Tomorrow’s Monday – who’s excited?
To say there’s a lot going on this week would probably be an understatement. Politics will of course take center stage both in the UK (election) and in the US (Comey testimony).
Saturday night’s terror attack in London adds another layer of uncertainty to the situation in the UK, where recent tightening in the polls has kept markets on edge.
Thursday’s ECB decision is expected to bring a shift in the central bank’s forward guidance. This has been telegraphed for some time (which is ironic because forward guidance is itself “telegraphing” so we’re now “telegraphing” the “telegraphing”), but the market will be watching the wording closely and you can bet they’ll be all kinds of algo, knee-jerking FX fun around the release.
“We expect Draghi to erase the ‘or lower’ when referring to the future possible path of rates and shift the balance of macroeconomic risks to neutral from ’tilted to the downside,'” BofAML wrote this weekend, adding that “we also expect Draghi to point out that the ECB stands ready to increase the asset purchase program in terms of size or duration but remark that this would be now less likely.”
In short, there are some potential land mines out there and it’s pretty clear that in all cases, FX will be the transmission mechanism be it in sterling, the euro, or, in the case of Comey’s testimony, USDJPY.
For their part, Barclays notes that given the above, “carry trades are vulnerable to a pick-up in volatility this week.” Find more from the bank’s Sunday “Thoughts For The Week Ahead” note below along with a calendar from BofAML…
We think carry trades are vulnerable to a pick-up in volatility this week. While improving manufacturing confidence has recently added to the constructive global risk environment (characterized by dovish central banks, low cross-asset volatility and rising equity prices), a potential increase in political uncertainty in the US may undermine this backdrop.
Ex-FBI Director James Comey is scheduled to give evidence to the Senate Intelligence Committee on Thursday. His testimony may raise further questions about the stability of the Trump Administration and its ability to deliver fiscal stimulus. Corresponding FX volatility would likely erode weekly carry trade gains. For example, our favoured carry trade basket of long INR and RUB versus SEK and CAD earns 13bp of carry each week (6.9% annually) but experienced a spot depreciation of 90bp when the bribery scandal involving President Temer in Brazil emerged on 17 May.
A change in ECB forward guidance or risk assessment is widely anticipated at its Thursday meeting (Figure 1).
While this suggests an unchanged statement would likely weigh on the EUR and support a rally in European equity and fixed-income asset prices, a more hawkish statement in line with our economists’ expectation of a removal of the reference to lower rates along with other adjustments may do the opposite. On balance, risks to market expectations appear skewed to only a slight reduction of policy accommodation given actual and expected inflation trends (Figure 2 and Figure 3) and the experiences of other major central banks in more cyclically advanced economies. As important, the Governing Council has the advantage of reflecting on the experiences of more cyclically advanced economies such as the US, UK and Japan, where central banks have erred in the direction of lower-for-longer monetary policy without a loss of inflation-fighting credibility.
UK political polls have continued to tighten ahead of Thursday’s general election. We think markets are sufficiently pricing the associated risks. We continue to see the fundamental case for sustained GBP appreciation over the course of the next year, as increasing information flow reduces Brexit uncertainty, and worst-case scenarios are trimmed. Betting market’s odds, for example, ascribe a 17% probability to a hung parliament and a 3% chance to a Labour majority – not dissimilar to the probabilities implied by option markets. Despite narrowing, polls still project a Conservative Party win (average Conservative lead is 5 percentage points, Figure 4); purely statistically speaking (in the context of poll margin of errors of +/- 2-3%), the main question remains how large such a majority would be and what message the election will deliver for Prime Minister May’s Brexit negotiations strategy.
EM political risks remain greatest in South Africa, Mexico and Brazil and we continue to recommend avoiding these high-yielding currencies, preferring TRY, RUB, INR and IDR instead. Local elections in Mexico are taking place today (4 June) in a fragmented political environment and we think this could be a test of the ruling party’s (the PRI) strength ahead of the 2018 presidential elections. In Brazil, the 2014 election-result annulment trial is set to resume on Tuesday in the Electoral Court. Prior to the recent bribery scandal, our expectation was that the court would rule for the annulment of the elections, but preserving President Temer’s mandate. This new situation, however, could change the outcome of this process.