At the start of the year, our baseline assumption was for synchronized global growth that would lead to a weaker USD. The main rationale was that that strong global growth would allow other central banks to begin early cycle rate normalization versus late cycle normalization. As early cycle hikes strengthen a currency more than late cycle hikes, the USD should continue on its weakening trend.
Through April this year, the USD did weaken but subsequently, the USD has been on a tear as fiscal stimulus provided a tailwind for the US economy and European data unexpectedly weakened. Helping to accelerate the USD move has been an unwinding of extreme USD shorts as the markets had been positioned for further USD weakness. Looking forward, the main drivers of the USD are whether or not US data exceptionalism can continue, whether or not synchronized global growth can get back on track and whether or not trade conflicts accelerate and how much the FX markets price this in.
While the US economy has been performing well, it should also be noted that European data has recovered and supports QE tapering and hikes in 2019, justifying the expectation for synchronized global growth. If the rest of the world continues to recover and perform as expected, positioning and the factors that drove USD weakness last year/early this year could reassert themselves. Specifically, this refers to concerns over the longevity of the current US expansion cycle, the quality of US growth and its twin deficits as well as US political and policy risk. As such, our baseline view remains for slight USD weakness through the end of the year.
The challenges to the view of USD weakness are as follows. While data around the world has recovered, an escalation in trade tensions could undermined global confidence and stunt this recovery. We see this manifesting itself in weakening business sentiment across Europe. Beyond depressing economic sentiment around the world, trade tensions have proven to be USD positive as US growth remains strong relative to the rest of the world. While USD shorts have materially unwound, there is certainly room to go positive. A second threat comes from the impact of US’s domestic policies. When tax reform was passed, some in the markets interpreted its impact as a short term boost and not a structural change (i.e. boost in capex, increase in labor force participation) to the economy that would worsen the fiscal and current account outlook. However, strong Q2 growth is evidence that the administration’s policies are working and could be more positive than initially thought.
Trade war fears, soft Eurozone economic data and cyclical US outperformance have all combined to weaken the euro and strengthen the USD since the start of the year, however these factors appear to be easing. Soft economic data in Q1 has rebounded in Q2, with European economic data releases coming in generally on par with US data for the first time since the start of 2018. Additionally, political risks have faded with German Chancellor Merkel surviving her latest immigrant crisis and the Italian coalition government showing signs of moderation on its fiscal policies.
Our cautiously bullish view on the euro stems from our baseline assumption for a continuation of synchronized global growth. The resumption of above trend economic growth supports the ECB’s ability to end its QE program this year. Additionally, recent comments from ECB officials indicate that not all members are comfortable with the ECB’s calendar based guidance, so it is entirely possible for the ECB’s messaging to become progressively more hawkish as the economic recovery becomes more resilient.
Moreover, the Eurozone’s current account surplus should insulate the currency somewhat from an escalation in trade risks as markets could see the currency as a safe haven. However the euro has certainly been affected by trade concerns, as an escalation in trade conflicts remain a key risk. This is especially true given the potential for the White House to turn its attention towards European cars.
Beyond economic factors, the euro continues to be weighed down by concerns over politics despite the current moderation. Italy remains a sticking point and without further clarity over Italian fiscal policy the euro should struggle materially higher. The Italian government’s budget is scheduled to be released in September and the markets will be watching for the impact on credit ratings. Italy needs to maintain an investment grade rating from at least one of the four main agencies for Italy to be able to access the ECB’s refinancing system. Currently all four agencies have Italy two rungs above the threshold.
Ultimately we continue to believe that the populist government in Italy will avoid a Greece like situation where EU membership is used as a bargaining chip as the coalition government has taken down its rhetoric against the single currency. However, there will be lots of noise surrounding this.
The euro has traded in a tight range since May and is likely to continue to do so through the summer doldrums before a slight recovery towards the end of the year.
The GBP has been moving sideways for the past two months. But this is not due to a lack of drivers but more because the markets are having a difficult time determining what to make of all the Brexit headlines, both with regards to the ultimate resolution as well as the path to that end game. With so much uncertainty surrounding the Brexit process and the wide variance in impact of a hard and soft Brexit, it is likely that volatility remains elevated as market expectations will have to materially shift as the expected outcome (soft/hard/no deal and a delay) becomes clearer.
Even with the publication of the UK government white paper, Brexit visibility remains poor. The white paper calls for a free trade area in goods and a facilitated customs agreement that would indicate a softer Brexit for the goods sector. However, for the services sector, the white paper acknowledges that the UK will have to accept reduced market access, which moves towards a harder Brexit for services. As expected, the financial services industry, which makes up a significant part of the UK’s economy, has pushed back on this. Also, let’s not forget that the Irish border issue remains unresolved.
While PM May has managed to avoid a leadership challenge and has successfully navigated the various amendments proposed to her white paper from members of her own party as well as the opposition party, parliament remains highly divided. This means that PM May not only has to navigate a long and difficult withdrawal agreement but she also has to get that deal through a polarized parliament. As a reminder, parliament needs to sign off on any Brexit deal PM May negotiates with the EU. Moreover, the European Council meeting on October 18 represents a potential inflection point in determining the EU’s willingness to extend the Brexit “B-day” beyond March 2019.
On a monetary policy front, the BoE hiked rates by 25 bps at its August meeting. However, as we move closer to the Brexit deadline, rates should provide diminishing support for the GBP. No further hikes are expected this year and the UK still carries a large current account deficit in addition to Brexit drama.
The Canadian dollar has been stuck in a tug of war, moving between periods of strength and weakness as US trade conflicts pull the currency down and positive economic data supportive of BoC rate hikes pull the CAD up.
This dynamic was illustrated by USDCAD’s move from ~1.30 in early June to ~1.34 around late June as the escalating US-China trade conflict drove markets to price in higher NAFTA uncertainties. USDCAD then fell back towards ~1.30 in early July as the BoC looked past these issues and raised rates 25 bps. It is this BoC rate hike that reaffirmed our view that the BoC will be able to broadly match the Fed’s rate hike path and keep the CAD range trading for the balance of the year.
Given this, there remains uncertainty surrounding the BoC’s rate reaction function regarding trade tensions. Recent bank communication drew a clear line between realized risks and unrealized risk, with the bank deliberately excluding unrealized risks (auto tariffs) from forecasts and rate decisions. The BoC also emphasized that the monetary policy implication is ambiguous as tariffs could be both inflationary positive and growth negative. As a result, we will most likely have to wait until we get closer to October, when the BoC’s next rate hike is expected, before CAD gets a material boost from rate expectations.
Relative to the beginning of the year, oil prices have been supportive of the CAD but supply disruptions continue in Canada, which limit the upside potential from oil. With regards to NAFTA, headlines for a NAFTA deal in the “finishing stages” have reemerged with some speculating that a NAFTA 2.0 will be ready before the US midterm elections in November. While this has helped the CAD, many of the same deal breaking issues remain including rules of origins, the sunset clause, and the elimination of chapter 19 (dispute settlement process). Moreover, the new administration in Mexico will not take office until December 1 and both Mexico and Canada continue to support trilateral talks. All of this makes a quick NAFTA resolution difficult.
Over the first half of 2018, the JPY traded in a narrower than average range due to combination of factors including balance between Japan’s current account surplus and outbound investments, Bank of Japan inactivity and decline in sensitivity risk sentiments. This last reason helps to explain how the JPY was able to weaken despite a deterioration in the US-China trade dispute.
Looking at the second half of 2018, there are a handful of key risks that imply a stronger JPY. Beyond the JPY appreciating as US-China tensions rose, other FX measures imply that a relatively small amount of trade conflict risk premiums have been priced in. As a safe haven currency, the JPY would expect to appreciate should economic uncertainty increase.
The second risk comes in the form of political risk. PM Abe’s role as prime minster faces uncertainty via a leadership ballot later this year. While the expected outcome is for PM Abe to remain in control, his popularity has taken a hit from ongoing land scandals and could open the door to a challenger, which in raises the possibility of Abenomics ending. A third risk manifests itself through possible trade tensions between the US and Japan with the US exerting trade pressure on Japan in front of the US midterm elections. Lastly, as we move closer to the end of the year, the likelihood for a hawkish shift from the BoJ has risen. While inflation data in Japan has remained soft, there has been growing concerns within the BoJ of the negative side effect of easy money policies. At the BoJ’s most recent meeting, the bank refrained from making sweeping changes to its policy but did tweak its 10 year yield target and reduce the amount of balances subject to negative interest. Expect markets to remain sensitive to headlines regarding monetary policy.
On the flip side, there remain factors which support a weaker currency. The first is the market’s optimism to trade fears as it has been reported that the US and China have reopened talks. Moreover, if synchronized global growth, led by the US, picks up as we expect, the BoJ’s accommodative monetary policy positions the JPY to remain a funding currency. Finally, Japan’s foreign direct investment flow remains strong and Japanese investor appetite for foreign securities remains robust.
The AUD has been on a steady decline since the start of the year. As we have stated in previous commentaries, a divergence in monetary policy between the Reserve Bank of Australia (RBA) and the rest of the G10 should be a main driver of the currency and keep the AUD under pressure through the rest of the year as the RBA is expected to be on hold for most, if not all, of 2018.
If anything, recent RBA commentary has only served to reinforce our policy divergence view. While the bank is forecasting an improvement to both inflation and unemployment, these improvements are expected to be gradual. This should result in an RBA that is comfortable with where rates are and results in little danger of a move in rates either to the downside or the upside, leaving Aussie rates steady as US rates rise.
Moreover, with Chinese data softening, and the CNY weakening sharply over the past 6 weeks, pressure on the AUD has increased. Expect a combination of softening Chinese economic data, weak commodity demand and trade fears to keep the AUD pressured. Positioning in the AUD has shifted more negative as investors use the AUD as an Asia proxy for the US-China trade dispute. While an argument could be made that large short positions are a reverse indicator and easing policies in China could support commodities, Australia remains particularly vulnerable to escalating trade tensions as a relatively small, trade orientated economy.
After spending much of the year consolidating, the Chinese yuan has accelerated its losses over the past 6 weeks, hitting a new one year low in the interbank market relative to the USD with CNY positioning hitting new record longs. However, it is important to note that the PBoC looks at currency stability relative to an official basket of currencies but even this measure is near a YTD low, suggesting CNY weakness is driven by more than just USD strength.
From an economic point of view, the Chinese economy was weakening before trade tensions flared up and the economy has continued to weaken and it appears that the Chinese government is becoming increasingly concerned about an economic slowdown. The government has stepped up efforts to support the economy through multiple reserve rate ratio (RRR) cuts, weaker fixings and encouraging banks to increase lending. While Q2 GDP came in at expectations, indicating that the slow down isn’t accelerating, signs of weaker domestic demand and weakening investments continue to flash.
All of this has been exacerbated by trade tensions, which have aided in pushing the CNY weaker as market pricing indicates that it believes the US economy is in a better position to handle trade headwinds. Ultimately, near term trade tensions and rhetoric are expected to continue to be a key driver. Most recently, high level talks between the US and China appear back on but these talks tend to break down as quickly as they start. With both sides having reasons to believe that it could win a drawn out trade fight, expect a prolonged battle that so far has led to USD strength, albeit at more muted pace than before. Beyond trade tensions, additional volatility should come through a shrinking current account balance. China’s positive current account has traditionally been a source of currency strength. With the current account shrinking, the more volatile capital account becomes a larger driver of the currency.
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