Sterling Takes It On the Chin

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  • Projections showing that the UK Tories could lose their outright majority in Parliament in next week’s election spurred sterling sales
  • The euro barely responded to the soft preliminary May CPI report
  • There were two notable economic reports from Asia
  • Poland May CPI is expected to remain steady at 2.0% y/y
  • Banco de Mexico releases its quarterly inflation report; COPOM is expected to cut rates 100 bp to 10.25%

The dollar is mixed against the majors in narrow ranges. The Swiss franc and Kiwi are outperforming, while sterling and Nokkie are underperforming. EM currencies are mostly firmer. CNY and KRW are outperforming, while RUB and IDR are underperforming. MSCI Asia Pacific was down 0.1%, with the Nikkei falling 0.1% too. MSCI EM is down 0.3%, even with Chinese markets up 0.4% after returning from holiday. Euro Stoxx 600 is flat near midday, while S&P futures are pointing to a lower open. The 10-year US yield is up 1 bp at 2.22%. Commodity prices are mostly lower, with Brent oil down nearly 2%, copper down 0.2%, and gold up 0.2%.

Projections showing that the UK Tories could lose their outright majority in Parliament in next week’s election spurred sterling sales, which snapped a two-day advance. Polls at the end of last week showed a sharp narrowing of the contest, and this saw sterling shed 1.3% last Thursday and Friday. It recouped about 0.35% in the past two sessions before today’s 0.6% drop to $1.2770, the lowest level since April 21.

It was May’s election to lose, and she is doing her best. A combination of reversals and a hapless campaign against what by all reckoning was a weak opponent are doing the trick. The real risk may not so much be May’s outright defeat, but rather the appearance of a weaker leader that could haunt her term.

The $1.2780 area corresponds to the 50% retracement objective of sterling’s advance since the election announcement. The 61.8% retracement is near $1.2720. Technical indicators favor additional losses. Several indicators (e.g. MACDS, RSI) did not confirm sterling’s high from the middle of the month, creating bearish divergence. In a word, sterling’s technical tone was fragile before the threat of a “hung parliament” spurred the sales.

The euro barely responded to the soft preliminary May CPI report. Germany, France, and Italy had already reported less price pressures than expected, which may have stolen whatever potential thunder today’s aggregate report had. The headline pace fell to 1.4% from 1.9%, and the core eased to 0.9% from 1.2%. This underscores the points Draghi (and several other ECB officials) have made about the lack of a sustainable inflation path toward the target and the need for continued extensive monetary support. Even the Bundesbank’s Weidmann has acknowledged the need for support monetary policy presently.

The ECB may formally recognize what has long been recognized by investors. The risk of lower rates has diminished considerably even as the downside risks to the economy have materially eased. It was also reported that April unemployment fell to 9.3% from a revised 9.4% (was 9.5%) in March. It is the lowest rate since 2009. The economic expansion is a necessary but not sufficient pre-condition for the end the unorthodox monetary policy. Political risks have diminished, but clearly not entirely gone away, with German, Austrian, and probably Italian elections this year. We also have the UK vote and Brexit, coupled with a protectionist and nationalist thrust of US policy.

The euro is little changed against the dollar, though gaining on a trade-weighted basis. It is consolidating in a range of about a third a cent below $1.12. Support is seen near $1.1160 on an intraday basis. The euro continues to be a major beneficiary of the unwinding of the so-called Trump trade. Investment advisers, banks, and the media have advocated equity investments in Europe over the US, and for all the fund flow trackers, the Dow Jones Stoxx 600, flat today, is up 0.8% this month. The S&P 500 is up 1.2% coming into today’s session.

There were two notable economic reports from Asia. Japan reported its strongest rise in industrial production in six years, with a 4.0% rise in April. It followed a 1.9% decline in March. While rising manufacturing exports helped, auto production surged (16.3% year-over-year from a revised 4.5% pace in March). Housing starts were also stronger than expected. And the Japanese economy appears to have begun Q2 on firm footing.

The dollar is trading within yesterday’s range against the yen. It has been confined to about a quarter of a yen both sides of JPY111.00. The JPY110.50 area is the 61.8% retracement objective of the dollar’s bounce from the middle of last month. The low from May 18 was near JPY110.25, which also corresponds to the 200-day moving average.

The other report from Asia was China’s PMI. The manufacturing PMI was unchanged at 51.2, while the non-manufacturing PMI rose from 54.0 to 54.5. One takeaway, ahead of the Caixin readings due tomorrow, is that the world’s second-largest economy may not be slowing as much as had been feared. On the margins, this may in turn help keep the debt concerns at bay a little longer.

Meanwhile, the yuan has strengthened. It is at its best level since last November, appreciating by 1% over the past three sessions. Spurred in part by a funding squeeze in Hong Kong, the offshore yuan (CNH) has rallied 1.5% in the same time. Note that China’s officials have also formally introduced a new element (counter-cyclical adjustment) to the black box of the fixing. The suspicion is that officials want a stronger yuan to deter capital outflows, and allow the kind of reforms that would address some MSCI concerns. Officials have also introduced a new benchmark fixings for one-, seven-, and 14-day reports.

One of the reasons that dollar is having difficulty gaining much traction, we argue, is that interest rates remain unexpectedly low. Fed Governor Brainard seemed to capture the sense in the markets now. She said that while it may be appropriate to soon remove some accommodation (her signal of agreement for a hike in two weeks), she expressed some caution that inflation was no longer moving toward its target. The US 10-year yield tested 2.20% yesterday, having been near 2.60% when the Fed hiked in December 2016 and March 2017.

The US reports the Chicago PMI, pending home sales, while the Fed releases the Beige Book. The EIA updates its monthly supply reports today even as oil remains under pressure. Iron ore prices also remain under pressure and making new cycle lows.

Poland May CPI is expected to remain steady at 2.0% y/y. This would still be in the bottom half of the 1.5-3.5% target range. Central bank minutes will be released Thursday. The central bank continues to keep its forward guidance for the first hike in 2018. Next policy meeting is June 7, and rates are expected to be kept steady at 1.5%.

Banco de Mexico releases its quarterly inflation report. This will be followed by its minutes Thursday. At that meeting, the central bank surprised many in the markets by hiking 25 bp to 6.75%. Next meeting is June 22, and another hike then seems likely, especially if the Fed hikes on June 14.

COPOM is expected to cut rates 100 bp to 10.25%. However, a small handful of analysts expect a 75 bp cut. IPCA inflation was 4.1% y/y in April, in the bottom half of the 2.5-6.5% target range. However, political uncertainty and delays to fiscal reforms could lead COPOM to cut less aggressively. Moody’s cut the outlook on its Ba2 rating from stable to negative Friday, citing political risks to the reform agenda.