USD: Low Volatility Keeps Carry Trade Popular

Global currency markets have seen very limited action today, primarily because there have been no major data releases on the schedule, and uncertainty about central bank policy divergence remains in play. Federal Reserve rhetoric that it will keep short-term rates higher for longer has been underlined at least implicitly by the Reserve Bank of Australia (RBA) in recent days.

Minutes of the RBA’s May meeting, released overnight, showed rising concerns about inflation risks and so—as signalled by the bank governor recently—the RBA ‘is unlikely to cut rates anytime soon’. The RBA is talking about raising the key policy rate, but it does not want to be perceived as fine-tuning policy, so the minutes had little impact on markets.

On net, though, differences in central bank policy are not yet enough to trigger major moves in foreign exchange. Since the beginning of 2023, EUR/USD has been trading within a 1.0500-1.1000 range 90% of the time. G10 currency volatility is on the decline as investors price in the possibility of the Fed keeping rates closer to other major central banks as they discount a more benign outlook for the U.S. economy.

Investors are now looking for the Fed to cut rates by 40 basis points by year-end, versus 56 bps by the Bank of England and 67 bps by the European Central Bank. We think the market likely has room to discount more cuts than we expect at this point, but in the scope of current data and communication from the Fed, this seems about right.

Last week, Fed President Mester sounded sceptical of the Fed cutting three times this year. That is consistent with our view that two cuts are more likely.

However, even if three cuts ultimately prove the right call, the reality is two to three cuts by major central banks will likely be delivered starting this summer, and that move is already priced in.

Assuming the Fed does not revisit rate hikes, FX volatility should remain low, which will keep bolstering the preference for carry trades. With global growth holding up OK, the U.S. dollar can only go so far on the upside.

EUR: Good Carry-in in Current Account Data

The ECB will release its balance of payments statistics for March today, and they will show that the eurozone current account was on the march at the start of the year. February produced a surplus of EUR 29.5 billion, following a surplus of EUR 39.3 billion in January, the fourth largest on record. This follows a record deficit of EUR 31.9 billion back in August 2022, and the headline always paints the message for international investors.

Annualizing the recent surpluses, the eurozone has managed an annualized surplus of EUR 400 billion, which is a long way from a three-month annualized deficit of EUR 274 billion it managed at the worst point of the 2022 energy price shocks. The consensus forecast for March is a EUR 30 billion surplus.

The other thing to bear in mind is the other side of the balance of payments—the financial account—though since the ECB was pushed into negative rates in 2014 and QE in early 2015. Besides that, foreign investors withdrew euros to reduce exposure to bond markets in the eurozone, but in recent months, the demand for eurozone bonds has built, so that marks the strongest and most consistent such stretch since the ECB was forced into these policies.

Naturally, much month-to-month data is near impossible to forecast, but the balance of payments is likely to continue showing an improved external position for the eurozone relative to where it was. On an annualized basis, a current account surplus around about EUR 400 billion is supportive for the euro, and this is in keeping for the single currency’s characteristics as a haven. In the past, the euro would stand up to risk events, outperformed by most G10 currencies save the Swiss franc and occasionally the yen. This bodes well for a renewed safe haven status for the euro following the destabilization events from 2022-23 energy price shocks.

Market commentary and analysis from Luca Santos, currency analyst at ACY Securities

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