FX Daily: Volatility on the rise

FX markets are calmer today after Monday's wild ride. That ride was largely caused by a re-appraisal of China, where spreading lockdowns and quite a rare, fast drop in the renminbi spread a little panic through the emerging market FX complex. That panic has subsided a little after Chinese policymakers overnight promised to deliver more monetary support (having disappointed over recent weeks) and to speed up its review of the big tech/platform economy (helping Asian tech stocks overnight). The People's Bank of China's move to cut the Reserve Requirement Ratio on FX contracts yesterday also managed to stabilise the renminbi.

The market now awaits the outcome of the quarterly Chinese politburo meeting over the next few days to see what concrete stimulus measures actually emerge.

Away from the shorter-term challenges facing China, Monday's move in the renminbi will only add to the increasing sense that FX volatility is set to rise further. One month USD/CNY realised volatility is now at the highest level since February 2021 as the Chinese authorities seemingly let the renminbi float more freely. Remember that the PBoC had kept USD/CNY in a tight 6.35-6.50 range over the last year to control against imported inflation - the side effect being that the trade-weighted renminbi had soared 11% since early 2021 - a move now being reversed.

But FX volatility will also be driven higher by the withdrawal of central bank liquidity - both by rate hikes and by quantitative tightening about to come through over coming months and quarters as central banks start to shrink their balance sheets. The FX consequences of higher volatility should be that benign carry trade strategies fall out of favour and, like yesterday, the dollar will find more friends.

For today, we are interested to see whether US data like consumer confidence has any impact on Fed expectations. Last week's raft of poor consumer data in the UK dented Bank of England tightening expectations and saw sterling crumble. Will today's release of April Conference Board consumer confidence have any impact on the pricing of the Fed cycle? We suspect not. DXY may now be due some consolidation in the 101-102 area, but the trend towards testing the March 2020 high near 103 remains intact.

Monday's sell-off in European equities triggered a reasonably sharp adjustment in European Central Bank tightening expectations. Having priced 85bp of ECB tightening by year-end last Friday, those expectations have dropped to just 72bp. And as we suggested last week, the ECB debate over whether it hikes 50bp, 75bp or 100bp this year is being rather swamped by the potential 250-300bp adjustments to be made elsewhere in the world.

Developments in Ukraine are also at a dangerous phase. Russia now seems to be targeting Western military aid for Ukraine more directly with attacks on rail infrastructure, questioning whether attacks move closer to the border with NATO partners. Escalation is clearly a risk. For today, however, EUR/USD can consolidate in a 1.07-1.08 range before making a move towards the March 2020 low at 1.0635.

Elsewhere in Europe, the National Bank of Hungary looks set to raise its base rate by 100bp today. A calmer EUR/USD environment could see EUR/HUF dip back to the 370 area (after all the forint is an expensive sell with implied yields over 6%). Yet geopolitics will prevent it from returning to the 360 area.

Sterling continues to trade on a fragile footing after some consumer data put a dent in the Bank of England (BoE) tightening story. Most now feel that GBP/USD has to test 1.2500, and 1.2850 will now act as strong resistance - should it get that high. Tightening expectations for the 5 May BoE meeting have dropped backed to 29bp from 38bp early last week. However, by December, Bank Rate is still priced at 2.17%.

For us, one of the key stories this year will be whether central banks push ahead with tightening even as growth slows. That will clearly deliver flatter or inverted yield curves, but could actually see currencies staying strong. So until the BoE waves the white flag on the rest of its tightening cycle, we think it may be too early to write off sterling - particularly against the euro. Don't be surprised if EUR/GBP sinks back into a 0.8300-0.8400 range.

At one point yesterday, USD/BRL was nearly 3% firmer, following a 3% rally on Friday. After a stellar rally this year on the commodities story, we now think the Brazilian real is entering a vulnerable period. The key risk here is one of equity outflows after about US$18bn flowed into Brazilian equities - heavily weighted to the materials sector - over the last four to five months.

The Fed driving real US interest rates into positive territory to battle inflation and a difficult external environment mean that those equity flows into Brazil are subject to reversal. At the same time, Brazil's central bank is close to the end of its tightening cycle (near 12.75%) and the Brazilian presidential election will be hotting up. Brazilian growth near 0.5% this year leaves plenty of room for last-minute fiscal adjustments - typically the Achilles Heel of Brazilian asset markets and still a concern for Brazil's central bank.

We have quite a bearish set of BRL forecasts this year and remain happy with those.