Will Recovery Be Shaped Like an L, U, V or W?

Aggressive action by several central banks and governments helped reduce the extreme tail risk that had seemed so dominant in the second half of March. Strains in the funding markets eased, and equity markets recouped some of the steep losses inflicted during the frenzied panic. To be sure, most major economies were largely shut down in April, and the lagging economic data is dreadful.

 

 

Various measures of the contagion showed signs of peaking in the major economies, and in the coming weeks, more shutdowns are expected to be lifted. Economies are likely to be bottoming in next month or so. There has been much debate about whether the recovery will be characterized by an L, U, V, or W.  At his press conference following the recent FOMC meeting, Federal Reserve Chairman Jerome Powell said he was more pessimistic than the "W" camp.  

Much depends on the course of the virus, which remains a significant unknown. Will the easing of the shutdowns see a new surge in the virus? Do antibodies give one immunity, and, if so, for how long? While national closures are unlikely to be re-imposed, localized restrictions on movement, as some countries have re-introduced, seem a more reasonable response to new outbreaks.

 

At first, the reopenings are likely to be slow and tentative, and activity is unlikely to explode higher immediately. Large social gatherings, including the use of mass transportation and the like, may take some time to re-build, especially in the absence of a vaccine or effective treatment. The extended supply chains and the desynchronized nature of the epidemic will also complicate economic recoveries. However, the math behind GDP and the change in the change, as it were, does set the stage a strong rebound later this year.  

 

The stresses in the capital markets eased considerably in April. They remain on life-support provided by central banks stepping up as lenders-of-last resort. In addition to bond markets, several central banks also supported the short-term corporate bill market and offered guarantees on bank loans.  

The Federal Reserve indicated that corporate bonds that had recently lost their investment-grade status ("fallen angels") would be included in its support to the sector. It also announced that within specific valuation parameters, it could buy high-yielding bond ETFs. The ECB has issued a waiver that allowed it to buy Greek bonds, which are rated below investment-grade. It took another step and indicated it would accept "fallen angel" bonds as collateral for loans from the central bank. 

The funding markets have gradually begun normalizing. LIBOR is on a clear downtrend, as is Euribor. As stability returned to the capital markets, several central banks, including the Federal Reserve, the Reserve Bank of Australia and the Reserve Bank of New Zealand, began scaling back their bond purchases. 

The U.S. dollar was mixed, as it sat at the fulcrum between the strengthening dollar-bloc currencies and the weaker euro-complex. The yen, danced to a different beat as it were, enjoyed a small gain. Emerging market currencies, recovered from earlier losses and by the end of the month, the JP Morgan Emerging Market Currency Index rose 0.6% in April, mostly due to gains at the very end of the month, after tumbling 8.4% in March. The Indonesian rupiah (~9.6%) and the Russian ruble (~5.4%) resisted the U.S. dollar's pressure, led the pack. On the other hand, resignations from the government drove the Brazilian real lower (-5.1%). Despite large scale intervention, the Turkish lira was the weakest currency in the world, falling almost 5.3% in April.      

 

 

U.S. Dollar:  The aggressiveness of the Federal Reserve's response should not be under-estimated. It has already bought more Treasuries and mortgage-backed securities than in the third and most significant round of QE during the Great Financial Crisis. It has launched nine asset-buying programs, seeded by funds from the Treasury Department. The Fed's balance sheet is a little more than 30% of GDP. The ECB's balance sheet is closer to 40% of EMU's GDP, while the BOJ's balance sheet is over 100% of GDP. Neither the incremental change nor the proportionate size of a central bank's balance sheet appears to be a good predictor of inflation or the direction of the exchange rate. The Congressional Budget Office projects a deficit of about $3.7 trillion this year, or about 18% of GDP. A recent Pew Research poll found that around 2/3 of Americans thought the risk was too early of a relaxation of the shutdown than too late. The staggered re-opening of some areas and states have begun, and the lag time before other states (Northeast and West) is sufficient to detect if a new flare-up of infections is occurring. 

 

Euro: The eurozone again is being stymied by the lack of strong central authority. Its response is hampered by the divide between creditors and debtors in Europe. The EC has accepted the emergency suspension of its fiscal rules in fact, and the ECB has been bold with its Pandemic Emergency Purchase Program, which it will likely have to increase before Q4. However, the EC itself, the European Parliament, the European Council have yet to offer a vision or program. There does seem to be a gradual evolution toward 1) using the multi-year EU budget for 2) a program that will likely include a combination of grants and loans that could be more than a trillion euros. Without a bold plan, the antagonism will only deepen and provide more fodder for the anti-European voices. Moreover, it will generate weaker growth and lower returns on investment.

 

Spot:  $1.0955 ($1.1030) 

Median Bloomberg One-month Forecast  $1.0925 ($1.1100) 

One-month forward $1.0960 ($1.1065)    One-month implied vol  6.3% (9.3%)    

 

Yen:  The Bank of Japan is the largest user of the Federal Reserve swap lines, which, in turn, reflects the use of the extensive use of the dollar as funding currency by Japanese institutional investors when they purchase U.S. assets, even as the markets calmed. Often the USD/JPY is seen as a risk-barometer. Yet, over the 30 and 60 sessions, the inverse correlation has fallen to the lowest in nearly ten months. The yen's correlation with interest rate differentials has also broken down. After large swings in February and March, the yen entered a consolidative phase around the middle of this year's range, a little below JPY107.  Japan reports Q1 GDP on May 17, and the BoJ's forecast for FY19 assumes no worse than a 2.75% contraction. The BoJ anticipates the economy will contract between 3% and 5% in the first year that just began before rebounding next year by 2.8%-3.9%.

 

Spot: JPY107.20  (JPY107.55)      

Median Bloomberg One-month Forecast  JPY107.10 (JPY107.50)     

One-month forward  JPY107.15  (JPY107.50)    One-month implied vol 7.1%  (13.2%)  

 

Sterling: In each of the last three full weeks of March, sterling's range was over a dime. The calmer markets were reflected in narrower ranges. The largest weekly range in April was a little over three cents. It spent April in about a two-cent band on either side of the mid-point (~$1.2460) of its range (~$1.14-$1.35) since the peak on the UK election results last December. Sterling's exchange rate seems to be more a function of the broad dollar direction and euro's underperformance. The Bank of England meets May 7. With the bank rate at the zero bound, the BOE could increase its asset purchases, but there seems little need at present. The Chancellor of the Exchequer Sanuk has expanded the range of economic support to include more small businesses.  The UK may be among the last of the G7 countries to relax its shutdown.  

 

Spot: $1.2590  ($1.2430)   

Median Bloomberg One-month Forecast $1.2375 ($1.2455) 

One-month forward $1.2590  ($1.2430)   One-month implied vol 8.6%  (14.5%)

  

 

Canadian Dollar:  The U.S. dollar traded in a broad range of roughly CAD 1.3850 to CAD 1.4300 in April. The government and the central bank's response has been forceful, but it is not going to prevent a deep contraction. It is not only the virus, but the hit from oil and commodities more broadly is a terms-of-trade shock. There is also a risk that the drop in oil prices has a significant knock-on effect on real estate, where underlying problems were not fully unwound. The IMF forecasts a 6.2% contraction this year. The Canadian dollar is among the most sensitive of the major currencies to the shifting risk-appetites (using the S&P 500 as a proxy). Canada is the only G7 country besides Germany that has a AAA sovereign rating. The large-scale borrowing by the federal government and provinces warns of the risk of a downgrade, although the timing is not clear.  

 

Spot: CAD1.3945  (CAD 1.4065) 

Median Bloomberg One-month Forecast  CAD1.4140  (CAD1.4025)

One-month forward  CAD1.3945  (CAD1.4060)    One-month implied vol  7.4%  (11.7%) 

 

 

Australian Dollar: After falling almost 6% in March, the Australian dollar was the strongest of the major currencies in April (~6.2%). The Reserve Bank of Australia meets on May 5. With the cash rate at its effective zero-bound (25 bp), and an asset purchase program and targeting the three-year yield at the cash rate, the meeting is unlikely to alter policy. Still, it provides an opportunity to update its economic and financial assessment. The cash rate does not appear to be setting the floor of interest rates. Instead, the 10 bp the RBA pays on exchange settlement balances may be the new lower bound.

 

Spot $0.6510 ($0.6145)       

Median Bloomberg One-Month Forecast  $0.6460 ($0.6165)     

One-month forward $0.6510  ($0.6145)     One-month implied vol  11.6% (18.1%)   

 

 

Mexican Peso:  The peso fell for the third consecutive month against the dollar.  The greenback spiked to record high a little below MXN25.80 in early April and carved out a low near MXN23.30.  Mexico has had, according to the IMF, among the mildest responses to the pandemic, committing less than 1% of GDP. At the same time, Mexico is expected to among the hardest hit. After failing to grow in 2019, it contracted 1.6% (quarter-over-quarter) in Q1 20. Mexico is expected to contract by 6.6% in 2020 by the IMF, and even more by some private-sector economists. Banxico surprised with a 50 bp rate cut on April 21, bringing the official target rate to 6.0%  Its remains high in real and absolute terms. March CPI stood at 3.25%. Another rate cut at the May 14 central bank meeting is likely. The price of insuring against a sovereign default (credit default swap) has nearly quadrupled since late last year to over 300 bp, the most in 11 years, and half peak during the Global Financial Crisis.    

 

Spot: MXN24.15 (MXN23.77)  

Median Bloomberg One-Month Forecast MXN24.10 (MXN 23.46)  

One-month forward MXN24.20  (MXN23.81)     One-month implied vol  19.6%  (33.7%)

 

 

Chinese Yuan: Output of the world's second-largest economy fell by almost 10% in Q1, but the fiscal and monetary response remains modest by its own historical responses and what other countries are doing. More measures will likely be forthcoming in the period ahead. The dollar traded in a range of about CNY7.03-CNY7.1250 in April and was net-net was practically unchanged on the month. China's handling of the COVID-19 crisis may put at risk the country's strategic goals. The UK is expected to soon move to block Huawei from constructing its new mobile network. Several countries are tightening rules aimed at deterring Chinese acquisitions. The World Health Organization has been criticized for not including Taiwan, ostensibly to appease China. It has subsequently upgraded Taiwan's status.  Local government infrastructure projects will help the domestic economy recover, while the exports may take some time to regain traction.  

 

Spot:  CNY7.0630  (CNY7.0820)

Median Bloomberg One-month Forecast CNY7.0620 (CNY7.0760) 

One-month forward  CNY7.0760 (CNY7.0790)    One-month implied vol  4.3% (5.7%)