March 01, 2019
In last month's outlook, we touched on the dovish pivot from the Federal Reserve and highlighted it as a key driver of the USD. In short, Jay Powell confirmed a “Powell Put” by indicating that the Fed remains willing to provide policy accommodation as well as flexibility with its balance sheet normalization program. Specifically with the balance sheet normalization plan, the Fed acknowledge that its QT program could have influenced market volatility at the end of 2018. Moreover, the dovish signal took on increased significance as it came when US economic data and financial conditions were better and more accommodative, respectively, than in December when the Fed raised rates.
As a result of this change in stance, USD sold off sharply but subsequent price action has been limited with USD proving to be more resilient against developed market (DM) currencies relative to emerging market (EM) currencies. To this point, the USD is actually stronger against certain DM currencies than it was pre-Fed announcement.
This divergent performance is characteristic of the difference in growth momentum between the DM and EM. While US growth momentum has indeed slowed, the DM has also slowed with DM central banks following suit with their own dovish tones. Conversely, EM forecasts have been relatively stable. So while performance isn't stellar in the EM, remaining still while the rest of the world moves backwards amounts to relative outperformance.
Looking forward, we still see a case for shallow dollar weakness but highlight that the dollar's performance will most likely be uneven across currencies, with higher yielding currencies benefiting the most. Case in point, with Europe continuing to show economic softness, the US dollar's status of the higher yielding currency should limit its weakness relative to currencies to which the US has a negative interest rate spread, i.e. the US has higher yields. To be fair to Europe, we should also point out that growth risks remain globally.
Additionally, the disarray in Washington should continue to weigh on the USD. The longest government shutdown in history has ended but risks remain as political dysfunction in Washington signal a strained relationship between the divided Congress and the White House affecting their ability to come through with legislation as required.
The two key upcoming legislative events are the debt ceiling debate and the ratification of USMCA (NAFTA 2.0). With regards to the debt ceiling, deepening tribal politics make us believe this will be a contentious process. There exists a real possibility of a fiscal accident regarding the increase to the U.S. debt ceiling as Democrats and Republicans lock horns, and gridlock jeopardizes needed fiscal action and risks the possibility of a sovereign downgrade to the U.S.'s credit rating. The timing of these two issues, along with other Washington issues (Mueller), comes at a time when the US economy is slowing. This could then leave the USD exposed to vulnerabilities (twin deficits) that have always been present but masked by strong growth.
As a result, while the Fed has turned dovish, the ultimate movement of the USD remains contingent on economic performance ex-US as well as geopolitical issues (Brexit, Italy, Washington D.C. discord and trade wars). Without stabilization of growth ex-US, it will be difficult for material USD weakness to be realized.
In our last outlook, we mentioned that we remained cautiously constructive on the euro in 2019 but expected the euro to remain pressured in the near term, and the economic data has played out accordingly. Eurozone growth, which ended 2018 on a negative note, has remained weak to start the New Year.
This persistent weakness in economic data, which put Italy in a recession and materially slowed Germany and other countries, forced the ECB into acknowledging that risks have skewed to the downside. Keep an eye on the ECB's March meeting where it could push down its forecasts and announce new easing measures. As a result, the euro has been unable to take advantage of the Fed taking a materially dovish pivot where it signaled the possibility for tolerating larger inflation overshoots.
Over the medium term, we remain mildly positive on the euro as the labor market remains tight and some transitory factors suppressed growth in Germany. This positive outlook for the export-heavy EU economy will be strengthened when an orderly Brexit and a resolution of the US-China trade is realized as expected.
But in the near term, we remain neutral as persistently poor European economic data should dominate a dovish Fed and relatively high US interest rates continue to support the USD even with the Fed on hold.
In terms of wild cards, keep an eye on how the US Section 232 investigation evolves as automotive tariffs are a key lever to get the EU to pressure China or concede on bilateral talks. It's been reported that President Trump will take the full 90 days allowed before he has to take action on the report in order to use auto tariffs as negotiating leverage. Additionally, new elections are to be held in Spain for the third time in four years. Spain has been the beneficiary of financial flows deterred by the Italian situation, implying general financial stability impacts from any disruption in Spain. Finally, we would like to point out that European parliament elections are scheduled for May 2019 and could become a risk factor, especially should populists gain a significant number of seats. Currently, polls continue to show Eurosceptic parties winning a minority of seats.
We have been harping on Brexit as a key driver for the GBP and, with all due apologies for repetition, the month of March will be the epitome of this because of the March 29 deadline when the UK is set to crash out of the EU.
Since PM May's first attempt to pass a Withdrawal Agreement, which failed by a historic margin, the GBP has rallied and has hit multi-month highs against the U.S. dollar and euro. This move was in response to the markets pricing out the risks for a no-deal exit/increased likelihood for an extension to Article 50 and even the remote possibility of a second referendum. However, with legislation needed to avoid a no-deal exit (the default option is a no-deal exit) and Parliament unable to build a consensus around a path of action, the recent appreciation of the GBP may be short lived.
Over the medium to long term, we remain constructive on the GBP based on our base case for an orderly resolution. The reason for this is that Brexit is a process, not a single event. Even in the case where a Withdrawal Agreement (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 on 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. Moreover, in an ironic twist, the passage of the WA could actually be argued as relatively GBP negative as it eliminates the possibility of a no-Brexit outcome, which is the most GBP positive event.
But these are longer term issues, leaving the market's focus fully on the March 29 deadline. PM May has been obligated to renegotiate with the EU by Parliament, but thus far, the EU has been unwilling to reengage in talks and defeats on amendments have weakened May's negotiating position. Moreover, defections from both the Labour and Conservative parties has changed the dynamics around a possible second referendum or a snap election. With time running out, it is looking increasingly likely that an extension will be needed. Unanimous approval from all EU states will be needed for this, all indications are that approval should be granted. While an extension is better than a no-deal outcome as such is likely to be GBP positive, the extent of this remains contingent on the details around any extension as the extension only gives more time and doesn't eliminate risks or promote compromise. Keep an eye on the European Council Meeting on March 21-22 as a potential event where the UK and the EU could come to an Irish backstop breakthrough. With regards to possible elections (currently a hypothetical scenario) in the UK, the Labour Party losing more members reduces the likelihood of a leadership change.
Three main themes are set to influence the JPY over the next couple of months. These are the dovish turns from the Federal Reserve that put a bearish slant on US yields, seasonal factors around Japan's fiscal year end (March 2019) and heightened concern around a global slowdown.
With the Bank of Japan's (BoJ) yield curve control policy pegging Japanese yields around 0%, the JPY has been moving along with US yields. This makes us believe the dovish Fed pivot could put a ceiling on how much the JPY could depreciate. With both central banks on hold for the foreseeable future, it is possible that the JPY could be in for an extended period of range bound trading. Proving this point is the relatively high correlation between USD/JPY and Fed Funds futures, which currently show zero expectations for a hike in 2019.
With regards to seasonal flows due to the repatriation of funds ahead of Japan's fiscal yearend, the past 5 years have been a bit mixed. In 2014 and 2015, the JPY weakened, but in 2016, 2017 and 2018, the JPY strengthened. However, there were other factors at work in 2016 and 2018. In 2016, there were concerns around the US economy as well as the credit worthiness of European financial institutions which accompanied a global equity selloff and a fall in US yields. In 2018, there was another sell off in global equities and a rise in the volatility index with Japanese investors turning into net sellers of foreign assets.
Looking at 2019, it appears that Japanese investors were net sellers on foreign assets in December 2018 during last year's sharp equity correction. This then hints that the dynamic of JPY appreciation due to foreign asset selling may already be done. However, continued acceleration on global economic underperformance leaves scope for further risk off episodes. However, the increasingly dovish stance from global central banks provides a buffer to this.
The same can't necessarily be said about geopolitical risks. US-China trade tensions remain, along with an uncertain Brexit outcome and further political turmoil in D.C. While the government shutdown is in the past, there remain negative implications of continued Washington dysfunction that bode poorly for the impending debt ceiling debt and USMCA ratification.
Since the beginning of the year, the CAD has reversed course from its weakening trend to strengthen to levels not seen since November 2018. A reversal of course in global equities to start the New Year accompanied by commodity outperformance have changed the short term dynamics in favor of the CAD.
Markets were expecting the Bank of Canada (BoC) and the Fed to move broadly in sync as both banks forecasted roughly the same rate normalization path. However, subsequent to the Fed's December rate hike and pivot to the dovish side, markets have changed its expectations for US and CAD rates with markets anticipating 0.05% of cuts in the US against 0.05% of hikes in Canada over the next year.
Beyond central bank expectations, we continue to expect that USMCA ratification risks will be a key driver for the CAD. While we believe that it will ultimately be ratified by all three countries, the road to ratification should be noisy. The recent US government shutdown, which is the longest in history, illustrates the contentious relationship between the Republicans and Democrats. This bodes poorly for a smooth process especially with the Democrats possessing multiple options to delay the process and little incentive to help Republicans cap off a signature achievement. The risk to delays mainly comes from the possibility that President Trump counters by withdrawing from NAFTA 1.0. This would start a 6 month clock, after which there will be a cliff edge fallout unless NAFTA 2.0 is ratified. Clearly, such brinksmanship would elevate market uncertainty to the CAD among other assets. As a final note, we would like to note NATFA uncertainty's impact on the BoC's rate path as the bank has acknowledged trade uncertainty as a limiting factor to rate hikes.
Combining all these factors, we see a scope for near term CAD weakness based on the reasons above with the CAD ultimately strengthening after ratification of USMCA by the end of the year but acknowledge that the timing and final outcome remain uncertain.
The AUD went on a bit of a monetary policy rollercoaster this past month. Initially, the AUD strengthened as the Reserve Bank of Australia (RBA) issued a post-meeting statement that held onto the bank's “glass half full” narrative more than the market expected. This then was followed by a speech from RBA Governor Lowe which contradicted the post-meeting statement with a more cautious message on economic risks which pushed the AUD weaker. Ultimately, this tie was broken by the RBA's meeting minutes which flagged a number of economic concerns (specifically housing) aligning more with Lowe's speech than the post-meeting statement and confirming the RBA's dovish shift.
However, it's not all negative news for the Aussie dollar. A more dovish Fed should provide support through less pronounced interests differentials as well as through increased commodity demand. Additionally, there are nascent signs that Chinese stimulus is taking hold and stabilizing the economy.
Given this, we continue to see scope for the AUD to remain weak for the balance of 2019. Domestic economic data continues to disappoint. Moreover, shipments of commodities out of Australia dropped sharply in line with the drop in Chinese Industrial Production numbers. While Chinese stimulus is gaining footing, poor economic data continues out of China making a sharp near term rebound unlikely.
Finally, politics remain a risk factor for the AUD. 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 remains materially high.
After sharply depreciating for most of last year, the CNY has been one of the top performing Asian currencies since the New Year correlating strongly with a sharp Chinese equity market recovery. This appreciation has been driven by the December trade truce with the US and subsequent positive developments in trade negotiations with President Trump announcing an extension of the imposition of further tariffs. Moreover, as part of the trade negotiations, there have been reports that the US is pressing China for a more stable CNY. To this point, there are indications that the Chinese authorities also desire to have a more stable and steady currency over the medium and longer term.
If common ground is indeed found on a more stable CNY, our bias remains for the CNY to gradually weaken due to the following factors. Assuming a trade deal is struck with the US, which is our base case, the Chinese economy will remain weak. This implies additional domestic stimulus. Fiscal stimulus/infrastructure spending as well as efforts to supplement consumption through tax cuts and initiatives to drive health care, tourism, and education should stimulate the economy. All these steps should result in increased consumption/imports and a further deterioration in China's current account position. Additionally, a positive resolution to a trade deal with the US should improve overall investor sentiment, reducing concerns of an impending downturn and bring the Fed rate hikes back in play.
Near term, it will all be about how the trade talks with the US evolve and how the markets perceive them. While the recent news flow has been positive, little progress has been made on the more difficult issues such as IT protection and forced technology transfers. These issues hit at the core of the race between the US and China to gain and maintain global superiority and as such, will not be easily settled.
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