July 01, 2019
The key event for the USD over the past month has been the dovish shift from the Fed. This development has caused the USD to weaken and has increased expectations for rate cuts as soon as the Fed’s meeting this month. While this shift from the Fed represents a dramatic shift in guidance relative to start of the year, there are some reservations on whether this signals broad based dollar weakness moving forward.
Year to date, the USD has been resilient because of its high yielding status among other G10 currencies, which has drawn fund inflows for market participants searching for yield. Even if all the rate cuts that are currently priced in are realized, the USD would still be among the highest yielding currencies. Moreover, the USD has benefited from safe haven flows due to uncertainty around global growth. With global conditions similar to the turn of the year, these factors above should continue to support the USD.
Unlike at the turn of the year, central banks are looking to cut rates rather than normalizing rates. To this end, it is noteworthy that the Fed has more room to cut than other central banks, giving more room for relative USD weakness. However, the same factors driving a Fed cut will also drive cuts elsewhere which would have an offsetting impact. This implies mixed, rather than directional, USD performance.
For broad based dollar weakness, growth outside of the US would have to improve, allowing central banks around the world to normalize and converge with the US. Alternatively, should the Fed cut rates to spur inflation (not due to global weakness), the USD could weaken as other central banks are not as likely to follow suit.
Key sign posts to watch include geopolitical tensions, Washington dysfunction (debt ceiling, spending caps) and the evolution of the White House’s currency policy.
The outlook on the JPY has materially changed since our last currency outlook as a risk adverse backdrop supports flows into safe haven assets such as the JPY. On trade, US-China tensions dominate the headlines, and while the G20 meeting between Presidents Trump and Xi were constructive, uncertainty still remains around the actual ability to achieve a deal and the negative drag from already high tariffs remain.
Moreover, US-Japan talks will resume after Japan’s July election. Should the US take issue with the yen’s perceived undervaluation, it would likely additional appreciating pressure on top of the already present safe haven demand. Monetary policy wise, expectations are rising for a BoJ rate cut. However, as is the case with most countries, the US has more policy room to cut, leading to the ironic possibility of upwards pressure on the JPY as both central banks cut due to the same factors.
Mitigating this pressure for further yen appreciation is the continued demand of Japanese investors for foreign assets as returns in Japan remain depressed. While the dovish turn from the Fed has pushed yields down, this move has been seen as a positive for equities and support the view for continued investment outflows.
In our past currency outlooks, we have been negative on the euro as economic data out of the single marketplace continues to disappoint, trade risks (auto tariffs) with the US remain and Italian uncertainty remains in the background.
While all these issues remain, we have shifted to a more neutral stance due to the Fed’s shift towards a dovish stance that raises the possibility of narrower interest rate differentials. We do acknowledge that the ECB has signaled that all easing options are on the table, but also point out that the Fed has more room to cut. Moreover, with Draghi’s tenor ending October 31, there remains questions around his successor’s willingness to cut as well as the overall political support for further easing in Europe.
A smaller interest rate differential should provide support to the undervalued euro as it enhances the EU strong balance of payment position and central bank diversification away from the USD and into euros. However we do reiterate that euro upside is likely capped. The economy in Europe remains challenged and trade concerns with the US continue to be an overhang to the economy. Should additional tariffs be imposed, they should impact the export oriented EU economy more than the US economy.
The GBP has spent most of last month drifting lower. This move reflects the market's reassessment of possible Brexit outcomes. With PM May signaling that her premiership will end on June 7, the focus now shifts to the leadership contest to pick the next leader as his or her Brexit philosophy will determine the way forward.
It is expected that PM May will be replaced by a more hardline Brexiter with the possibility of a second referendum/general election having also risen. Whoever wins is likely to push through a new version of Brexit but critically, the new leader will continue to face the same problems that PM May had—there doesn't appear to be a majority support in Parliament for any single Brexit option. Moreover, the EU parliamentary election results showed a similar split over Brexit options from the general population.
The passage of a Withdrawal Agreement (WA) and a second referendum should both be GBP positive. The impact of a general election remains tricky as it depends who is leading the Conservative party/the polling headed into the election.
Ultimately, it is a very fluid situation and as such it is difficult to identify a clear cut “likely” path. As such headlines bear watching as they could signal the need to revisit the assumption that a no-deal Brexit has indeed been eliminated by a parliamentary majority.
Canada unfortunately finds itself in the middle of trade tensions from both the US-China trade standoff as well as NAFTA/USMCA ratification risk.
Starting with the US-China trade conflict, Bank of Canada (BoC) officials have specifically called out how the tension from this conflict has raised uncertainty with the Canadian economy and suppressed investment in the country, with the impact increasingly negative the longer it drags out.
As for USMCA, the White House has expressed a desire for a quick ratification. While an agreement has been struck on steel and aluminum tariffs, several key Democratic issues remain unresolved. The possibility of a protracted process could prompt Trump to withdrawal from NAFTA 1.0 as leverage for action, as he has threatened to do. Ultimately trade uncertainty, whether stemming from US-China talks or USMCA ratification, continue to weigh on the Canadian economy.
With regards to the domestic economy, the BoC has taken a neutral tone, highlighting improvements in data but also acknowledging the increase in global trade risks. The longer the trade issues discussed above drag out, the more likely the BoC's projected economic rebound in the second half of the year gets put in jeopardy. This could then warrant the markets to begin pricing in the possibility of rate cuts.
The AUD has been slowly grinding lower throughout the year and indications are that this trend should continue.
A slowing economy has driven a dovish pivot from Australia’s central bank, which cut rates by 25 bps at its most recent meeting. Additionally, minutes from that meeting indicated that further rate cuts are “more likely than not”, which should continue to keep the AUD pressured. It is notable that misses on growth and inflation are more significant in Australia than in other DM, which provides scope for the AUD to weaken even if other central banks are also easing.
However, unlike at the beginning of the year, the second half of the year is starting off with a bearish global growth outlook. This refers not only to ongoing trade tensions but also a drop in global PMI readings. As a commodity oriented economy, Australia’s economy tends to underperform during periods where the global economy is weak or the Fed is easing, two scenarios that are possible during the second half of 2019.
Domestically, the housing market remains weak which implies continued weakness in consumer spending. Moreover, the labor market, which has been a source of strength, is flashing signs that labor demand is slow. Taken all together, AUD is likely to remain pressured.
The ebbs and flows of trade war escalation/de-escalation has been the key driving factor for the CNY since our last outlook. While the G20 meeting between Presidents Trump and Xi have gotten talks back on track, the CNY remains pressured as uncertainty remains high. Ultimately, it is not a forgone conclusion that a deal can be reached and high tariffs remain in place.
Near term, rhetoric around trade should continue to dictate the direction of the yuan. The PBoC has taken steps to push against CNY weakness and that has help to keep the currency fairly range bound. However, risks remain that USDCNY could break through the psychological 7 yuan to 1 USD level. Clearly the higher the level of tariffs and the larger the list of goods to which tariffs are applied, the greater the depreciating pressure there will be.
Expect continued currency jawboning around the 7 yuan to 1 USD level as China desires to position the CNY as a reserve currency and wants a stable currency for trade talks. However it remains to be seen how strongly authorities will defend this level. Regardless of this, the probability of disorderly depreciation after a break of 7 yuan to 1 USD is less likely than previous cases. This is due to a couple of factors. Increased capital controls put in place have proven to be effective in keeping outflows curbed and the inclusion of China’s onshore bonds into major indexes have drawn counterbalancing fund inflows.
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