is tantalisingly close: Three quarters of all citizens have now received at least one dose of vaccine while half have received two.
Growth expectations have improved dramatically: The economy is seemingly progressing through the phased reopening with minimal scarring – most consumer spending and business investment indicators are firmly in positive territory. The Bank of England now expects output to expand 7.5 per cent in 2021.
Prices are rising: Annualised inflation more than doubled in April to 1.5 per cent from 0.7 per cent in March, with energy costs leading the charge higher. The central bank expects core inflation to temporarily exceed 2.5 per cent this year, before reverting downward as pent-up demand is met and supply chain issues are resolved.
The housing market is on fire: Prices have risen more than 11 per cent in the last year, enhancing homeowner wealth and adding fuel to the consumption boom.
Retail sales are soaring: Non-essential brick-and-mortar retailers that reopened in April racked up receipts at an incredible pace, suggesting that excess savings built up during the pandemic will power the country’s growth engine for months to come.
Front-end rates are rising in anticipation of central bank hikes: In an interview last week, Monetary Policy Committee Gertjan Vlieghe suggested that sustained economic growth, paired with a sharp recovery in the labour market could push the Bank of England into a tightening cycle early next year.
But lockdown uncertainties remain: Coronavirus cases, some tied to a variant first identified in India, have risen in the past two weeks, endangering the government’s plan to lift the fourth and final set of social distancing restrictions on June 21.
Domestic forces are also playing second fiddle to a larger dollar narrative: The pound has moved in lockstep with a weakening dollar since the end of February, and a reversal could quickly wipe out any gains. Tomorrow’s non-farm payrolls report and a mid-month Federal Reserve meeting could overshadow all else when it comes to determining the cable’s near-term direction.
Retail Sales, Seasonally-Adjusted Monthly Growth
2018 April – April 2021
Sources: Office for National Statistics, Author Calculations
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The renminbi has strengthened almost 11 per cent against the dollar over the past year, buoyed by surging investment flows and world-beating export growth.
Beijing’s 6 per cent annual growth target looks easily achievable: Gross domestic product grew 18.3 per cent year-over-year in the first quarter.
Investor demand for Chinese assets remains spectacular: High interest rates and attractive growth opportunities in the country’s increasingly consumption-driven economy are pulling global investment flows inward.
Speculators are also enthusiastic: The renminbi has been a one-way bet for most of the last year, and a number of major banks expect the dollar exchange rate to break the 6.20 mark in the near future.
But export competitiveness is wilting: On a trade-weighted effective basis, the currency is nearing levels last seen ahead of 2015’s shock devaluation and before opening salvos were fired in the 2018 trade war.
Current levels of export growth are probably unsustainable: Fading fiscal stimulus efforts and easing lockdown restrictions are likely to trigger a shift in Western consumption patterns in the months ahead.
Further appreciation could smooth the economic rebalancing process: A rising exchange rate might enhance consumer purchasing power, and offset raw materials costs – advantages articulated by Lyu Jinzhong, a central bank researcher, in an editorial written for China Finance last month.
But this doesn’t reflect official policy priorities: Lyu’s piece was subsequently deleted, and the People’s Bank of China released a statement saying,“The key is to properly manage expectations, firmly crack down on attempts to manipulate the market or maliciously create one-sided expectations…Enterprises and financial institutions should adapt to a two-way fluctuation of the exchange rate”.
Authorities are overtly intervening: Over the weekend, the central bank raised its reserve requirement for banks’ foreign exchange deposits to 7 per cent from 5 – a step designed to reduce dollar liquidity and weigh on the yuan.
Unofficial intervention is also likely underway: State-owned financial institutions are suspected in a string of large yuan sales timed to coincide with periods of dollar weakness over the last month, and greenback-denominated assets are rising across the banking system.
Balance could return: An ongoing normalization in global interest rates could begin to diminish the relative appeal of Chinese financial markets in the month ahead, and a shift in post-pandemic export demand might slash overall trade surpluses – reducing the balance of payments pressures that have propelled the exchange rate upward.
OUT OF THE COMFORT ZONE
Effective Trade-Weighted Exchange Rate Indices v. Nominal CNYUSD Exchange Rate
% Change, 2010 = 0
2010 January – May 2021
Sources: Bank for International Settlements, Bloomberg, Author Calculations
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The Japanese yen is the worst-performing major currency this year, down almost 6 per cent against the dollar.
A fourth coronavirus wave is hitting hard: Daily new cases, new deaths, and total active cases are reaching record highs. The state of emergency in Tokyo, Osaka, and seven other prefectures has been extended until June 20, and restrictions are tougher than in the previous wave. Bars and restaurants are banned from selling alcohol, store hours are limited, and department stores had to cut back on most services offered.
Consumption is suffering: Household spending, which typically contributes nearly half of the country’s gross domestic product, is flagging as citizens stay home and confidence ebbs.
Growth is contracting: The economy shrank 1.3 per cent in the first quarter of 2021 and household consumption dropped at an annualised rate of 5.6 per cent, according to preliminary numbers – and this performance is likely to be repeated in the second quarter.
Exports remain strong: Booming American car sales global demand for chip-making equipment helped boost exports by a whopping 38.0 per cent in April, the fastest gain since 2010.
Inflation is non-existent: Despite relying on many of the same global supply chains, Japanese citizens and firms are not reporting the same cost changes seen in other major economies. The central bank’s preferred gauge of price growth fell 0.1 per cent year-over-year in April – far below rates seen elsewhere.
The Bank of Japan is stuck in neutral: Governor Haruhiko Kuroda’s latest projections show inflation remaining below target until 2023 or later.
Yield differentials remain tilted against the yen: Expected policy differentials are keeping long-term bond yields deeply depressed, reinforcing the currency’s role in funding global carry trades.
In hosting the Olympics, Japan’s economy will win bronze, at best: Inoculation rates are expected to rise – particularly with recent approvals for the Moderna and AstraZeneca vaccines – but the public remains deeply skeptical of the Games, ruling out a material rise in consumer consumption around the event itself.
Safe-haven flows pose an upside risk: The yen’s slide looks likely to continue in the month ahead, but a spike in global risk aversion could spark an unwind in carry trade flows – and see the currency rise sharply once more.
YEN FOR TRAVEL
% Change in Nominal Exchange Rate v. US Dollar, Year to Date
Sources: Bloomberg, Author Calculations
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The Australian dollar ran into a brick wall last month, repeatedly trying and failing to sustainably the break the 78-cent mark against the US dollar.
The Australian economy is (essentially) fully recovered: Output expanded 1.8 per cent on a quarter-over-quarter basis in the first three months of the year, with household consumption and real estate activity doing the heavy lifting. Overall economic activity was 0.8 per cent higher than in the fourth quarter of 2019.
Vaccination is proceeding slowly: While the country has been exceptionally successful in keeping infections rate low, AstraZeneca supply shortages have limited the number of jabs administered. Just 1.8 per cent of the population has been inoculated thus far, raising the risk of further lockdowns.
Central bankers remain extremely dovish: In its latest decision, the Reserve Bank of Australia reiterated a commitment to maintaining “highly supportive monetary conditions”, keeping its 3-year bond yield target in place, and ruling out any hike in the cash rate until 2024.
A taper decision looms: Governor Lowe has suggested that the central bank will consider shifting its yield target beyond the April 2024 bond when it meets next in July.
Markets seem unworried: By targeting specific expiries at inception, monetary authorities were successful in anchoring investor expectations around the scale and duration of intervention measures. And the cash rate – pinned at 0.1 per cent, and likely to stay there until 2024 or later – remains far more important in determining overall liquidity conditions.
Trade tensions haven’t derailed commodity exports: A war of words between Canberra and Beijing hasn’t resulted in a significant shift in the volume of raw materials shipped across the Pacific.
But Beijing’s bubble-popping campaign might: Authorities have launched a war on commodity speculation, issuing threats against market manipulation, clamping down on the use of raw materials as loan collateral, and prohibiting the retail distribution of futures-linked investment products.
Monetary policy is working in sync: Chinese year-over-year broad money supply expansion dropped to 8.1 per cent in March – undershooting expectations and overall economic growth rates.
Commodity markets have rolled over: Raw industrial materials prices, from coal to steel rebar have plummeted in recent weeks, and a number of China-focused benchmarks have fallen into bear market territory.
Winter is coming: Another volatile month beckons as domestic forces interact with a more frigid Chinese demand backdrop. The Australian dollar’s long rally looks increasingly vulnerable to correction.
WHILE THE IRON IS HOT
% Change in Commodity Prices and AUDUSD Exchange Rates
2020 January – May 2021
Sources: Bloomberg, Author Calculations
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