Ebury: Volatility in view … in foreign exchange markets

By Enrique Diaz – Alvarez *

Last week we noticed some strange action in the market. The headlines of the financial newspapers were dominated by the relentless sell-off in the global stock markets, which led the S&P 500 to flirt with the informal limit of the formation of a downward trend at 20% below its historical highs. Among the G10 currencies, the Swiss franc recorded a rare victory, as the search for safe havens combined with the central bank’s interest rate hike led to a gain of more than 2% against the US dollar.

The biggest surprise was the general weakness of the US dollar, which failed to take advantage of its role as a “safe haven”. In fact, the winners of the week were the Latin American currencies, which is particularly striking in the current environment which avoids risk. However, because we believe in Latin American currencies, we have no complaints.

Next week, the focus will be on any shift in volatility from the stock market to the foreign exchange markets, and on the PMI. Eurozone and UK indices are expected to reach well above 55. We believe that these levels dispel fears of a recession that appears to dominate asset markets. It is difficult to reconcile real interest rates that are still in negative territory, huge budget deficits and full-time economies with any prolonged economic downturn.

Sterling

Data from the United Kingdom continued to suggest a dichotomy between emotion and reality. The consumer sentiment was sad, but the job data was very strong, as were the retail sales. Inflation in April was as high as expected. Sterling recovered, following the general sell-off of the Dollar, also managing to make some gains against the Euro. We believe there is little evidence that a recession is likely, and PMI data this week is expected to reinforce this view. It seems that the Bank of England’s apparent willingness to tolerate inflation due to growth risks is misplaced. In the short term, the Bank of England’s timid stance may weigh on the pound, but after the recent sell-off we believe the currency is quite cheap and offers a solid opportunity in the long run.

Euro

The European Central Bank’s “pigeons” retreat in the face of inflation accelerated last week, as the “hawk” board member from the Netherlands hinted that not only an increase in interest rates in July is almost certain, but that it will could reach 50 basis points. This is happening at a time when short-term interest rates in the US are finding it difficult to move higher, in part because several elements on the part of the Federal Reserve have already been discounted. As a result, interest rate differences in the Atlantic have shrunk to the heights of March. The trend should be supportive of the euro and we may have already seen the bottom. This week’s PMIs should be strong and partially alleviate fears of a recession in the US, allowing the ECB to continue its policy recovery and focus solely on curbing inflation.

US dollar

Strong retail sales last week confirmed that so far there are few signs that higher prices are discouraging the US consumer. However, it is an unstable indicator and one can not draw safe conclusions. US yields fell, in line with equities, and for now the US dollar seems to have reconnected with interest rate differences from the rest of the world, so it also fell. This week, it is important to publish the minutes of the last meeting of the Federal Reserve, which we expect to reinforce the view that the next two increases are likely to be “double”, ie 50 basis points. However, all of this has already been priced by the markets and it will be difficult for short-term US prices to be priced further. We believe that the dollar is vulnerable to a steady decline.

* Chief Risk Officer of the international payment company Ebury