Written by Convera’s Market Insights team
USD risks skewed to downside?
George Vessey – Lead FX Strategist
The US dollar is on track for a second successive quarter of gains thanks to elevated inflation-adjusted yields, a resilient US economy, and safe haven flows amid European political upheaval. Although the dollar can stay lofty whilst these factors remain, it might be tougher for the US currency to make sizeable gains from here, with risks skewed to the downside if weaker macro data continues to come in.
That being said, in the current low volatility environment, “carry trades” remain a popular strategy that attempts to profit from interest rate differentials between two regions by borrowing, or shorting, a currency with low interest rates to fund, or buy, a currency with a higher interest rate. The Bank of Japan is in little hurry to raise interest rates, leaving its inflation-adjusted rates in negative territory, making the yen a popular funding currency of choice. Whist in the US, the Fed funds target range has been steady at 5.25%-5.50% for seven consecutive meetings and policymakers do not expect it will be appropriate to reduce rates until they have greater confidence that inflation is moving sustainably toward 2%.
Thus, in the short-term, all eyes remain on Friday’s core PCE deflator – the Fed’s preferred inflation gauge, which is expected to print at its slowest monthly pace this year. Rate swaps suggest that traders have pencilled in 70% of a chance for a cut by the Fed in September. Should inflation come in lower than forecast, there’s scope for a dovish repricing that could weigh on the dollar.
USD/CAD maintains a bullish bias post hot CPI print
Ruta Prieskienyte – Lead FX Strategist
In May 2024, Canada’s annual inflation rate rose to 2.9% from 2.7% in April, defying market expectations of a decline to 2.6%. Policymakers’ preferred measures also showed acceleration: trimmed CPI inflation rose to 2.9% from 2.8%, and median inflation increased to 2.8% from 2.6%. However, the common core measure fell to 2.4% from 2.6%. Despite a 1.3% decline in gasoline prices, interest-sensitive spending categories like car and auto leasing presented inflationary challenges. Shelter costs remain a significant source of inflation, contributing 11 basis points to monthly inflation and 1.9 percentage points to the annual rate, driven by high mortgage-interest expenses. The Bank of Canada (BoC) expects that as rates are cut and mortgages reset, shelter inflation will moderate, potentially lowering the headline rate further. However, if lower mortgage rates boost homeownership demand, inflation could rise again.
Following the data release, USD/CAD remained stable as markets awaited the US PCE report. Realised volatility in the spot market hit four-year lows. With negative surprises in US economic data since early 2019, CAD bulls have avoided the dollar. The largest gains were seen against NOK, SEK, and EUR. EUR/CAD touched a month high of 1.4600 but dropped over 2.1% against CAD since early June due to the French election premium. Technical indicators suggest EUR/CAD may stabilise but not significantly bounce back until after the 7 July French election.
In the options market, one-week implied volatility remains low but is trending upwards. USD/CAD risk reversals eased, with the one-month measure at 0.315% favouring dollar calls, the least bullish in two weeks. This sentiment shift aligns with BoC rate expectations. The Canadian bond market saw a sharp selloff, with the two-year bond yield rising by 7 basis points, the largest increase in six months. Consequently, expectations for a July BoC rate cut dropped to 45%, down from 61% the previous day, as measured by overnight index swaps.
Euro weakens on hawkish Fed comments
Ruta Prieskienyte – Lead FX Strategist
The euro’s better than expected start to the week was followed by an onset of bearish trading amid hawkish Fed Bowman’s guidance reawakening the appetite for the US dollar. The quarter-end flows amid portfolio rebalancing injected volatility in the spot markets. However, the realised volatility remains low as markets remain in a wait-and-see mode ahead of the Friday’s US PCE release.
With the domestic calendar sparse, the only surprise was an upward revision in Spain Q1 GDP, which was reportedly grew by 0.8% in Q1 2024, surpassing the preliminary estimate of 0.7%. The revision marked the strongest growth rate since Q2 2022 for Europe’s sixth largest economy. Elsewhere, spreads on French bonds retreated from the highest level in over a decade, in a sign that investors are becoming more sanguine about potential disruption at a snap parliamentary election that begins Sunday. The OAT-bund spread eased to 75bps for the first time in a week but remain 1.5 times above the pre-announcement level. The 1-week implied volatility on EUR/USD jumped close to 8 vol at the start of the week, which now captures the first round of the French legislative elections. Excluding the snap election announcement date, this marks the highest expected volatility since the beginning of January and the highest spread versus realised volatility since March 2023.
Despite anticipation of larger spot swings, the euro may stay exposed and range-bound until after the second round of France’s elections on July 7, when several potential outcomes could steer the currency. The currency is down over 1% vs. the franc and just over 1.8% against the Norwegian krone, compared with its level before the European parliamentary elections. Volatility expectations has been concentrated on shorter-term maturities, which has translated into an inverse implied volatility term structure for EUR/USD. This assumes the premium for French political jitters will eventually fade.
Low yielders yen and franc remain pressured
Table: 7-day currency trends and trading ranges
Key global risk events
Calendar: June 24-28
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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.
