G4 exchange rate
U.S. Dollar Index: The U.S. has entered a phase of active replenishment, and the U.S. Dollar Index has historically been strong. At present, the US economy is performing better than other advanced economies, and the delay in the timing of interest rate cuts is also bullish for the dollar. The seasonality of the dollar's strength in May was significant, and the dollar index still had upward inertia ahead of the June interest rate meeting.
Euro: The European Central Bank is optimistic about the prospect of disinflation, and it is more likely to cut interest rates in June, and it is expected that the rate cut will be greater than that of the Fed throughout the year, and it will continue to be bearish for the euro in the short term. In addition, the impact of the European and American financial markets on the euro is asymmetrical, and the Fed's interest rate cut and the pressure on U.S. stocks have obvious negative effects on the euro.
GBP: The outlook for the UK economy is still not optimistic, while inflationary pressures in the service sector are expected to gradually ease, and there is a high probability of a rate cut this year, but later than the European Central Bank. Similar to the euro, the pound is also affected by the bearishness of the US financial market, and there is still room for further downside in the short term.
JPY: The U.S., Japan, and South Korea's Treasury departments issued a joint statement agreeing to maintain close communication on foreign exchange market volatility. In the short term, it may be difficult for USD/JPY to break 155, and the top of the range will move up during the year. The "underlying inflation rate" and "long-term inflation expectations in the household sector" are the new inflation anchors for monetary policy.
1. Exchange rate market correlation
2. The U.S. dollar index: strong shocks
The U.S. economic data released in April was generally positive, with only the Conference Board LEI significantly weaker than the fundamental indicators we monitored. The new non-farm payrolls and CPI data were stronger than market expectations for three consecutive months, stimulating the convergence of interest rate cut expectations. In view of the strong performance of economic data, the tone of Fed officials' speeches in April also turned hawkish, and the postponement of interest rate cuts has gradually become a consensus, with some officials believing that interest rate cuts are not needed, and even interest rates can be raised if economic data allows. The U.S. dollar index moved strongly higher on the back of economic data and expectations of a delayed rate cut, hitting as high as 106.5.
2.1 The United States entered the active replenishment of stocks
Based on the U.S. inventory cycle demand index and the ISM PMI manufacturing inventory index we constructed, we can define the stages of the U.S. inventory cycle. The use of PMI inventories instead of NBS inventories is mainly due to the timeliness of the data, which has a 2-month lag, while PMI inventories are only 1 month behind. Since January 2024, the United States has entered the stage of active replenishment, that is, demand and inventories have rebounded simultaneously. Looking back at the history of the United States entering the cycle of active replenishment, the U.S. dollar index is generally strong, and it is more common for the dollar index to fluctuate higher. Neither the federal funds rate nor the policy spreads between the US and non-US advanced economies can explain the trend of the DXY well, but the long-term interest rate differentials between the US and non-US advanced economies have a strong correlation with the US dollar index. This is because long-term interest rates imply more expectations for future monetary policy, and long-term interest rate differentials naturally reflect the difference in the monetary policy outlook between the US and non-US advanced economies. Logically, the U.S. economic cycle is usually slightly ahead of non-U.S. advanced economies, so when the U.S. enters an active inventory replenishment cycle, the Fed's monetary policy is relatively tighter, making relative interest rate differentials higher and driving the U.S. dollar index to appreciate. More special was in the second half of 2017, when the market had high expectations for the eurozone to raise interest rates and exit QE, which once caused the US relative interest rate differential and the US dollar index to decline.
The current mainstream expectation in the market is that after the Fed postpones the rate cut, the Fed may cut interest rates later than the European Central Bank and the Bank of England, and the timing of the next rate hike by the Bank of Japan is unknown. While the U.S. economic fundamentals maintain a comparative advantage, the Fed's monetary policy outlook is relatively more hawkish (OIS can be clearly reflected), which is a strong support for the U.S. dollar index.
2.2 High-frequency fundamentals are strong in the short term
Since mid-March, high-frequency fundamentals in the United States have rebounded rapidly and strengthened, and the dollar index and Treasury yields have also risen simultaneously. The indicator usually shows a cyclical fluctuation pattern of 4~6 months, and there may be two paths at present. One path is that the six-month cycle starting from early December 2023 has not yet ended, and the fundamental rebound since mid-March is only a short-term improvement in the downward cycle, with fundamentals falling again in May and bottoming out in mid-to-early June. The other path is to start a new four-month cycle from mid-March, and the fundamental rebound will continue to weaken from late May to early June, and then bottom out in mid-July. These two paths will also affect the difference between the short-term peak pace of the US dollar index and US Treasury yields.
We expect that the incremental information of the May interest rate meeting will be limited, and it is likely to maintain the short-term hawkish tone. Markets need to wait for the release of a new dot plot at the Fed's interest rate meeting on June 12, and until then there is a strong chance that the dollar index will maintain its upward inertia. Even if the median dot plot in June becomes 5.25% or even 5.5%, the market is already fully priced in. The June interest rate meeting may become a turning point for the short-term bullish exit of the US dollar. Fundamentals and the U.S. dollar index are more likely to follow the second path above, peaking in late May to early June, after which the margin weakens. However, judging from the difference between the ISM PMI and the S&P PMI, the domestic economic prosperity of the United States is still stronger than that overseas, which will limit the decline of the dollar index.
2.3 Technical Analysis
In terms of CFTC holdings, against the backdrop of the sharp strength of the U.S. dollar index in April, both non-commercial net shorts and commercial net longs increased to a three-year high, and the net shorts of leveraged funds also increased to a three-year high. Seasonally, there is a high probability that the dollar index will strengthen in May. Be wary of the recent short squeeze that has accelerated the upward movement of the dollar index. Technically, the U.S. dollar index is in good shape on the uptrend, with the possibility of further testing resistance at 107, 107.5 and support at 105.4 and 105 below.
3. Euro: The European Central Bank cut interest rates earlier than the Fed
Eurozone economic data remained weak in April, while CPI was in line with expectations. ECB President Christine Lagarde signaled that the ECB was close to cutting interest rates after the April interest rate meeting and the recent IMF spring meeting. The ECB's interest rate cut ahead of the Fed is the core logic of the recent pressure on the euro.
3.1 The eurozone disinflationary process
On April 15, ECB Governing Council member Lien delivered a speech on "Disinflation in the euro area: an update"[1]. The Eurozone Expert Survey (SPF) shows that the right tail of the medium- and long-term inflation expectation distribution has narrowed significantly, the probability of financial markets expecting inflation above 2.5% has also decreased significantly, and the risk of long-term inflation above target has been reduced. There is a relatively close medium-term relationship between wage inflation and inflation in the labour-intensive services sector, which accounts for the bulk of domestic inflation. Forward-looking wage growth is already showing signs of slowing. Salary survey respondents also expect lower wage growth. As a result, Lien believes that while the short-term inflation outlook may be volatile, inflation is expected to move toward policy targets by 2025 due to reduced labor cost pressures, compression of unit profits, energy shocks, supply bottlenecks and the adverse effects of the reopening of the pandemic, as well as the effects of restrictive monetary policy. If inflation is persistently approaching the target, it would be appropriate to reduce the level of current monetary policy constraints. This further strengthens the likelihood of a rate cut by the ECB in June.
At present, the market still expects the ECB to cut interest rates as early as June and cut rates by 75bp for the whole year. The ECB cut interest rates earlier than the Fed and expects a larger rate cut, which continues to be bearish for the euro in the short term.
3.2 Long Beta bearish euro
From the perspective of the beta factor of EURUSD, it still shows the asymmetric impact of the financial markets of the United States and Europe. The beta coefficient of the US dollar OIS and the US Treasury long-end yield against the euro against the US dollar is much higher than that of the euro OIS and the German bond long-end yield. In addition, the euro continues to maintain a clear high equity beta characteristic, with a high positive correlation with European and American stock markets.
From the perspective of the U.S. stock-bond linkage model, the recent feature is that the U.S. Treasury yield (rises) is negatively correlated with the U.S. stocks (fall). The marginal improvement in U.S. fundamentals and the weakening of interest rate cut expectations have led to an upward trend in U.S. Treasury yields, increasing pressure on U.S. stock valuations and falling stock prices. In the process, the euro has been affected by the convergence of Fed rate cut expectations (US dollar OIS), the rise in long-end yields on US Treasury bonds, and the decline in stock markets. From the above analysis of US fundamentals, high-frequency fundamental indicators may peak in late May and early June, after which the margin weakens. At that time, market expectations for Fed rate cuts may re-strengthen, US Treasury yields will fall, the pressure on the stock market will ease, and the euro is expected to rebound.
3.3 Technical Analysis
After the recent depreciation, EURUSD spreads remain slightly overvalued. CFTC position data shows that non-commercial shorts have signs of profit-taking, commercial longs are gradually rebounding, leveraged funds and asset managers continue to maintain high short positions, and the degree of position differentiation is still far from oversold. Technically, the current 60-day moving average and 250-day moving average are both turning downward, and the EUR/USD pair is still under downward pressure, with support at 1.06 and 1.05 below and resistance at 1.07 and 1.08 above.
Fourth, the pound: there is still room for a pullback
The Bank of England is cautious about cutting interest rates as the UK economic data stabilizes and improves in April, while the CPI for March is stronger than expected, and the timing of the rate cut is expected to be later than that of the European Central Bank. The Conservative Party (the ruling party) in the UK has hit a record low in support and is expected to hold a general election in mid-October this year, with political uncertainty looming.
4.1 The timing of the interest rate cut is postponed
In April, BoE Monetary Policy Commissioner Green said that rate cuts would not come soon and that rates would remain in "restrictive territory" for "some time". The UK will face a "bumpy road" in bringing inflation down and remains concerned about energy price shocks and other supply-side shocks in the Middle East. Judging from the leading indicator non-financial corporate debt service ratio, the UK economy still faced downward pressure during the year. In addition, the growth rate of wages in the services sector in the UK has gradually slowed down year-on-year, indicating that the CPI of the services sector will continue to slow gradually. From this point of view, interest rate cuts within the year are still a high probability event. At present, the market expects the Bank of England to cut interest rates in August or September at the earliest, and it is expected to cut interest rates by about 50bp for the whole year. The timing of the rate cut is later than that of the European Central Bank and closer to that of the Federal Reserve.
4.2 Beta is bearish
Similar to the euro beta, the pound sterling beta also reflects the characteristics of being more influenced by the US financial market and positively correlated with equity. Short-term U.S. Treasury yields continue to be strong, the equity market still has room to adjust, and the pound still has some downside against the dollar.
4.3 Technical Analysis
CFTC position data shows that the overall position differentiation is still slightly overbought. Technically, the GBP/USD 60-day moving average is downward, with the possibility of further testing 1.23, 1.22 support, and upper resistance at 1.25, 1.26.
5. Japanese yen: The Treasury departments of Japan, South Korea and the United States issued a joint statement on the exchange rate
In April 2024, catalyzed by the strong US dollar interest rate exchange rate, the USD/JPY approached the 155 strong resistance mark upward. Japan's Ministry of Finance is highly concerned about the yen exchange rate and has issued a joint statement with the U.S. and South Korean ministries of finance agreeing to maintain close communication on foreign exchange market fluctuations.
In the short term, the core trading logic of the yen exchange rate is "intervention", while the main line in the medium term is still monetary policy. As we mentioned in our previous report, the Japanese authorities are likely to stand guard around USDJPY 155. This move may involve a front-loading process of selling U.S. bonds and obtaining U.S. dollar liquidity, which will have an impact on U.S. Treasury rates. Logically, Japan's sell-off of U.S. bonds will lead to an increase in long-term U.S. bond interest rates, which will weaken its intervention in the exchange rate. Considering that there is little room for further convergence of the Fed's interest rate cut expectations this year, and high-frequency data shows that the U.S. non-farm payrolls data in April may fall back, the magnitude and fluency of the long-end U.S. bond interest rate rise in May may not be as smooth as in April, and the difficulty of USD/JPY intervention will also be reduced, and the joint announcement issued by the United States, Japan and South Korea means that there is a possibility of joint intervention, and there is no suspicion of being accused of exchange rate manipulation. It will be difficult for USDJPY to break above 155 in the short term, but the upper limit of USDJPY may move to the 160-165 range this year against the backdrop of the Fed's strong hawkishness.
In terms of monetary policy, the Bank of Japan was widely expected to keep its interest rate target unchanged in April, but there were still doubts about whether the Bank of Japan would adjust its statement on government bond purchases. "The Bank of Japan will maintain the same rate of government bond purchases as before, and will respond flexibly to the rapid rise in long-term interest rates, such as increasing the volume of government bond (conventional) purchases and fixed-rate bond purchases, as well as providing collateral to fund operations," the March statement said. Regarding the amount of government bond purchases in the past, the statement mentioned that "the amount of government bond purchases is 6 trillion yen per month, and the Bank of Japan will continue to announce the government bond purchase program and take into account market developments and supply and demand when purchasing bonds." In his April speech, Bank of Japan Governor Kazuo Ueda mentioned that "initially the BOJ underestimated the inflation rate... Sometime in the future, the size of purchases of Japanese government bonds will be cut... Accommodative financial conditions are expected to remain in place for some time. "Considering that the reduction of government bond purchases will lead to an acceleration and steepening of Japanese bond interest rates, financial conditions will tighten faster, and the Bank of Japan may also implement this tightening policy at a later date.
The core issue of the BOJ's monetary policy direction in the next stage is to confirm the "anchor" of monetary policy. In terms of inflation, Bank of Japan Governor Kazuo Ueda recently mentioned that "the central bank must maintain an accommodative monetary policy for now, as the underlying inflation rate is still slightly below the 2% target and long-term inflation expectations are still close to 1.5%". It proves that after the initial core CPI is transmitted to wages, the "underlying inflation rate" and "long-term inflation expectations" will replace the core CPI and the core CPI excluding energy, and become the inflation anchor at the current stage of the BOJ's monetary decision. The Underlying Inflation Rate (Underlying Inflation) is obtained after the temporary fluctuation of the CPI is eliminated, reflecting the level of medium- to long-term natural inflation without the influence of exogenous factors, and the Bank of Japan releases the underlying inflation rate data every month, which is currently around 1.5%. Long-term inflation expectations vary from entity to entity, and the Bank of Japan is likely to be more concerned about inflation expectations in the household sector as it affects private consumption. Household sector inflation expectations are calculated using the Carlson-Parkin probability method based on the question "How do respondents think prices will change in the next five years?" in the Bank of Japan's public survey "Opinion Survey on the General Public's Views and Behavior". The latest data shows that household sector inflation expectations have not broken the range since 2005. In addition to this, the Bank of Japan has not publicly disclosed other anchors that will affect its monetary policy decision, and we will keep a close eye on it.
Annotation:
[1]https://www.ecb.europa.eu/press/key/date/2024/html/ecb.sp240415~08ef84923c.en.html
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