It’s been a tough month for the USD as domestic and international factors have worked to pressure the USD lower via a change in relative fundamentals.
On the international front, a hawkish shift among G10 central banks has driven a repricing of expected US vs. global interest rate differentials. Specifically, the Bank of Canada (BoC) and the European Central Bank (ECB) stand out as central banks for which interest rate divergences, relative to the US, could evolve differently than the market has previously expected. Previously, it was expected that the Fed would be more active than the ECB in preparing the markets for tapering. However, now, an argument can be made that the Fed has shifted to a noncommittal stance while the ECB has taken the more active taper preparation role. As for Canada, economic data and BoC comments have shifted the bias from “on hold” to hawkish.
On the domestic front, politics—Russian investigation, Trumponomics—have complicated the dollar’s outlook with the bias now towards a lower dollar as the Russian probe doesn’t appear to be going away anytime soon. Moreover, the Fed has been noncommittal with regards to balance sheet normalization, and Congress is struggling with healthcare, pushing tax reform and infrastructure spending. Without material pro-growth policies, it is becoming increasingly difficult to build a case for dollar strength as political risk factors should keep the dollar pressured.
The euro has continued to rally despite the most recent dovish rate decision as the market continues to believe that an ECB tapering may be in the cards. As it stands, the market is looking towards autumn (possibly at the September meeting) for an announcement on the ECB’s tapering plans.
Adding to support for the euro has been the recent rise in developed market rates due to the Fed’s noncommittal approach towards balance sheet normalization. Given that the market is pricing in a more active ECB tapering function than previously expected, we have modestly raised our 3-month target. However, we want to note that the market is fairly well positioned for an ECB taper as evidenced by significantly long euro positions and stretched euro valuations versus interest rates. Positioning, valuations and the negative feedback loop between a stronger euro and lower ECB inflation forecasts should combine to put a cap on how much stronger the euro can move in the near term. On the flipside, continued political turmoil in the US makes the case for continued euro strength.
Moreover, inflows into European equity ETFs, which hit their highest level in two years after the French election, appear to be slowing as European equity valuations are no longer seen as cheap as before. Additionally, signs are beginning to emerge that European earnings are not growing as robustly as US earnings, which should imply a slowdown in capital inflows and lead to lower euro demand moving forward. However, the prevalence of unconventional monetary policy has put the world in unchartered waters and has resulted in the breakdown of previously consistent relationships so the impact due to the end of QE could overshadow inflow changes.
With regards to European politics, developments in Italian politics have slowly started to turn euro-supportive. Recent polling has shown support for Euroskeptic parties, especially for the Five Star Movement, falling towards 12 month lows. Moreover, messaging from the Five Star Movement indicates that a euro referendum is no longer a priority, which is clearly euro positive. Keep an eye on economic growth, politics and inflation.
The GBP has evolved into one of the trickiest currencies to forecast as it is tied to a variety of variables, all of which have uncertain outlooks. Clearly, politics have been the dominant driver of the currency over the past year with the umbrella issue of Brexit uncertainty being further muddied by an indecisive snap election result that has implications on both Brexit as well as fiscal and, potentially, monetary policy.
Conversely, over the last month or so, monetary policy has been the dominant driver with the Bank of England (BoE) delivering a more hawkish than expected hold as 3 of the 8 Monetary Policy Committee (MPC) members voted to hike rates in June, an increase of 1 vote relative to the prior meeting. However, we don’t believe the market’s hawkish take on the BoE’s rate decision as straightforwardly hawkish for the following reasons:
Firstly, June was the last meeting for Kristin Forbes, who voted for a hike, and the replacement member is unlikely to vote against the Governor and the majority. Secondly, there is uncertainty surrounding the BoE’s reaction function. It’s not simply higher inflation equals higher rates as concerns from the Brexit overhang keeps the bias for accommodative policy in anticipation of economic weakness. The corollary to this is the recent softness in economic data that supports the expectations for future economic headwinds as well as a continuation of monetary accommodation. Net on net, for the possibility for rate hikes to be credible, we feel that the MPC will need to see growth accelerating, not just inflation.
Politically speaking, the Conservatives were able to strike a deal to form a minority government, but questions still remain around the prime minister’s authority and longevity of the current government. Given this, an argument can be made that a weak government is actually positive for the GBP to the extent that it results in concessions from the Conservative’s “hard” Brexit stance towards a “soft” Brexit. To this point, it has been reported that even the strongest supporters of Brexit within the prime minister’s cabinet are pivoting towards favoring a transitional post-Brexit deal. Ultimately, we retain our bias for a GBP weakness due to Brexit concerns and the resulting drag on the economy.
Last month, we touched on how the Bank of Canada’s (BoC) hawkish policy shift shook the market. The BoC pivoted from a dovish stance of prolonged concern over labor market slack, soft inflation, and export underperformance to a hawkish one in which the BoC raised rates for the first time since 2010. Moreover, the CAD’s correlation with oil has diminished as interest rates are playing a bigger role.
The BoC appears to be signaling the start of a full tightening cycle; Canada has now moved to the front of the line in what appears to be a global shift towards rate normalization. However, it is important to note that inflation remains under target and labor market slack does remain. Therefore, the hawkish narrative out of Canada is more due to signaled policy intentions than realized economic performance. Signaling has been able to move the CAD because of the BoC’s strong belief that inflation is undershooting due to temporary factors, conviction that the output gap will close as forecasted and belief that the closed output gap will drive inflation. Given this, it warrants mentioning again that inflation has persistently been below target, and if it doesn’t pick up as expected, all bets are off.
Looking forward, an argument could be made that the CAD is looking a bit stretched against the USD under the assumption that underlying inflation dynamics between the two countries are similar. This is evidenced by the fact that core inflation in both countries is ~1.4% but the market is pricing in more rate hikes, in Canada than the US, through the end of this year implying an adjustment as one of the sides converges towards the other.
Keep an eye on the BoC, inflation data, OPEC (oil prices) and US trade policy (NAFTA renegotiations). Uncertainty comes in the form of NAFTA renegotiations, which are set to begin mid-August, and should touch on a wide range of issues including the possibility for the addition of a currency manipulation provision.
Given the Bank of Japan’s (BoJ) continued commitment to accommodative monetary policy, including holding its 10-year yield near 0.0%, we continue to see US rates as a key determining factor. To this point, the JPY has remained relatively flat in the month of July as the US/Japanese 10-year yield spread has also remained relatively constant.
In addition to US rates, the possibility of political elements playing a role in the exchange rate still remains. The North Korean situation has deteriorated, and while it could be argued that this hasn’t heightened investor risk aversion, this could quickly change. Moreover, political uncertainty in Japan has risen with PM Abe’s Liberal Democratic Party suffering a historic defeat in the Tokyo Metropolitan Assembly Election at the start of July as well as a sharp drop off in PM Abe’s own approval rating.
With the BoJ still far away from achieving its inflation target, easy money policies are expected to persist for the time being, so we defer back to the US where stronger/weaker growth leads to a weaker/stronger yen via an aggressive/conservative Fed rate hike path. Also, keep an eye on geopolitical factors, such as North Korea, that could impact the market’s risk appetite.
The AUD rallied up to multiyear highs this past month due to the improvement in economic data and sentiment out of China, as well as a run of positive domestic economic data. While it appears that the stronger currency isn’t yet a concern to the Reserve Bank of Australia (RBA), a stronger currency does push down inflation, which would raise the hurdle needed for the RBA to turn hawkish.
To this end, the RBA made a concerted effort to create distance between itself and other more hawkish central banks, both through its most recent statement as well as verbally pushing back on the market’s hawkish narrative. As a result, we ultimately think that the AUD will decline on shrinking rate differentials as we move forward. However, we do acknowledge that the factors supporting the AUD are likely to persist in the near term.
The caveat to all of this is the market’s conviction and pace for Fed rate hikes as political turmoil and pro-growth policies remain stuck in Congress. Additionally, Fed officials have signaled a preference for balance sheet normalization and wage and inflation data has softened, meaning the case for rate hikes has weakened, implying a slower rate of decline in the interest rate differential. Keep an eye on Australian inflation data and the Chinese property investment data.
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