For the last couple of months, the USD (DXY index) has been consolidating after a long period of declines. Moving forward, we see risks for this USD consolidation to continue in the near term, and this is especially true given the most recent Fed rate decision; the Fed raised rates and moved up its dot plots for 2019 and 2020 which could lead to an improved outlook for the USD. However, over the medium to long term, we maintain our bias for the USD to weaken as reflected by the Fed's inability to materially raise its long term outlook.
The key driver behind our soft dollar view revolves around our continued belief that the synchronized global growth trend will continue. If this trend continues, as we believe, it should help the central banks around the world initiate and follow through on policy normalization which in turn leads to a convergence of monetary policy.
To this point, it is important to note that the US economy is characterized by late cycle growth and rate hikes versus the majority of G10 economies that are in early cycle policy normalization stages. This difference in policy normalization stages results in a difference in market reactions and reduces the support the USD should expect to receive from future Fed hikes--currencies tend to strengthen heading into hiking cycles and weaken during the late stages of these cycles.
With regards to tariffs and trade wars, risks and uncertainty remain elevated especially in light of the aluminum, steel, and Chinese specific tariffs recently announced. On their own, the actions taken aren't material but the true risks lie with escalation and retaliation. However, we currently see a full trade war as a low probability event with non-USD reserve assets such as the JPY, CHF, EUR and gold benefiting should a trade war be realized.
Beyond this, Washington uncertainty via the Mueller investigations, risks for a midterm swing towards the Democrats in the House and further turnover in Trump's cabinet all remain present and remain supportive of a USD discount.
Towards the end of 2017, City National FX published a Year Ahead report that anticipated a higher euro based on an improving European economic situation as well as an unwinding of the ECB's unconventional monetary policies. As we move into the second quarter of the year, our view for a steadily increasing euro based on an improving economy and eventual policy pivot from the ECB remains intact.
As a reminder, the euro area GDP has outgrown the US for the past two years and is set to continue this outperformance. This eurozone outperformance, combined with strong investment inflows and a strong current account surplus, creates a solid base from which the euro can push higher and has caused some in the markets to pull forward expectations for the end of QE as well as the ECB's first rate hike.
From a valuation perspective, we acknowledge that short term interest rate differentials may be signaling a euro overshoot. However, it is important to point out that this measure needs to be looked at in the context of monetary policy, i.e. the potential exit from QE. Keep in mind that in 2015, when the ECB entered into QE, the exchange rate undershot interest rate fair value by over 15%, suggesting that the current ~6% overshoot isn't an insurmountable valuation. To this end, the euro has proved to be resilient in the face of a disruptive result from the Italian elections that concluded with non-mainstream parties holding a slight majority in the senate.
However, in the near term, it is possible that we may continue with a period of euro consolidation as some short term economic measures (ex. the economic surprise index) have pulled back from multiyear highs to multiyear lows. Additionally, the ECB speak has pulled back on the market's momentum for policy change. But net on net, we do not view these factors as a changing of the tide but simply an indication that consolidation may continue in the near term before the euro ultimately moves higher.
On a trade weighted basis, the GBP has been stuck in a period of inertia. This lack of movement certainly isn't reflective of a lack of drivers (growth has waned, policy expectations have dropped, and Brexit still remains elusive) but is rather reflective of the market's difficulty determining direction given the multiple dimensions to Brexit and how it interfaces with unstable UK politics.
With regards to economics, the UK economy has lost momentum with GDP numbers being revised down. While this slowdown isn't unique to the UK, it has caused the market to shorten and flatten out its projected Bank of England (BoE) rate path. Moreover, we want to reiterate that the current hiking cycle is materially different from normal hiking cycles due to Brexit and high inflation paired with weak growth. As a result, the GBP is not expected to receive the same 7-8% appreciation associated with normal tightening cycles. This point becomes especially poignant given minutes from the latest BoE which saw two hawkish dissenters, setting the narrative for a rate hike at its next meeting in May.
Beyond monetary policy issues, the UK's external position remains weak as it has the worst financing position in the G10. The UK's issues extend beyond a significant current account surplus as Brexit uncertainty has caused a collapse in long-term capital flows into the UK. This has forced the UK into having the highest dependency on short-term flows of any G10 country, increasing financial uncertainty.
Finally, there is the great overhang that is Brexit. Despite indications of positive developments with negotiations, the overall Brexit outlook remains very much unclear as many sensitive and substantial issues remain unresolved, i.e. the Irish border issue. An apparent swing in the UK parliament towards opposing a Brexit that removes the UK from the customs union has added support to the GBP but also adds to the uncertainty of what the UK wants post Brexit.
In last month's outlook, we identified the pace of Bank of Canada (BoC) normalization and NAFTA negotiation risks as two key themes which would drive the CAD, and we continue to hold that view.
With regards to the BoC and its normalization path, the risk for a more dovish BoC has been realized. One of the more visible sources for BoC dovishness has been uncertainty surrounding NAFTA negotiations. Evidence of this can be seen in recent BoC communications that have emphasized the downside uncertainties associated with US trade policy developments.
On its own, NAFTA negotiations have been making slow but steady progress, with signals of good faith suggesting a reduced risk of a full crash out of the trilateral trade deal. However, these signs of progress have been overshadowed by other aspects of the Trump administration's trade policies, including the implementation of tariffs that has put a negative overhang on negotiations.
However, the BoC's dovish turn extends beyond trade negotiations. There appears to be building concerns over a drop in investments due to a lack of competiveness as US tax reform may divert investments otherwise headed to Canada. Additionally, a recent speech from BoC Gov. Poloz has resurrected the possibility of running a “high pressure economy" to nurture capacity which suggests the BoC will be more tolerant of inflation pressures; as a result, this would put the BoC on a more dovish normalization path relative to the Fed.
In total, a dovish BoC and uncertainty surrounding US trade policy developments justify a near-term view for CAD weakness. However, longer term, once trade uncertainty dissipates, it is reasonable to expect CAD strengthening via BoC rate hikes especially with the Canadian economy currently operating at full employment.
On a year to date basis, the JPY has been the top performing currency. This appreciation was most likely driven by the following three factors that accelerated the JPY's appreciation.
The first factor would be the uptick in stock market volatility. This was followed up by a market that was more sensitive than expected to hints that the BoJ could take a hawkish turn with its monetary policy. Lastly, there was the increase in US protectionisms (see the USD section). While risk factors are well known, this creates a type of JPY appreciation synergy as they all come at once during the end of the fiscal year (in Japan the government's fiscal year ends March 31st) when USDJPY has a tendency to appreciate.
Adding to this perfect storm has been Japanese political uncertainty via a land sale to a school with ties to PM Abe as well as the Japanese Minister of Finance admitting to altering documents relating to the land sale above. All of this increases uncertainty around PM Abe's ability to win a third presidency for his Liberal Democrat Party (LDP) in September and as a follow on, the future of Abenomics.
Given this, there are reasons to believe the JPY will weaken in the near term. As discussed above, inflows prior to the end of the fiscal year should turn to outflows at the start of the new fiscal year. Evidence of this can be seen via the strong demand for foreign investments over the past 2 plus years. Moreover, with short term US rates higher, FX hedging cost have risen making it more likely that these investment outflows could be done unhedged, further adding to JPY weakness.
Additionally, looking at the JPY's historical performance in April confirms our thesis. Over the past 10 years, the JPY has depreciated in the month of April the vast majority of the time. This is especially true if we see concerns over US protectionism and Japanese politics abate over the next couple of months and continued global growth supporting higher yields abroad that create an even more favorable environment for Japanese investors to invest overseas.
Not much has changed our AUD outlook since last month. As outlined in our past commentary, monetary policy divergence between the Reserve Bank of Australia (RBA) and the rest of the G10 should be the main driver of the currency as the RBA is expected to be on hold for most, if not all, of 2018.
Our belief that the RBA will remain on hold for the foreseeable future was reinforced when an RBA official noted that “…our circumstances are a little different. We are still some way from what could be considered full employment and our central scenario for inflation is for it to remain below the midpoint of the medium term target for the next couple of years." Additionally, in its March statement, the RBA softened its tone on domestic growth. This is all to say that the AUD is unlikely to see any support from a monetary policy perspective in the near term. To wit, there is now a negative policy rate spread between the US and Australia.
While we have confidence in the future direction of the AUD, there remains uncertainty around the timing of the move. The Australian economy is greatly influenced by the Chinese economy, and with Chinese growth solid, the pace of the AUD's decline may be initially slow. However, we would like to note that if market volatility increases with a rise in global rates, market participants are likely to reconsider their carry preferences.
The Chinese yuan has been in a broad consolidation trend over the past few months but has appreciated markedly over the past year. From a fundamental point of view, this appreciation has been driven by robust economic performance and current account stability after a period of turmoil in 2015/16. Looking forward, there aren't any indications that this momentum is turning.
Moreover, Chinese bonds are expected to remain an attractive diversification option for global investors. If anything, the appeal for Chinese bonds should increase with their inclusion in a major global bond index for the first time.
The wildcard to all this are the trade tensions that have recently been ramped up. However, as mentioned in other commentaries, trade actions taken so far (i.e. tariffs) appear to be more of a negotiation move than progression towards an actual trade war. Given this, we would still like to point out that emerging market currencies (including the CNY) tend to appreciate over the medium term as part of the resolution to lower trade tensions.
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