September 03, 2019
The USD index (DXY) set a new YTD high in August despite the Fed delivering its first interest rate cut in over a decade. This, in a nutshell, illustrates what is going on with the USD. While the US economy is slowing, the economy and US interest rates remain relatively better than the rest of the world. This dynamic continues to attract flows that have supported the dollar. As such, the USD is up against 70% of the G10 currencies on a YTD basis despite US yields falling.
The dollar’s resilience underscores that Fed easing, on its own, isn’t sufficient for USD weakness as context matters. Historically speaking, the USD tends to perform better as the percentage of global central banks ease. It is important to note that a broad number of central banks around the world are expected to ease/have started easing. Moreover, communication from the Fed informs us that the central bank is easing due to concerns over negative global growth factors and their possible spillover into the US. In other words, the same factors that drive Fed cuts should also drive cuts elsewhere around the world and underscores that Fed cuts, on their own, are not always USD negative.
As a final point, the risk of unconventional US policy continues to hang over the dollar. While the Fed has reiterated its independence, the frequency and intensity at which the President has criticized the Fed has not let up. While currency intervention is rare and unconventional, the current administration is anything but conventional. This makes intervention a more likely tail risk than it would otherwise be despite little evidence of its effectiveness.
The JPY has appreciated due to safe haven flows as trade tensions have stepped up. While the US stepped back some of the tariffs on China it announced earlier, the escalation in tensions matters more than the delay. Ultimately, total tariffs are now higher and delayed tariffs simply means the negative impacts are just delayed, leaving safe haven assets in demand.
Further biasing the yen towards strength has been the global drop in yields as markets price in further economic headwinds. While Japanese yields have also fallen, and expectations are for the BoJ to cut short term rates further, there is limited scope, relative to other central banks, to fall further due to adverse effects on the financial sector. The BoJ finds itself in a difficult spot. Cutting rates risks further damage to the financial sector and defending its yield curve control policy risks currency strength.
As a result, a global easing cycle could lead to yen strength if Japanese yields are unable to keep pace with the rest of the world. Keep an eye on the absolute move in US yields as an indicator of where USDJPY is headed. On the trade front, while the US and Japan have reached a trade deal in principle, US-China tensions should overshadow this positive development.
The demand for foreign assets remains strong and persistent, pushing against yen strength. Large amounts of Japanese Government bonds are maturing, and investors looking for yield have no choice but to invest these funds overseas, leaving a structural element to yen selling even during periods of market volatility.
Throughout the year, the forecast for the euro has had an upward sloping trajectory. This was an attempt to capture the near term cyclical weakness in the eurozone as well as the structural support the single currency enjoys over the longer term. As a reminder, the euro enjoys the strongest balance of payment position in the G3 as well as cheap valuation relative to the USD.
As we moved throughout the year, the case for near term bearishness has become increasingly clear. Weak economic data continues out of the eurozone. The EU is an export-orientated economy. As such, the EU has been one of the hardest hit areas from the US-China trade war. Germany, the EU’s largest economy, is of particular concern as its Q2 GDP showed contraction with the economy increasingly likely to head towards a recession.
From a positioning point of view, there remains room for further downside. Euro positioning is currently less negative now than was in Draghi’s Jackson Hole speech and the onset of QE in 2015. Admittedly this time around, multiple major central banks are expected to ease, but nevertheless, there remains scope for further euro shorts. In total, weak data, entrenched trade tensions, positioning and ECB easing are all the main drivers of a bearish near term euro view. Beyond the immediate term, the view flattens out as euro positive structural factors play a greater role. However, this is reflected as a range bound euro opposed to an upward sloping path.
The pound outlook finds itself simultaneously simple and complex. It’s simple because it’s all about Brexit. It’s complex because it’s all about Brexit with all options on the table and little visibility as to what is the consensus path.
For us, we still hold the view that the UK will avoid a no-deal exit. However, we acknowledge a relatively high degree of uncertainty around this view due to the increasingly hardline view of PM Johnson toward a no-deal exit. Most recently, PM Johnson has called for a suspension of Parliament (formally called proroguing and running from September 9-October 14) in an effort to minimize time for Parliament to stop a no-deal exit. With Parliament returning September 3, expect a volatile first week of the month.
Clearly, recent actions have made a no-deal outcome a legitimate option. It is this increasing risk/overhang of a no-deal outcome that has pushed the GBP down to around its lowest levels since the Brexit vote. However, there is also building momentum from members of Parliament (MPs) to block the PM’s ability to exit without a deal.
Labour has already indicated that it will take steps to stop a no-deal exit and lawsuits have been filed challenging PM Johnson’s move. Moreover, Speaker of the House Bercow has called PM Johnson’s move to suspend Parliament a “constitutional outrage,” ensuring he will explore all options to allow MPs a say on the government’s timeline. In short, Parliament’s ability to stop a hard exit has been impacted but still remains intact. As such we still believe MPs will ultimately be able to prevent a no-deal exit if so desired.
With PM Johnson expected to stick with his current stance, expect the GBP to move lower as odds of a no-deal exit increase with the approaching deadline. Notably, the bias for a weaker GBP is driven by no-deal Brexit concerns with increasingly bearish economic factors taking a backseat. However, as noted above, uncertainty is high, leaving the GBP vulnerable to sharp swings on changing sentiment.
In our past currency outlook we envisioned near term strength, due to better economic data and an on-hold BoC, that would eventually lead to longer term weakness as the BoC cuts due to a slowing domestic economy as well as to keep pace with the Fed.
With the benefit of hindsight, we continue to see a fading of economic activity as Q2 GDP was driven by temporary factors. However, the call for near term resilience has been undercut by a spike up in trade tensions which has strengthened the USD as well as hit commodity prices/global growth prospects. However, it should be noted the CAD still outperformed half of the G10 currencies over the past month.
Trade wise, the US’s focus on China has pushed USMCA ratifications onto the backburner. While it is highly unlikely that ratification will happen ahead of next year’s election, the risk of a high stakes showdown in Congress has also dropped.
Looking forward, the BoC’s rate path, especially relative to the Fed’s, will likely be one of the biggest variables. Over the past month, markets have priced in increased cuts, but the BoC remains one of the central banks with the most uncertainty. Beyond the solid, albeit temporary, domestic data, Canadian rates have never fully normalized, so technically, conditions remain accommodative. As such, the BoC could be less compelled to cut rates on the margin. Markets still expect BoC cuts, despite strong domestic data, because the BoC will need to follow the Fed to maintain monetary conditions.
Assuming that a global recession is avoided and global growth continues to muddle through, it is likely the Fed and BoC deliver broadly parallel cuts that will keep the CAD range bound.
We have held a bias for AUD weakness, and that outlook has been reinforced by the re-escalation of trade tensions even with the RBA looking to pause its rate cutting cycle over the next couple months. While the RBA has increased the bar required for further easing by indicating the need for “additional evidence” to support a cut, an easing bias remains. It will likely take a particularly weak GDP print for an October cut, otherwise November remains in focus.
Prior instances of trade tariff escalation were followed by downgrades in global growth, and there is no reason to expect any other response to the latest actions. Given the AUD’s exposure to global trade and commodity prices, this setup sets the stage for further weakness. Commodity prices have pulled back as illustrated by the sharp fall in iron ore prices, which is a key export for the Australian economy. Any weakness in the global environment only exacerbates the domestic economic picture. The Australian economy has stabilized, partly due to RBA action, but desired wage growth remains elusive and inflation remains weak. When the domestic picture is combined with a weakening global picture, further RBA cuts are reasonably expected.
However, we acknowledge that the markets have priced in high expectations for the RBA with nearly 40 bps of easing priced in through the end of this year. With the RBA showing a desire to pause and monitor data flow in order to assess the impact of interest rate cuts and fiscal stimulus, the possibility for central bank disappointment remains material. As such, it is possible that the AUD could benefit from rate cut expectations adjustments should the RBA disappoint markets. It should be noted that market pricing of the Fed cuts are also aggressive with any Fed disappointment bearish for the AUD.
The yuan finally broke through the psychologically important 7 yuan to 1 USD level this month. While the US’s surprise decision to implement additional tariffs sparked the move, the PBoC’s decision not to push as forcefully against depreciation, as in the past, gave markets the greenlight to move higher. Likely, this was a decision on China’s part to use currency depreciation to buffer the negative effects of tariffs amid a worsening domestic economic backdrop. While the US ultimately walked back some of the tariffs, our baseline case of elevated trade tensions and bias for CNY depreciation pressure remains for the following reasons:
The latest round of re-escalation makes it more difficult to reach a deal as it erodes trust and entrenches both sides. China sees this latest escalation as a violation of the agreement the two Presidents reached and the US feels China hasn’t lived up to its commitment to increase agricultural purchases. Moreover, the currency manipulator designation on China opens the door for the US to apply broader tariffs.
Secondly, despite the delay, overall tariff rates went up on September 1. Furthermore, tariffs have been delayed, not cancelled. This means the negative impact on growth from these moves have simply been delayed, not eliminated. Growth has taken a hit after every other tariff escalation, and there is no reason to think this won’t happen again, implying a weaker CNY. Finally, the PBoC has let the yuan move above 7. Without the need to defend this level, the PBoC will likely be more tolerant of further CNY weakness. However, it is important to remember that the PBoC still desires currency stability. As such, RMB depreciation is expected to remain a gradual process with occasional jumps when tariff increases are confirmed or escalated.
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