FxWirePro: Dollar eases amid trade-war and unemployment data, intricacies of LatAm Central Banks’ approach to keep FX volatility on check

The minutes of the last FOMC meeting did not provide any ground-breaking insights as regards the central banks' future approach. By and large, the FOMC members agree that further gradual rate hikes are opportune. There is uncertainty as to the speed and amount of further interest rate hikes. However, it is not just the US central bank that is facing this dilemma. There are very different views amongst market participants too in this regard.

The dollar fell today on the lingering trade war between the United States and China that smacked tariffs on the other's imports; however, a paused response from the FX markets indicated the escalation had largely been priced in by investors focusing on a U.S. jobs report due later in the day. Today’s labour market report is likely to further illustrate the dichotomy the market is facing. Anyone looking at the development of employment, for example, will be surprised about the continued high increases of approx. 200,000 jobs on average per month.

Latam intervention has been heavy in many countries year-to-date and we believe central banks still have significant firepower in case needed. This, however, should lower volatility but not necessarily alter the FX direction.

In Brazil, the BCB appears to be content to intervene in FX markets if the BRL becomes misaligned with fundamentals rather than hiking rates.

The persistent FX depreciation would threaten its inflation target, however, with our pass-through estimates indicating that a 10% NEER depreciation pushes inflation higher by around 120bp over four quarters.  The BRL has depreciated about 9.4% YTD, whereas the BCB’s Focus Survey indicates an increase of 12m inflation expectations of only 30bp. While the Brazilian Central Bank has increased its pace of FX swaps auctions meaningfully, in addition to providing repos to respond to market illiquidity in conjunction with the Treasury’s bond repurchase program. The BCB swap line is currently at $67bn, from $24bn 2-months ago (BRXSCS Index in Bloomberg).

A clearer sign of deterioration in fiscal policy beyond the elections would likely trigger rate hikes but with a final set of candidates not clear until mid-August, a substantial sell-off in the currency reflecting external factors and/or a rise in inflation expectations will likely be needed for the central bank to hike rates at its early August meeting (only 18bp priced currently).

In Mexico, Banxico hiked 25bp in its last meeting to provide additional support to MXN and continues to roll its $5.5bn FX swaps with the ability to increase intervention to $20bn without reverting to the FX Commission (expect another 25bp hike in August).

Most of the central banks deploy other financial instruments before selling USD outright to help with FX pressures, like FX swaps, repos and certificate of deposits. This is because, since 2013, it was understood that liquidity provisions (repos for example) are better suited to respond to disorderly FX moves when funding liquidity dries up, and FX swaps when market liquidity dries up and hedging demand increases, particularly from foreigners. Courtesy: JPM

Currency Strength Index: FxWirePro's hourly USD spot index is flashing at -131 levels (which is bearish ahead of today’s unemployment data announcement), while articulating at (13:52 GMT). For more details on the index, please refer below weblink:

http://www.fxwirepro.com/currencyindex