May 01, 2019
The USD spent the last month broadly range trading with a measure of USD volatility at a five year low. Looking ahead, we expect this trend to continue in the near term as the factors suppressing the USD’s movement remain in place. While there are several factors compressing the USD’s range, mostly related to offsetting forces around global growth, the three key ones are as follows.
As a final note, politics and trade policy remain noisy. Many headlines hint at a near term resolution of U.S.-China trade tensions but this remains elusive. Assuming the U.S. and China trade talks resolve, U.S. trade policy aggression can still impact markets through talks with the EU, Canada, Mexico and Japan. As a result, while we see scope for USD weakness by the end of the year, near term, the USD is likely to remain supported.
Even since the Bank of Japan initiated its policy to hold Japanese yields around zero, U.S. yields have been a key driver for USDJPY. However, this relationship has been weakened due to consistent and strong demand from Japanese investors for foreign assets that have weakened the JPY despite a fall in U.S. yields.
During the first quarter of 2019, Japanese investors purchased more foreign bonds than they did during the same period in 2016 and 2017 combined. Moreover, Japanese foreign direct investment over the first two months of 2019 was roughly half of last year’s annual total.
Looking forward, this trend is likely to continue as capital outflows are structural as well as opportunistic. Ever since the BoJ started its negative interest rate policy, bond returns in Japan have become unattractive. As a result, Japanese investors are forced to invest maturing bonds as well as excess cash elsewhere in search of yield.
Risks to the view of a weaker JPY manifests itself through thin liquidity during Japan’s Golden Week at the beginning of May and U.S.-Japan trade talks. Trade talks with the U.S. officially kicked off on April 15 with the two countries far apart. While the U.S. and Japan have agreed to table auto tariffs (auto makes up 70% of Japan’s trade surplus) as long as talks are ongoing, the risk of the U.S. criticizing the JPY’s undervaluation remain. Reducing trade deficit and winning market access for U.S. agricultural products appear to be the U.S.’s top priorities. A deal with Japan purchasing more agricultural products is more likely than a deal with “voluntary” auto quotas like in the 80s.
We maintain our forecast for a weaker AUD through the end of the year. We do acknowledge the AUD’s run up over the past month due to positive developments to the Chinese economy and expectations for a near term resolution to U.S.-China trade talks. While these factors are supportive for growth and sentiment, it is important to recognize the limited upside these two factors would have on the Australian economy. Presumably, any trade deal between the U.S. and China would include steps to reduce the bilateral trade deficit, raising the possibility that China shifts commodity purchases from Australia to the U.S.
Domestic factors also present a headwind for the AUD. Falling housing prices have thrown uncertainty around the consumer consumption picture and forward labor market indicators are signaling a slowdown in labor demand. This uncertain domestic picture provides the backdrop for the RBA’s progressively dovish policy stance, a narrative supported by the most recent soft inflation print. To this end, the RBA discussed scenarios under which it could cut rates at its more recent meeting, adding another layer to previous central bank communication that formally moved the bank towards an easing bias.
As a final point, Australia will hold its election on May 18. Polling has consistently showed support for the opposition party, making a change in power the expected outcome. While the AUD has historically rallied post-election, any rally is likely capped by some of the opposition party’s policies that are seen as less market friendly.
The euro finds itself roughly in the same place where it was about 6 months ago with EURUSD volatility and price range around their all-time low. While we still hold the view for mild appreciation in the euro by the end of the year, the offsetting forces that have left the euro range bound are likely to remain in place in the near term.
One of the key reasons why the euro has remained flat has been the combination of slowing U.S. growth combined with an unconvincing Eurozone recovery. In essence, the U.S. growth isn’t strong enough to push an expensive dollar higher and European growth, while showing signs of stabilizing, is still unconvincing with soft manufacturing data countering rebounding services data.
This push/pull dynamic also appears in monetary policy. While the Fed is clearly dovish, the ECB has committed itself to another round of easing and is evaluating the use of tiered deposit rates, which allows the ECB additional optionality to further lower deposit rates.
Finally, the conflicting flow dynamics have worked to keep EURUSD price action muted. On a valuation basis, the euro is undervalued and the USD is overvalued. Because the USD has an interest rate advantage, it has attracted short term flow from the euro. Conversely, longer term investors (central banks) are most sensitive to valuation and have been buying euros and selling USD. These flows into the euro are made even more supportive against the backdrop of the EU’s strong current account position. It is the favorable balance of payment position that provides scope for medium term euro appreciation despite the headwinds the euro is currently facing.
Like the EUR, the CAD has been range bound over the past month as the economic surprises and disappointments have largely offset each other. To this point, the recent strong monthly GDP data came on the back of a string of disappointing prints leaving an overall picture of subdued activity.
However, unlike the EUR, the USDCAD looks poised to break out of its range to the upside (weaken). BoC has taken a more dovish stance by dropping its mild rate tightening bias as there appears to be increased slack in the economy and continued uncertainty around housing and consumptions.
Monetary policy aside, the key driver for the CAD is likely to be the ratification process around USMCA, a process that will likely be a contentious one, including the possibility that the President threatens to pull out of NAFTA all together. Discord in Washington D.C. remains high and the President’s desire to swiftly ratify USMCA, with reminders that he is willing to withdrawal from NAFTA, stands in stark contrast with what Democrats desire.
Namely, the Democrats have concerns around labor and enforcement issues and have expressed a desire to reopen negotiations, something the Canadians have drawn a redline line against. As a final point, the steel and aluminum tariffs that are currently in place still remain unresolved. Republican Senators and Canada have indicated that these need to be removed for ratification. All of this leads to bias for downside risk to the CAD as a risk premium around USMCA ratification gets priced in and uncertainty keeps monetary policy biased to dovish.
Year to date, the Chinese yuan has been one of the best performing Asian currencies. Positive developments on trade talks with the U.S. have improved sentiment around the yuan. However over the past month the CNY has been fairly range bound as trade talks with the U.S. have failed to make further progress. As long as talks continue with the U.S., it is reasonable to expect Chinese authorities to keep the CNY stable. To this end, there is evidence the PBoC has been fine tuning its fixing rate to promote stability.
Beyond trade talks, economic data is starting to show signs of improvement as stimulus from Chinese officials appear to have gained traction. Notably, Chinese authorities have warned against the expectation for “flood like” stimulus. Should growth stabilization be confirmed and should the U.S. and China reach a trade deal, it’s likely that Chinese stimulus will be turned down. Given this, near term accommodative conditions are expected to continue, and as such, the domestic economy should remain supported with growth likely to rebound in Q2/Q3 this year and the CNY remaining fairly stable.
Three years of Brexit uncertainty apparently wasn’t enough for the U.K. and the EU as the deadline has been extended, again, until October 31, 2019. Beyond this, everything else is pretty much unknown. The extension does nothing to close the impasse between the two sides. With the government unable to secure support for its deal and Parliament unable to find majority support for an alternative plan, it is likely markets can find itself in the same place come October. Notably, PM May’s surprise move to reach across the aisle to Labour has not yielded any progress.
Looking forward, the GBP’s outlook remains cloudy with the currency’s low volatility a reflection of the markets confusion over the ultimate resolution to Brexit and not fundamental stability. With a 6 month extension, multiple political permutations—leadership change, government change etc.—are possible. As such, recent price action also reflects this uncertainty. Prior to the most recent extension, the GBP appreciated as the markets nearly eliminated all GBP shorts as they fully embraced the narrative of a softer Brexit. However, the GBP has subsequently been slipping lower as a deeply divided Parliament throws this assumption into question.
We still look for an orderly Brexit, but there is a high degree of uncertainty along the timing and path to this outcome. Certainly, it is reasonable to believe that an orderly exit would lead to a higher GBP as the market removes some of its Brexit risk premium. However, gains should be capped as an orderly Brexit still implies more damage to the U.K. economy relative to a no Brexit.
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