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May FX Outlook – Corrective Tone to Continue Given Shortage of Major Events

May FX outlook – corrective tone to continue given shortage of major events
April saw more unwinding of the positive USD trade as the Trump administration failed to add any real meat to the bones of its tax plan. Although Trump did produce a tax proposal at the end of April, it lacked major detail and now has to go through the Congressional budget process, which is likely to take months. It may yet prove USD supportive but any market impact is likely to have to wait until Congress produces something with more detail. The main event for May is the second round of the French presidential election on May 7th. While this is still a significant event, the polls suggest that anything other than a win for the first round victor – the moderate Macron – is very unlikely. We also have an FOMC meeting on May 2-3, but no change in policy is expected and the market will be much more focused on the June meeting. 

Three-Month USD Index:

Outlook for May
1) The Trump and Republican agenda
In the end, we are still waiting for any significant developments on the Trump tax reform plan. His end of April proposal had even less detail than his campaign proposal, but did propose significant tax cuts. The question now is whether Congress signs up to these, or produces a much amended version. As it stands, the proposal would lead to a much higher deficit, so Congress is likely to propose ways to make the tax reform much more budget neutral. The possibility of a border adjustment tax, or something similar, remains one way that the lost revenue could be made up. There is also the potential for taxes on profits repatriated from abroad. Both of these would be USD positive. News on either of these issues would be significant for the USD, but may not be heard in May, or possibly for several months beyond.

2) The French election – second round vote May 7
The first round of the French presidential election on April 23rd was won by centrist independent candidate Emmanuel Macron with fair right candidate Marine Le Pen of the Front National in second place. These two will contest the run off on May 7th. While their first round votes were quite similar in size (24% to 21.3%), Macron looks set to win the second round comfortably, as he is likely to gain most of the votes from both the traditional parties and the left wing who lost out in the first round. Le Pen cannot be discounted completely, despite being nearly 20% behind in the polls. She has resigned as leader of the Front National to fight the election, trying to garner more of the centrist votes. But it is hard to believe a swing of the magnitude required is possible in so short a time. The EUR benefited from the first round vote (see EUR/USD impact in chart below), mainly because the chances of a Le Pen victory are now seen to be remote, so there is now only modest upside potential if Macron does win as expected.
3) The UK election build up – election on June 8
The big surprise in April was the announcement of a UK election on June 8. Prime Minister Theresa May had said many times that she would not call an election before the scheduled date in 2020, but it seems the opinion polls indicating that her Conservative Party could gain a much increased majority proved too tempting. At the moment, it is hard to see anything other than an increased majority for the Conservatives, mainly at the expense of the Labour Party, but the Liberal Democrats may (re)gain some seats in the South where Brexit was unpopular. (see GBP/USD impact in chart below)

4) North Korea
Tension in North Korea was a factor in weakening the USD and some of the more risk positive currencies in April, but appears to have faded a little for now. It is very hard to assess the FX market risks because we must assume that worst case scenarios will be avoided, in which case the net impact is unlikely to be significant. But jitters have tended to hurt the USD and help the JPY and any further tension can be expected to have the same effect.

Currency Outlooks
After dipping early in the month EUR/USD made strong gains in the second half of April to new highs for the year, mainly because of the victory for Macron in the first round of the French election, which largely eliminated the risk premium attached to the EUR because of the concern about a possible victory for Le Pen. The EUR has also been helped by more solid data and a pick-up in inflation in April after the dip seen in March (fluctuations very likely reflecting the timing of Easter). Draghi also indicated a more upbeat ECB attitude on the economy at the April ECB meeting, but made it clear that at this stage they have no appetite for a change in policy as they see the trend in inflation as little changed. However, there is talk of a possible tapering announcement in June if there are no shocks from the final round of the French election. This, combined with the possible further modest benefit on an expected Macron victory in the French election, suggests a mild upside bias for EUR/USD.

From the USD side, the Q1 GDP data disappointed, but strong price indices along with some hawkish recent Fed comments were enough to keep a possible Fed hike in June on the table. This is currently priced as around a 65% chance. The Fed meeting on May 2/3 is not expected to deliver anything major, but hints at the possibility of a June move will be looked for in the statement, and may determine the early month USD trend. The long term EUR/USD downtrend is still in place and looks unlikely to be seriously threatened in the absence of a major event or policy shock, so the pre-US election high of 1.13 looks safe for now. EUR/USD may manage modest gains to 1.10 or a little beyond if the Fed fails to add to expectations of a June hike, but gains seem likely to be hard to extend, and more hawkish Fed language could well see the French election chart gap to 1.0780 quickly closed.

Three-Month EUR/USD:

The surprise UK election announcement triggered substantial gains in GBP/USD in April. Many in the markets see the probability of a bigger Conservative majority after the June 8 election as more likely to mean the government can achieve a favorable outcome to Brexit negotiations, and this was widely seen as the rationale behind the GBP recovery on the news. However, the recovery also owed a lot to the existing large speculative short positioning in GBP that can be seen in the futures market data, and while that position has now been reduced a little, it remains very large by historic standards and consequently a significant support for GBP unless new negatives emerge. The negotiation with the EU will not start in earnest until after the UK election on June 8, but initial skirmishes on the weekend of April 29/30 suggested it will be difficult process with neither side wanting to concede much ground. Even so, there is unlikely to be a major short term impact on GBP. Perhaps more of a concern for GBP is the Q1 data on GDP and retail sales. Q1 GDP growth was the weakest since Q1 2013, and retail sales fell in Q1 and were the weakest since 2010.  Coming into the election, these are probably background rather than immediate concerns, and for now momentum and positioning suggest a mild upside bias to GBP/USD. But the scope beyond 1.30 looks quite limited.

Three-Month GBP/USD:

After early month gains on a stronger oil price and some stronger Canadian data, the CAD fell back in the second half of April as the oil price weakened and the US imposed a tariff on Canadian lumber. Technically, USD/CAD had found the expected strong support near 1.32 early in the month, and once the news turned against the CAD gains were quite swift. At this stage, the lumber tariff looks unlikely to be extended to other goods, so is far less serious that a general border adjustment tax, but this remains a possible way for Congress to propose shoring up the US budget against the proposed tax cuts, and the lumber tax should highlight the vulnerability of Canada should the US take this course. As with most other USD pairs, USD/CAD will be sensitive to fluctuations in expectations about Fed policy coming into the June Fed meeting, but the downside now seems well protected at 1.32 and upside to the 1.38-1.40 area is targeted.

Three-Month USD/CAD:

USD/MXN had a relatively quiet April after the volatility of recent months, holding in a tight range of 18.46-19.30. The big pre-election support area around 18.00-18.15 was not tested, but the USD tone was generally on the soft side given the lack of progress on tax reform and healthcare and the softer US data in Q1. The issue of US tariffs or border tax remain the most important for USD/MXN, and as long as there is no progress on this from the US, the risks look more to the downside than the upside. However, a break down below 18.000 would probably require some conclusive news that the US is not going to impose any new tariffs or border tax, and this looks unlikely at this stage, so a period of range trading is expected for now.

Three-Month USD/MXN:

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