Carry trades in spotlight
Expectations that US interest rates will remain higher for longer are supporting the US dollar, whilst ongoing debt ceiling negotiations keep risk sentiment fragile. Money markets are pricing in a roughly 20% chance that the Federal Reserve (Fed) will deliver another 25-basis-point hike next month and have scaled back expectations of Fed rate cuts later this year.
It’s all about interest rate expectations, which continue to be driven by incoming economic data primarily, but also by the progress of US debt ceiling talks. Yesterday’s discussions between President Joe Biden and House Speaker Kevin McCarthy to raise the debt ceiling were described as ‘productive,’ and despite the elevated uncertainty around this matter and the monetary policy outlook, FX volatility around the world – both in the developed and emerging markets – remains highly subdued. Volatility has fallen back to pre-Ukraine invasion levels in early 2022 and this has paved the way for a slightly more constructive risk environment.
Unless US debt ceiling negotiations take a turn for the worse, or we see more obvious signs of US disinflation, this low volatility climate could spur carry trades – converting low interest rate currencies like the Japanese yen into high-interest rate currencies like the US dollar – as USD/JPY scales 6-month peaks.
GBP/JPY lingers near 7-year high
The pound is nearly 1% higher against the euro this month amid disappointing economic data from Europe, but is over lower against the US dollar on higher-for-longer US rate expectations. Against the Japanese yen though, sterling continues to press towards fresh 2016 highs amidst diverging monetary policy paths.
Money markets are currently pricing an 82% probability of another Bank of England (BoE) rate hike next month and for rates to peak at 5% by September before staying there until the middle of 2024. Conversely, the Bank of Japan’s commitment to loose monetary policy makes the Japanese yen an appealing funding currency for carry trades (previous section), which increases the risk of it depreciating further. As a result, GBP/JPY remains elevated above the ¥172.0 handle, less than 1% away from highs last witnessed before the Brexit vote in 2016. Today, we have flash PMI readings from the UK, which should see expansion in the services sector propping up private sector activity. More important though, tomorrow’s key UK inflation report will be released, and we could see the sharpest fall in 30 years from over 10% to 8.2%, due to base effects of energy prices.
BoE officials hope that the falling rate of inflation will persuade companies to think twice before increasing prices or agreeing generous wage settlements, but we might have to see core inflation, especially in the services sector, drop sharply too, if interest rate hike expectations are to be scaled back. Such a scenario could dampen the pound’s short-term outlook. On the flipside, a stronger-than-expected core print will underline inflation concerns and probably help the pound, particularly against lower-yielding currencies like the yen.
PMIs might aggravate EUR woes
Flash industry PMIs are the key data points in focus today. Like many other regions, robust services sector activity continues to drive economic momentum in Europe. However, overall economic data coming out of Europe recently has been more negative relative to expectations than at any time since June 2022, which has started weighing more on the euro.
Last month, service sector activity was revised lower but continued to point to the strongest growth in a year, with Italy and Spain being the main drivers, helped by the tourism industry and a travel boom. Price pressures subsided though, and confidence slipped to a 3-month low. Meanwhile, manufacturing across the Eurozone has been in contraction for ten months running. After recording up to 3.3% annual gains in early May, EUR/USD has erased two-thirds of its 2023 rally in just over two weeks as markets revise down their rate cut bets in the US and question the impacts of a potential US default. While US rate expectations remain critical, the euro is also becoming less attractive amidst the weaker economic backdrop across Europe and thus today’s data could reinforce a pullback below EUR/USD’s 100-day moving average around $1.08, whilst GBP/EUR clings onto €1.15.
Despite EUR/USD falling from a one-year high of almost $1.11 to a 2-month low of less than $1.08 recently, net speculative long euro positioning remains stretched, and this presents an additional downside risk to the common currency, especially if economic data favours the US over Europe, promoting a rethink on interest rate expectations.
Dollar outperforms as rate cut bets recede
Table: 7-day currency trends and trading ranges
Key global risk events
Calendar: May 22-26
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*The FX rates published are provided by Convera’s Market Insights team for research purposes only. The rates have a unique source and may not align to any live exchange rates quoted on other sites. They are not an indication of actual buy/sell rates, or a financial offer.
