USD: Dancing on the Debt Ceiling

Asia last Friday overnight:

Investor confidence remains delicate due to the lack of progress in raising the US debt ceiling. However, a meeting between US National Security Adviser Jake Sullivan and China's top diplomat Wang Yi aimed to improve relations and reduce yields on US Treasury bonds, providing a slight boost to investor sentiment. The rise in initial jobless claims in the US raised hopes of a slowdown in the labour market, resulting in lower yields on US Treasury bonds. Currently, most Asian stock markets are trading lower, while S&P500 futures show modest gains. Despite the decline in US Treasury bond yields, the US dollar remained strong due to weakened sentiment. The Swiss franc (CHF) performed moderately well during the Asian session. Conversely, the New Zealand dollar (NZD) significantly underperformed among the G10 currencies last Friday, following a drop in inflation expectations in New Zealand during the Asian session.

GBP: after the BoE

The Bank of England (BoE) increased interest rates by 25 basis points during its May policy meeting and indicated that further tightening might be necessary to curb inflation. Despite two dissenting votes to maintain unchanged rates within the Monetary Policy Committee (MPC), the outcome of the meeting was slightly more hawkish than anticipated, particularly considering the upward revisions to growth and inflation forecasts. However, Governor Andrew Bailey presented a more mixed outlook during the press conference following the release of the Monetary Policy Report (MPR). He emphasized the significance of factors like food price inflation, which could positively impact inflation but negatively affect growth, while downplaying the importance of wage growth, which could contribute to inflation and bolster domestic demand. Bailey's comments indicated that although the BoE's outlook had improved from the dire scenario projected in February, it hadn't significantly deviated from the stagflation scenario the MPC had been anticipating since May 2022. As a result, expectations of a rate hike in the UK market have slightly diminished following the BoE meeting. This could also explain why the British pound (GBP) continued to be influenced by broader movements in the US dollar (USD) and fluctuations in global risk sentiment.

USD: dancing on the (debt) ceiling

I’ve been into some meetings with institutional clients, and all indicate that they no longer consider the US dollar (USD) as an attractive high-yielding safe haven. This shift in sentiment can be attributed to the recent turmoil in the banking sector and the ongoing debt ceiling issue in the US. These factors have raised concerns about the economic outlook and increased expectations of rate cuts by the Federal Reserve (Fed) (As we know this will not happen on my view, Paul is already anticipating that he will not have on the agenda rate cuts for this year.). Additionally, the lingering risk of a banking crisis in the US has prompted some investors to price in aggressive emergency rate cuts by the Fed. As a result, the USD has become less appealing compared to other high-yielding safe havens like the euro (EUR) and the Swiss franc (CHF).

While concerns about the US banking sector may persist for now, discussions between Democrats and Republicans in Congress have intensified. Both parties are expected to seek a compromise that could involve extending or suspending the US debt ceiling. Successful negotiations could provide a boost to the USD, aligning with the historical FX performance during debt ceiling episodes over the past three decades. Even if a potential bipartisan deal leads to a temporary suspension of the debt ceiling until September, it will allow the US Treasury to rebuild its cash reserves through additional debt issuance. This, in turn, could prompt investors to scale back their bets on Fed rate cuts, potentially resulting in a reduction in USD liquidity and further exacerbating USD scarcity.

In addition to the debt ceiling developments, FX investors will also pay attention to the release of the University of Michigan Consumer Sentiment Index and a speech by Fed's Mary Daly. With many negative factors already priced into the USD, significant disappointments in data or dovish rhetoric from the Fed would be required to influence the US rate outlook and, consequently, the value of the USD.

NZD: the RBNZ sees some success

The Reserve Bank of New Zealand (RBNZ) has achieved a minor victory as inflation expectations for the next two years continue to decline, entering the RBNZ's target range of 1-3% for the first time since Q421. The RBNZ has previously expressed satisfaction with the decrease in inflation expectations, which peaked at 3.62% in Q422. However, they have also acknowledged that the expectations were still too high, surpassing the central bank's desired midpoint within the 1-3% target band. With inflation receding rapidly and inflation expectations cooling, the market now views the RBNZ's 25 basis point rate hike on May 24th as a close decision (and I share the same view). On the other hand, supporting the case for another rate hike is the fact that while inflation has decreased, it remains high at 6.7% year-on-year, well above the RBNZ's target range. New Zealand's labour market also remains tight, with the unemployment rate at near record lows and strong wage growth.

USD/JPY: supported by equities

USD/JPY's short-term fair value has increased again over the past week, rising from 135.75 to 136.01, despite a slight downside surprise in US CPI data. While the decline in the US-Japan short-term rates differential initially pulled down the exchange rate's fair value, the performance of equity markets has remained a strong driver for USD/JPY's fair value. The strength of the Nikkei and the weakness in global equity markets have contributed to an upward adjustment in USD/JPY's short-term fair value. Given the ongoing risk-off sentiment in trading, USD/JPY is still supported as the USD serves as a safe-haven currency with attractive yields. The outperformance of the Nikkei has led foreign investors holding Japanese equities to hedge their FX exposures by selling JPY forward. Currently, USD/JPY is trading at a modest undervaluation of less than one standard deviation.

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