FX Daily: Volatility on the rise

USD: Consolidation in stores after Monday’s wild ride

Currency markets are calmer today after Monday’s frantic run. Much of this run was caused by a revaluation of China, where the spread of lockdowns and a fairly rare and rapid drop in the renminbi caused a bit of panic in the FX emerging markets complex. That panic eased a bit after Chinese policymakers overnight promised to provide more monetary support (after disappointing in recent weeks) and to speed up their review of the big tech/platform economy (helping Asian tech stocks overnight). Yesterday, the People’s Bank of China’s decision to reduce the reserve requirement ratio on foreign exchange contracts also succeeded in stabilizing the renminbi.

The market is now awaiting the outcome of China’s quarterly political bureau meeting over the next few days to see what concrete stimulus measures will actually emerge.

Away from the near-term challenges facing China, Monday’s move in the renminbi will only add to growing sentiment that currency volatility is set to increase further. USD/CNY’s one-month realized volatility is now at its highest level since February 2021 as Chinese authorities apparently let the renminbi float more freely. Recall that the PBoC had kept USD/CNY in a narrow range of 6.35-6.50 over the past year to combat imported inflation – the side effect being that the weighted renminbi trading function had climbed 11% since the start of 2021 – a trend in the process of being reversed.

But currency volatility will also be pulled higher by the withdrawal of central bank liquidity – both rate hikes and the quantitative tightening about to materialize over the coming months and quarters as central banks are starting to reduce their balance sheets. The FX consequences of higher volatility should be that benign carry trade strategies will fall out of favor and, like yesterday, the dollar will find more friends.

For today, we are interested to see if US data such as consumer confidence has an impact on Fed expectations. Last week’s string of poor consumer data in the UK dented expectations for Bank of England tightening and saw the pound plummet. Will today’s release of the Conference Board’s consumer confidence for April have an impact on Fed cycle prices? We suspect not. DXY may now be due to some consolidation in the 101-102 area, but the trend to test the March 2020 high near 103 remains intact.

EUR: expectations of ECB tightening suffer

Monday’s selloff in European equities triggered a reasonably sharp adjustment in European Central Bank tightening expectations. After pricing in 85 bps of ECB tightening by the end of the year last Friday, those expectations have fallen to just 72 bps. And as we suggested last week, the ECB’s debate on whether to hike 50, 75 or 100 basis points this year is rather overwhelmed by the potential adjustments of 250 to 300 basis points to be made elsewhere in the world. .

Developments in Ukraine are also in a dangerous phase. Russia now appears to be targeting Western military aid to Ukraine more directly with attacks on rail infrastructure, questioning whether the attacks are moving closer to the border with NATO partners. Climbing is clearly a risk. For today, however, EUR/USD may consolidate in a range of 1.07-1.08 before heading towards the March 2020 low at 1.0635.

Elsewhere in Europe, the National Bank of Hungary is expected to raise its policy rate by 100 basis points today. A calmer EUR/USD environment could see EUR/HUF fall back into the 370 area (after all, the forint is an expensive sell with implied yields above 6%). However, geopolitics will prevent it from returning to the 360 ​​zone.

GBP: picking up the pieces

The British pound continues to trade on a fragile basis after some consumer data put a damper on the Bank of England (BoE) tightening. Most now believe that GBP/USD needs to test 1.2500, and 1.2850 will now act as strong resistance – if it hits that level. Tightening expectations for the BoE meeting on May 5 fell to 29 basis points from 38 basis points at the start of last week. However, in December, the Bank Rate is still set at 2.17%.

For us, one of the key questions this year will be whether central banks push ahead with tightening even as growth slows. This will clearly produce flatter or inverted yield curves, but could actually see currencies remain strong. So until the BoE waves the white flag on the rest of its tightening cycle, we think it may be too early to write off the pound, especially against the euro. Don’t be surprised if EUR/GBP falls back into the 0.8300-0.8400 range.

BRL: the most exposed

At one point yesterday, USD/BRL was nearly 3% firmer, following a 3% rally on Friday. After a spectacular rally this year on the commodity story, we now believe the Brazilian Real is entering a vulnerable period. The main risk here is that of equity outflows after around US$18 billion has been invested in Brazilian equities – heavily weighted to the materials sector – over the past four to five months.

The Fed pushing US real interest rates into positive territory to fight inflation and a challenging external environment means these equity flows into Brazil are likely to reverse. At the same time, Brazil’s central bank is near the end of its tightening cycle (close to 12.75%) and the Brazilian presidential election will heat up. Brazil’s growth close to 0.5% this year leaves plenty of room for last-minute fiscal adjustments – usually the Achilles’ heel of Brazilian asset markets and always a concern for Brazil’s central bank.

We have a fairly bearish set of BRL forecasts this year and we remain happy with it.
Source: ING

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