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June is a progressive month.Political drama over the U.S. debt ceiling clouded market sentiment, even if it didn’t stop the dollar from rising or the S&P 500 and Nasdaq hitting new highs for the year. It's as if the two political parties in the United States are playing chicken and daring the other to surrender. Both sides are encouraged to do whatever it takes to convince their voters they're getting the best deal. Neither side appears to want to remove the cap, as it has proven over the years to be an effective lever for the opposition to win concessions. However, a higher debt ceiling and some FY24 budget spending cuts are a trade-off.

Many thought it was different this time. They say the partisanship is so extreme that it risks running afoul of the law. They could indicate major disruptions in the US Treasury market and rising prices for US default insurance (credit default swaps). Neither party can be certain that it will not be liable for the anticipated and unintended effects of bankruptcy. The risk with the chicken is that no driver will make a last-minute turn. There are only negative situations in case of default, even short-term, and there is no default of any obligation. On the other side of the debt ceiling, bills would rise and the Treasury would rebuild its account with the Fed. This increases short-term interest rates and reduces liquidity.

In addition to fiscal policy, there is also the drama of monetary policy. The Fed began raising rates in March 2022, and at its May meeting, Chairman Powell signaled the possibility of a pause. While he made it clear it was not a compromise, markets viewed the quarter-point move as the latest. However, a combination of strong economic data, firm price pressures and some hawkish rhetoric has left expectations swinging (60%) for a rate hike at the June 13-14 meeting. In addition, the Fed's real interest rate (weighted average) is about 5.08%, and the market implied real interest rate at the end of the year is about 5.0%. It was close to 4% on May 4, which shows the scale of this interest rate adjustment. Even if Fedstands is confirmed in June, we expect President Powell to confirm that the market expects another rate hike is likely (July).

Worrying economic signs continue to emerge in the United States, including an inverted yield curve, a sharp decline in major economic indicators, an overall contraction in the M2 money supply, tightening lending standards, and declining credit demand. At the same time, however, despite the slowdown, the labor market remains strong, with work-age participation rates improving. Consumption rose 3.7 percent in the first quarter and the second quarter looked good early on, with auto and retail sales rising in April. Supply chain disruptions have eased and shipping costs have fallen and returned to 2019 ranges. The Atlanta Fed's GDP tracker forecast growth of 1.9% in the second quarter, close to the Fed's uninflationary pace of 1.8%, although slightly faster than the first quarter (1.3%).

Another drama that is playing out is the pressure on Bank of America. Low-yielding assets growing banks are not offering rates comparable to prime money market funds (which only invest in US government/agency bonds) and the US Treasury market itself. Several of the largest banks reported higher net interest income as the banking system lost deposits. However, even after small bank deposits stabilized, the pressure on its share price continued. The pressure to sell can seem exhausting. June could also be the breakout period for the show. Still, many regional banks face a stressed commercial real estate market.

Europe avoided a tragic winter energy crisis, but the dramatic inflation was tricky and the regional economy appeared to stall at the end of the first quarter. In fact, revised data showed that the German economy contracted by 0.3% in the first quarter, following a 0.5% contraction in the fourth quarter. 22 Eurozone and UK economies grew 0.1% MoM in the first three months of this year. The Eurozone and UK appear to have stagnated, but markets are confident that the European Central Bank and Bank of England will raise interest rates by 25 basis points in June.

Japan has its own drama. The Bank of Japan is under new management, but its unusual policies have proven to be more than a quirk of former Governor Haruhiko Kuroda. Several surveys of market participants have identified June/July as a likely date for adjusting policy settings. However, President Ueda's plea for patience indicated there was no rush, with some expectations pushed back to the end of the third quarter. The recent history of raising interest rates or monetary caps suggests that even under the best of circumstances they can provoke a sharp market reaction. However, the best time to adjust the 10-year cap is when it is not being questioned. The Bank of Japan was the last central bank to introduce negative interest rates. It's getting harder and harder to prove this. The swap market is only priced at a positive rate at the start of the second half of the fiscal year, which begins on Oct. 1.

Geopolitics is always full of drama. It is clear that U.S. officials, including President Biden, view bringing NATO to the Russian border as a provocation. After a relatively muted reaction to Russia's invasion of Georgia and takeover of Crimea, the reaction to last year's invasion of Ukraine was a huge shock to almost everyone. The U.S.-led coalition has stopped Russia by supplying Ukraine with weapons, training, money and intelligence.

Initially, China appeared to be the net loser from the invasion of Russia. NATO is stronger. American leadership was once again on display. Similarities are everywhere between Ukraine and Taiwan. There has been a rapprochement between South Korea and Japan, with both sides increasing military spending. The United States has established a new base in the Philippines. However, China is finding its own opportunities.

Just as the US thinks Russia is in a swamp, China may think it is one with the US. President Biden has put the defense of Ukraine on the front lines of the struggle between democracy and authoritarianism. However, the support rate of the American public is not particularly high, and continued unlimited support may become a political issue in next year's general election. Meanwhile, China finds itself in a vacuum created by US and European sanctions. China has brought Russia into its sphere of influence in ways Beijing could never have dreamed of before the invasion. Swap lines with the PBOC enable many developing countries to pay for imports from China. The same applies to producer financed sales in a market economy. China is taking advantage of niche markets that the US and Europe have created intentionally and unknowingly. Despite its troublesome debt, the Belt and Road Initiative is creating and strengthening a trade network that may become increasingly important to China in the future.

The sharp rise in interest rates in May has been a tough time for risk assets. Both developed and emerging market equity indices fell in May, with notable exceptions. The S&P 500 and Nasdaq hit new highs this year. Germany's DAX and France's CAC hit record highs, while Japan's Topix and Nikkei hit their highest levels since 1990. Among emerging markets, Brazil (~6%), Chile (~4%), Poland (~3%), Hungary (~notable exceptions), Taiwan (~6%) and South Korea (~2.3%).

Emerging market currencies mostly fell in May. The J.P. Morgan Emerging Markets Currency Index fell 1.3 percent after falling about 0.35 percent in April. It was the first monthly decline since four consecutive months of decline between June and September last year. Basically the same throughout the year. Latin American currencies continued to outperform. They accounted for four of the top five emerging market currencies in May: Colombia (~5.1%), Mexico (~1.9%), Peruvian Sol (~1.0%) and Chile (~0.4%). The South Korean won was the exception; its 1% gain put it in the top five.

The Bannockburn World Currency Index, a GDP-weighted currency basket of 12 major economies, fell about 1.4 percent in May. This reflected losses for most currencies against the dollar. In the BWCI, only the South Korean won (~1%), the Mexican peso (~1.9%) and the Russian ruble (~0.3%) strengthened against the dollar. Collectively, they make up about 6% of the basket. The Japanese yen was the weakest, down about 3%, but the euro was not far behind, down 2.75%. In third place was the Chinese yuan, which fell more than 2.1 percent.

The BWCI bottomed out around 92.80 in early November last year, confirming the dollar's rise. It peaked around 98.15 in early February. The March decline reversed roughly half of its gains, while the yearly low (~95.25) set in late May is within 0.75% of the key zone. This is in line with our base case that while the USD may have room to grow further, this appears to be limited as the rate adjustment also appears to be complete or close to completion. In the cross-currency analysis below, we try to quantify where the baseline breaks.

Dollar:Markets are approaching the Fed rather than the opposite for rate adjustments, with the knock-on effect of dollar support broadly in line with the views outlined here last month. The two-year yield rose about 65 basis points in May to around 4.65%, the highest level since mid-March. The year-end rate was closer to 5%, not 4.5% at the end of April. We suspect that the rate adjustment is nearing completion, which may be supported by slower economic growth following the recovery in 2Q. The growth profile is almost a mirror image of 2022. So the economy contracted in the first half of the year. And counterattacked in the second half. This year, economic growth appeared to be close to trend in the first half of the year and is expected to slow in the second half. Before Memorial Day (May 29), the chances of a rate hike by the Fed on June 14 are around 65% and the July meeting is completely out of the question. The Fed will update its economic forecasts. The average growth forecast of 0.4% at the March meeting looked too low and could increase. Meanwhile, the year-end unemployment rate of 4.5% looks excessive. The unemployment rate was 3.4% in April. The median forecast is down slightly. The debt-ceiling battle hasn't put the best of America in the making, but barring an actual default, it won't have lasting effects. Outside of the Treasury market and credit default swaps, investors are unimpressed with this particular American political tradition. Our working hypothesis is that the USD should "correct" the sell-off that began in early March, when banks became stressed. In the last week of May, the US dollar index broke through the retracement target near 104.00. A break above 104.70 points to a return to the 200-day moving average (~105.75) and the March high around 106.00. A break below the 103.00 level suggests a possible top.

EUR:The euro exchange rate cannot keep up with the sharp rise in the US exchange rate. German two-year bond yields rose around 20 basis points in May, less than half that in the United States. However, the euro's decline of around 2.75% in May is not just a dollar story. The well-known flowers come from roses. In fact, the Eurozone avoided an energy crisis thanks to preparation and luck (low oil/gas prices and a mild winter). Positive economic momentum continued into February, but growth stalled or deteriorated in late March. Looking closely, Germany's economic output contracted by 0.3% in Q1 (preliminary estimate of zero) following a 0.5% decline in Q4'22. The ECB started adjusting monetary policy later than most G10 countries, and institutional rigidities may make price pressures more resilient. The European Central Bank meets on June 15 and markets are confident of a 25 percentage point hike in the deposit rate, bringing the deposit rate to 3.50%. Staff will also update their economic forecasts. The final rate at the end of the third quarter or the beginning of the fourth quarter is about 3.75%. On June 28, European banks will repay about €475 billion in loans to the ECB (Targeted Long-Term Refinancing Operations). They account for around 6% of the ECB's balance sheet assets and nearly 45% of outstanding TLTRO loans. Sheer term size may be a distraction, and some banks may seek alternative funding. The ECB’s balance sheet has already been cut by about 3% this year, and TLTRO refunds will play a bigger role in one go. It should be remembered that at the end of last year, European banks returned almost 492 billion euros. The euro has surpassed our $1.0735 target. We suspect that the bearish correction in EUR is coming to an end, but a break above the 1.0680 area could signal a return to March lows around $1.05.

(May 26, indicative closing prices, previous prices in parentheses)

Seat: $1.0725($1.1020)
Bloomberg's average one-month forecast is $1.0890($1,0960)
Monthly prepayment of $1.0740($1.1040)6.8% monthly hidden turnover(7,5%)


Yen:Rising U.S. interest rates appear to have pushed the dollar higher against the yen. It rose just above 140 yen in May, the highest level since late November, and has more than halved since a high of around 152 yen last October. Just as there may be slightly more scope for the US 10-year Treasury yield to rise above 3.80%, there may be room for further gains in USD/JPY. The next important area on the chart is around 142.50 yen. Underlying price pressures in Japan continue to mount, and a weaker yen will only increase the pressure on the BoJ to adjust its currency settings. The economy grew by a much stronger-than-expected 0.4 percent in the first quarter, and in late May the government raised its monthly economic rating for the first time in ten months. Several surveys showed many see June or July as an opportunity for the BOJ to adjust monetary policy. Much speculation has centered on yield curve control (YCC), which caps yields on 10-year bonds at 0.50%. We don't think it's been completely abandoned, and you might want to consider targeting a shorter balance time. That could push the overnight rate target from -0.10% to zero. If experience is any indication of when it will come, the timing will likely adjust, and it will certainly be disruptive. That could weaken the correlation between the exchange rate and U.S. bond yields. Finally, there's been a lot of talk about Japan's early summer elections, as Prime Minister Kishida looks to secure his tenure and support, and has recently formed a cabinet. He organized the G7 summit and waved to the leadership. Politically, this could be the perfect time ahead of the Liberal Democratic Party leadership election in September 2024, and with the economy relatively strong and the stock market near 30-year highs, he is being viewed positively.

Local: JPY 140,60(136,30 yen)
Bloomberg's one-month median forecast is 133.45 yen(133,05 yen)
One-month forward contract JPY139.95(135,75 yen)Implied monthly volume 10.8%(9,5%)


GBP:May is two and a half months in British pounds. In the first half of the month, it extended the year-over-year rally around $1.1800 on March 8. Sterling peaked around $1.2680 on May 10, its highest level since June 2022, and has staged a stunning recovery from an all-time low of around $1.0350 last September. In the second half of May, the pound fell against the dollar, falling to almost $1.2300. The move is coming to an end and the $1.2240 area may prevent further declines. However, if the area shrinks, the benign appearance may drop another percentage. Sustained inflation and stable labor market conditions have led to a sharp adjustment in UK interest rates, which may provide support for the pound. The interest rate at the end of the year is above 5.50%. This is an increase of 70 basis points since mid-May. The 2-year and 10-year gilt yields held steady in the first half of May before surging around 75 basis points in the second half. The 10-year breakeven point (the difference between TIPS and traditional bonds) has increased by just over 10 basis points in recent weeks. The Bank of England meets on June 22, the day after the May CPI is released. The market is debating whether to implement a 25 or 50 basis point rally. We tend to reduce traffic unless the incoming data is surprising.

Seat: $1.2345($1,2565)
Bloomberg's one-month average forecast is $1.2400($1.2480)
Retweets $1.2355 per month($1,2575)Implied volume per month 8.0%(7,6%)


Canadian dollar:The Canadian dollar fell about 0.60% against the U.S. dollar in May, making it the best-performing currency among the G10. The Swiss franc came in second with a double-defeat. After testing the April low (~1.3300 CAD) in early May, the USD rallied to post a monthly high (~1.3650 CAD) in late May. While interest rate movements may help explain the broad-based rise in the USD, the Canadian exchange rate appears to be more sensitive to the general risk environment (we use the S&P 500 as a proxy) and more recently to oil. WTI crude oil prices for July fell from around $76.60 in late April to just under $64 on May 4. On May 24, it was back near $75 before stalling. There has been a notable correction in Canadian interest rates in recent weeks. The 2-year bond yield rose nearly 60 basis points. Even at the end of April, the market had already priced in a rate cut before the end of the year and has now fully priced in the increase. The Bank of Canada meets on June 6. The swap market has a 33% upside opportunity, fully discounted by the end of the third quarter. At the end of April, the risk to the June high was less than 10%. A break above C$1.3700 could mean a return to this year's March high around 1.3860.

Location: 1.3615 CAD($1.3550 CAD)
Bloomberg's one-month median forecast is C$1.3405($1.3475 CAD)
$1.3605 per month forwarded (1,3540 CAD)Implied volume per month 6.0%(5,8%)


Australian dollar:A surprise 25 basis point hike by the Reserve Bank of Australia pushed the Aussie above the upper bound of the $0.6600-$0.6800 range it has dominated since late February. Disappointing jobs data, concerns about the pace of China's recovery and a sharp sell-off in the New Zealand dollar, likely after the central bank's last rate hike, weighed heavily on the Aussie. Its low for the year was just below $0.6500. There is little apparent graphical support ahead of $0.6400, but a rally above $0.6600 suggests a bearish hold. Pressure on households is expected to increase in the coming months as mortgages begin to rise with higher interest rates at the onset of the pandemic. The RBA meets on June 6 and the chances of a rate hike appear slim, although markets are not convinced the tightening cycle is over. There may be a slight increase (about 15 basis points) in the third quarter. The first estimate of Q1 GDP will be released the day after the RBA meeting, but we assume officials will have some guesswork. Despite talk of the risk of shrinkage, it may build slowly.

Local: $0,6515($0,6615)
Bloomberg's one-month average forecast is $0.6785($0,6710)
Retweet $0.6525 per month($0,6625)Implied sales for one month 10.3%(10,1%)

Mexican Peso:Between the central bank's pause and a stronger dollar, the peso was caught in profit-taking after hitting a fresh seven-year high in mid-May. However, the considerations that led to its rise remained intact, suggesting its peak was not in place. These forces include attractive spreads (at 11.25%) and relatively low money volumes (especially in high-yield companies), nearshoring and friend support, which bring in portfolio inflows and direct investment, in part Relevant are strong international positions, record exports and strong employee shipments. The U.S. dollar fell to nearly MXN 17.42 in mid-May and its rebound stalled around MXN 18.00. A break above the MXN17.60 area could signal a bearish retest, but a move to MXN17.00 is possible in the medium term. While the Mexican government has not created an investor-friendly environment, the market appears to be rewarding a strong, independent central bank and supreme court.

Location: MXN17.6250(MXN 18.00)

MedianaBloomberg One-Month Forecast MXN18.1675(MXN18.26)

Retweet MXN 17.74 per month(MXN18.1250)Implied monthly volume 11.4%(10,3%)

RMB: China is notoriously opaque when it comes to information and economic data. The overall market sentiment is that Beijing will take further steps to ensure economic growth remains on track amid the weak price impulse. The lower CPI (0.3% y/y in April) is partly due to weak demand, but excess capacity in certain sectors such as autos is also causing deflation. Reserve requirements can be reduced. For investors, expected political differences matter more than small fluctuations in China's large and persistent trade surplus. As the dollar hit new highs above 7.00 yuan in mid-May, PBOC officials expressed concern about volatility and one-way markets. The yuan's decline intensified. The next important area on the chart is around CNY 7.10. Still, the yuan remains correlated with the euro and yen, whose weakness has pushed the currency to fresh lows this year. Chinese assets may not be particularly attractive to foreign asset managers, but the yuan is more commonly used to close deals (not just with Russia and Hong Kong). Its share of SWIFT news increased to 2.3 percent in April, the highest in six months.

Local: RMB 7.0645(6.9185 RMB)
Bloomberg's median monthly forecast is 6.8625 yuan(6,8570 RMB)
Forward 7.0500 CNY per month(6,9060 RMB)one- roll. Implied per month. 5.4%(4,9%)

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