Prime Minister Theresa May triggered Article 50 last week, officially starting the clock on the U.K.’s two year window to negotiate its exit from the EU. With negotiations beginning, GBP movement should take its cues from whether the markets view negotiations as going toward a “hard” or “soft” Brexit.
When triggering Article 50, Prime Minister May launched a bit of a charm offensive by calling for both sides to negotiate “constructively and respectfully.” Additionally, Prime Minister May indicated that the U.K. was not withdrawing from Europe and wished that the EU would “succeed and prosper.” Unfortunately for the U.K., EU unity is at stake. With anti-EU factions ready to pounce on any British gains from its EU departure, it is hard to imagine EU negotiators being anything but tough with negotiations.
The reality is that the two year timeline is an exceedingly short window to negotiate such a complex divorce but was set at this length on purpose to give the EU an advantage in negotiations and deter members from leaving. Given that negotiations of this complexity normally take longer than two years as well as the fact that both the U.K. and EU have indicated that no deal is better than a bad deal, the prospect of failed negotiations is real. However, before talks start, the EU insists the Brexit exit bill be paid, setting the stage for the first point of contention.
We hold the view that the AUD should weaken throughout 2017 on narrowing U.S./Australian rate differentials and a bearish outlook on commodity prices. Specifically, we see the narrowing rate differential driven by both rate tightening in the U.S. as well as the possibility for further easing in Australia.
Notably, the RBA’s minutes from its March meeting addressed a build-up of risks associated with the housing market as well as flagged the labor market as not being as strong as headline numbers would indicate, and of course, inflation remains low. On the commodity front, there have been some upward revisions to Chinese growth but an argument can still be made for a bearish outlook. Specifically, iron ore prices should come under pressure as additional supply comes online from higher cost suppliers.
Finally, Australia is an economy dependent on global trade and would be adversely affected should global trade tension rise, causing the markets to price in a higher risk premium. The tone and results of the bilateral summit between President Trump and Chinese leader Xi Jinping in April will be key.
With the Dutch elections delivering a defeat to the far right party and the French elections looking increasingly likely to deliver a defeat for Marine Le Pen, European populism fears that have driven euro weakness have subsided, pushing the euro higher.
Moving forward, we see two keys for determining euro direction 1) the timing and magnitude of U.S. fiscal stimulus and 2) the improved European economic outlook. On the U.S. front, the U.S. government’s inability to pass healthcare reform raises questions on the government’s ability to pass pro-growth fiscal measures. Notably, the Freedom Caucus, who voted down the healthcare bill, is also against the border adjustment tax.
This implies that not only is the passage of tax reform in question, but the magnitude of any passed reform also has a real danger of underwhelming. Any delay or reduction in fiscal stimulus implies a stronger euro. On the European front, economic progress is building. If we get past the French election, with a mainstream candidate victory, and if economic strength continues (EZ inflation at 1.5% after touching 2%), the prospect of a less dovish ECB becomes more of a reality and also implies euro strength.
The Bank of Japan (BoJ) continues to maintain its commitment to its “QQE with yield curve control” in which the BoJ maintains a 10-year Japanese Government Bond yield of ~0%. With the BoJ holding Japanese yields static, U.S. yields should play a key role in determining the path for the yen.
It was the change in U.S. yields that drove our reassessment of USDJPY levels. After the Republicans were unable to hold a vote on their efforts to repeal and replace Obamacare, doubts have been raised about their ability to pass meaningful tax reform and infrastructure spending. Given the uncertainty surrounding these key reflation trade elements, U.S. rates and the JPY have pulled back.
Notably, the correlation between USDJPY and U.S.-Japan yield spreads has declined materially, so even as U.S. rates rise according to Fed guidance, the impact would be muted compared to immediately post the U.S. elections. Finally, the possibility of political risks could also weigh on the yen. The U.S.’s trade deficit with Japan was the 2nd largest among trade partners, so it is likely that trade, and exchange rates, will be discussed at the U.S.-Japan bilateral economic dialogue scheduled to start in mid-April. If this happens, concerns on U.S. protectionism could rise again.
The Bank of Canada (BoC) meets again April 12th. The central bank has emphasized that, unlike the U.S., Canada has an economy that is characterized by excess economic slack; therefore, an accommodative monetary policy is appropriate.
Recently, we have had some strong Canadian economic data, but most likely, the BoC’s downside risk concerns and desire for Canadian rates to not be dragged higher by rising U.S. rates will persist. To reiterate this point, Governor Poloz recently stated that even if Canada grows faster than the U.S., Canada will still have a larger output gap.
Outside of monetary policy, oil prices have weighed on the CAD with crude prices sliding by over 5% over the last month. Looking forward, trade tensions still linger. Focus has shifted away from NAFTA negotiations, and the Trump administration has signaled a softer stance on NAFTA. However, risks still remain around the renegotiation of NAFTA which could lead to trade disruption with two of Canada’s largest trading partners.
Uncertainty surrounding how U.S. policy evolves remains a risk factor with the CAD being one of the currencies most vulnerable to a U.S. border adjustment tax should on there be an unexpected rally in support for this Republican proposal.
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