Elections and strong US data slam emerging market currencies

Highlights:

Last week’s interest rate cut from the European Central Bank was overshadowed by electoral and economic news.

The dollar rallied sharply against almost every major currency worldwide after a strong payrolls report sent US interest rates soaring, and traders priced out any chance of a Fed cut before the autumn. Some emerging market currencies were punished as election results in South Africa, Mexico and India were perceived to be market unfriendly, albeit for different reasons in each case. The Mexican peso was the week’s loser, giving up nearly 4% against the dollar.

Focus among investors this week will remain squarely on the US. Wednesday will be an unusually volatile day, as the all-important May CPI inflation report is released, followed by the latest Federal Reserve policy announcement. There will be no change in US rates, but the ‘dot plot’ that reflects FOMC member’s expectations for the path of interest rates should be considerably more hawkish than the previous one. The aftermath of the European elections, where the Right made significant gains, could weigh on the euro, which struggled during early Asian trading after Macron called early Assembly elections in France.

USD

The May nonfarm payrolls report directly contradicted the hints of a labour market slowdown that we had seen in second tier indicators like the JOLTS report and initial jobless claims. Job creation continues at a healthy pace (272k), well above the consensus of economists. A more worrisome development for the Fed is that wages grew at an annualised pace of nearly 5% in the month. This will make it increasingly difficult for the FOMC to bring inflation down to target in timely fashion.

As mentioned, Wednesday will see both the May inflation report and the latest Federal Reserve policy announcement. The key core sub-index of the CPI inflation report is expected to increase by 0.3%, equivalent to about 3.5-4% on an annualised basis. So even without another upward surprise, the stall in US disinflation around the 4% level seems to be intact. The Fed meeting later in the day will no doubt focus squarely on this worrisome trend, and how Fed officials are adapting their views and forecasts to it. We think that the ‘dot plot’ will show that FOMC members see two cuts in 2024, down from three, although there is a non-negligible risk that it shows just one, which would clearly be bullish for the greenback.

EUR

As was universally expected, and almost fully priced in by swap markets, the European Central Bank cut interest rates last week for the first time in five years. The ECB’s communications, however, resolutely refused to give any signal on the timing of any additional cuts, and the central bank insists that these remain completely data-dependent. The latest inflation forecasts were also revised upwards for both 2024 and 2025. Markets interpreted this as a ‘hawkish cut’, and the common currency was well supported until the blowout US payrolls report the following day, which sent traders scrambling to buy the dollar.

The European elections may be a factor in currency markets for the first time this week, as the shift to the Right has increased uncertainty and already brought about early national elections in France. Away from politics, market participants will be keeping tabs on a number of speeches from central bank officials this week, including ECB President Lagarde later in the week.

GBP

The prospect for an overwhelming Labour victory at the General Election next month is actually buoying Sterling, which has broken out of its year long range against the euro. Markets view a Labour majority as perhaps the most market-friendly outcome of the elections – a reflection of both the lingering damage done by Liz Truss’s ill-fated budget, a shift towards the political centre under Keir Starmer and the likelihood of a less contentious relationship with the European Union.

The next few days will see a handful of important macroeconomic data releases out of the UK. The key employment and wages report for May will be released on Tuesday. With services inflation running considerably hotter than expected, we would expect a significant market reaction to any upside surprise in wage growth, which continues to run at around 6% on an annual basis. Sterling bears, meanwhile, will be looking for signs of a growth slowdown in Wednesday’s GDP report for April – economists are currently pencilling in no growth at all.