April 01, 2019
After taking a dovish turn in January, the Fed doubled down on its dovish pivot in March by downgrading its economic outlook, removing all projected rate hikes for 2019 and tapering its balance sheet normalization plan that will ultimately end in September this year with the balance sheet at the high end of its projected range.
While US yields have fallen materially in response to the Fed’s most recent economic projections, the dollar index has been much more resilient as it is currently sitting roughly where it was prior to the Fed’s announcement. However, it does warrant mentioning that USD performance has differed versus DM (developed markets) and EM (emerging markets) currencies.
Since the turn of the year, EM economies have stabilized and the drop in US yields has provided outflow relief leading to a weaker USD against Asian currencies. However, versus the DM, the USD has been more resilient as DM central banks have followed the Fed’s lead in turning significantly dovish. As a result, the USD’s status as a high yielding currency has and should continue to provide support for the dollar despite a dovish Fed.
Given the positive performance of global risk assets (stock markets are up around the world) it appears that markets have started to price in the positive impact of global stimulus and a de-escalation of trade tensions. As a result, it most likely will require a material and sustained rebound in global growth to reverse G10 central bank dovishness and realize broad USD weakness.
The USD’s resilience notwithstanding, there are a number of building points of vulnerabilities facing the USD. On a monetary policy front, there is the upcoming review of the Fed’s inflation framework. The Fed is concerned about unanchored inflation expectations and its inflation target credibility. Changing methodologies to framework such as price level targeting would address these issues. If enacted, it should raise the bar for further rate hikes. Recent comments and actions from the Fed hint that it is moving this way, but it will take a formal announcement for the USD to make a material reaction.
Additionally, trade uncertainty remains with Europe and Japan even if a deal is stuck with China. Moreover, NAFTA 2.0 ratification risks remain. While the Mueller report did not find evidence of collusion, animosity between Democrats and Republicans remains high. This suggests not only that the issues around Russian interference in the election aren’t over, but it also suggests limited cooperation around NAFTA 2.0 ratification and the pending debt ceiling debate. This leads to scope for further near term USD strength vs G10 currencies on divergent growth prospects and positive interest rate differentials for the USD before weakening into yearend.
The big development for the euro, since our last currency update, has been the more-dovish-than-expected change from the ECB. At its most recent meeting, the ECB pushed back rate hike guidance from this summer towards the end of 2019. Moreover, several members appear to be in favor of a longer delay than the bank ultimately signaled. The central bank also took down its GDP and inflation forecasts as well as launched additional easing measures.
While all these steps are noteworthy on their own, the timing of some of these moves is also relevant. Using history as a guide, Mario Draghi has a tendency to signal an action well before actually following through on that action. As a result, the fact that the ECB acted with such haste and made downward revisions of the magnitude that it did speaks to the level of concern the ECB has over the economy. This aggressiveness from the ECB explains why the euro moved sharply lower despite the markets holding a dovish view and supports the possibility that the ECB could be on hold for even longer than it indicated, i.e. through 2020. As such, we are moving down our euro forecasts.
We do acknowledge that on a valuation basis, the euro is indeed cheap, but as long as Eurozone growth remains disappointing, the euro should continue to face headwinds. While the Fed has also taken decisively dovish steps and the markets are currently pricing in a ~80% chance of a rate cut by January 2020, the USD still benefits from positive interest rate differentials with the euro. This should continue to provide USD inflow support at the expense of the euro. Moreover, the persistent underperformance of the Eurozone economy has raised skepticism in Europe’s ability to rebound and raises the possibility the ECB could miss out on an entire hiking cycle as the bar to raise rates should rise in light of the Fed’s dovish pivot.
Beyond monetary policy, risks to the euro come through via potential trade tensions with the US. As the European economy is dependent on international trade, the possibility that the US imposes automotive tariffs is a material threat even if the US does reach a trade deal with China.
The GBP has proven to be a difficult currency to forecast given the drastic differences of possible outcomes combined with the fluid nature which makes it difficult to handicap the probability for each Brexit possibility. But, to be honest, the business end of Brexit has always had the potential to be chaotic both from a political and market point of view.
After many rounds of voting, both on the Withdrawal Agreement (WA) as well as indicative votes, there remains little clarity as to the direction for which Brexit will take. Some in the markets have noted that indicative votes on a permanent customs union and a second referendum garnered more votes than Meaningful Votes 1, 2 and 3. However, using three failed votes that lost by historic margins is hardly a high benchmark. The only clear thing that is definitive is the desire from Parliamentary to avoid a no-deal exit, which has been a key driver behind recent GBP strength.
In the short term, the markets will be focused on whether or not Parliament will be able to find majority support for any path. While this has proven to be a high hurdle, using the assumption that Parliament truly is against a no-deal exit, reality dictates that something needs to happen in front of the April 12 hard deadline. That is of course unless the UK agrees to take part in the EU parliamentary elections, which is a prerequisite for a longer delay.
While there are numerous paths for which Brexit can go, we hold on to our base case that an orderly withdrawal will eventually be achieved. While not much has changed to the WA that has failed by historic margins, the prospect of a much longer Brexit delay leading to an even softer Brexit, or a complete cancellation of Brexit, could ultimately push Euroskeptic MPs vote for PM May’s deal.
In the case where a deal is reached, the GBP is likely to rally but this rally is likely a limited one. The GBP has already made a big move up this year, reducing the Brexit discount priced into the currency. It is also important to remember that Brexit is a process, not a single event. Even in the case where a WA is agreed upon, there still remains the free trade agreement (FTA) which is both the more important part as well as the most complex to negotiate. With the negotiations to finalize the FTA unable to start after the UK legally leaves the EU, full visibility around the ultimate relationship between the UK and the EU remains years away. As a final point, the probability of a general election has risen above 50%, the highest level since the last election in 2017. Notably, the 8% lead that the Conservatives enjoyed two weeks ago has shrunk to a neck-and-neck race with Labour.
After a period of sharp appreciation in December 2018, the JPY has spent 2019 steadily depreciating despite US 10 year yields moving down during the same period. In our view, this was driven by two key factors.
The first factor is the positive risk backdrop. Since hitting its low around Christmas, US and Japanese equities have rallied sharply. Moreover, the VIX index (a measure of market volatility) has moved down materially. This rebound in risk sentiment is partly due to the oversold nature of December’s selloff but also due to positive developments from the US-China trade talks, which have been less disruptive than the markets initially expected. Given the JPY’s safe haven status, an improvement in risk sentiment would be expected to weaken the JPY, especially in light of the increased negative correlation between the JPY and stock prices.
A second factor is the robust demand from Japanese investors for foreign securities. For scale, Japanese investors net bought 5.4 trillion yen worth of foreign bonds versus a five year average (2014-2018) of 200 billion yen worth of net selling. With DM central banks (Fed, ECB, RBA, BoC) adopting dovish narratives, the downside risks to risky assets have been reduced, implying continued bond purchases, and JPY weakness, in the coming months.
However, there are risk factors to the current risk on market that could push USD-JPY down should they materialize. While positive news has come out of US-China trade talks, US-Japan trade negotiations are just ramping up. The two countries have reached an agreement where the US would not raise auto tariffs, but there still remains risks that the US could raise the issue of JPY undervaluation or insist on a FX clause, either of which should increase appreciation pressure. Additionally, the Japanese economy remains weak and speculation is rising that the BoJ could roll out additional easing measures. While easing measures generally weaken a currency, there is broad based easing in the DM. As long term yields outside Japan have greater room to fall, BoJ easing could be met with a narrowing of long term yields. As a final note, the US debt ceiling debate still looms over the market and a contentious battle between Democrats and Republicans would drive risk off sentiment.
A key development for the CAD since our last outlook was the Bank of Canada (BoC) joining other DM central banks in adopting a dovish outlook. At the BoC’s March meeting, the bank, for the first time since the start of the current rate normalization cycle, did not judge current or future rate hikes to be warranted. Instead, the BoC adopted a neutral stance and stated that it believed the economic outlook warranted a policy interest rate that was below its neutral range.
Once the markets overlaid the dovish BoC commentary on top of a weak Q4 GDP number, the markets have adjusted rate expectations from one that expected a rate hike to one that has a greater than 50% chance for a rate cut over the next two years. This adjustment has now put expectations for the BoC in line with the Fed as the markets have priced out any possible rate hikes.
Beyond broader global growth concerns, the CAD has all been hit by domestic issues. While domestic oil production cuts have helped stabilize local prices, it has also discouraged investment and growth in the oil sector. Adding to this has been the delays to projects designed to increase oil transportation capacity, which is clearly a negative to the energy sector but also the economy as a whole.
Political headwinds are also weighing on the CAD. Beyond the general future leadership uncertainty driven by the slip in the polls by PM Trudeau’s party, political uncertainty also distracts from policy making during a critical period. Ratification of USMCA remains a pending issue, and steel and aluminum tariffs from the US are still in effect. With regards to USMCA, we feel that it is a reasonable assumption that its ratification process will be a noisy one as exhibited by the signs of disagreement between Republicans and Democrats. This raises the possibility that President Trump could threaten/actually pull out of NAFTAT 1.0 as a means to motivate Congress’s ratification. This is a clear negative for the CAD as it would subject the markets, once again, to high uncertainty. Taking all this together, we see scope for USDCAD to remain elevated, albeit range bound, over the upcoming months.
The Reserve Bank of Australia (RBA) has joined the ranks for dovish DM central banks. As a result, markets have materially increased the probability of a rate cut this year, with some analysts calling for 2 cuts in 2019. This pivot marks a significant change from the “glass half-full” view that the RBA had and a ~40% chance for a hike only a couple months earlier.
Near term, weak growth, as exhibited by a disappointing Q4 GDP data, and expectations for RBA easing should continue to pressure the AUD. Notably, the RBNZ continued the trend of dovish central banks at its most recent meeting, leading some in the markets to believe that the odds of the RBA adopting a similar stance has increased.
With the Fed expected to be on hold and the RBA expected to ease, interest differentials should worsen to the AUD’s detriment. Beyond the near term, the fall in housing prices does not bode well for future consumer consumption. Housing values hold increased importance against the backdrop of a softening labor market. While labor market data over the past months have been solid, leading indicators hint at a slowdown in labor demand. To this point, the most recent labor report disappointed market expectations. Markets are likely to keep close tabs on the labor market report over the next couple months as market pricing indicates a greater than 50% chance of a rate cut starting in August.
Additionally, politics remain a potential headwind for the Australian economy. Former PM Malcolm Turnbull lost his leadership position last August. With instability within the government, the prospects of another leadership change at the next election remain materially high.
Given this, positive developments on China-US trade talks have been supportive and Chinese stimulus is starting to show signs of gaining traction. However, with Chinese officials reiterating that markets shouldn’t expect “flood-like” stimulus, the goal appears to be stabilizing growth. This implies a smaller expansion of credit than during previous periods of easing. Moreover, while the realization of a China-US trade deal will be positive, it is important to note that China is likely to shift commodity purchases from Australia to the US as part of the deal in order to reduce the US-China trade deficit.
After sharply depreciating last year, the CNY has been one of the top performing Asian currencies since the New Year. This appreciation was initially sparked by the December trade truce with the US and subsequent positive developments in trade negotiations since. Most recently, the March 1 deadline where tariffs were to be raised has been extended.
However, drivers of CNY strength extend beyond trade factors. Chinese authorities have been injecting stimulus into the economy. Credit has materially expanded and this should help stabilize growth. Additionally, Chinese authorities have pledged, on numerous occasions, to maintain a stable currency as it is a key issue for the US. A dovish shift from the Fed, with zero hikes expected in 2019 and balance sheet normalization being tapered and ending in September, has put a lid on US rates and should be supportive of EM economies and stock markets. To this point, Chinese equities have had a strong start to the year. This positive momentum, in addition to Chinese risky assets being included in global indexes, should support further inflows.
Counter factors to these bullish elements include continued pressure on exports and a deteriorating current account surplus. It is also worth noting that Chinese officials have repeatedly pushed back against “flood like” stimulus. This suggests expectations for economic stabilization and a gradual recovery versus a sharp rebound. Additionally, while the threat of additional tariffs have receded, there have been reports that existing tariffs could stay in place for a “substantial period of time,” even after a deal which would constrain any post deal recovery.
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