Since November of last year, the USD has been under pressure due to a number of factors. To illustrate the magnitude of the market's reassessment, one simply needs to look at the market's expectations for Fed rate increases. Towards the end of 2018, the markets were expecting two more hikes. Since then, the markets have pivoted to pricing in two cuts over the next two years at its most pessimistic point.
The Fed's most recent meeting only served to reinforce this view. At its January meeting, the Fed came off as more dovish than expected as it reacted to concerns over a global slowdown, subdued inflation, weak economic indicators and trade related uncertainty. Key developments from the January meeting included the removal of the Fed's expectation for further gradual rate hikes and increased flexibility with balance sheet normalization.
If previous tightening cycles serves as a guide, the use of “adjustments” instead of “increases” signals that the Fed sees the tightening cycle near an end. Moreover, the latter point is arguably the more significant change as comments indicating that balance sheet normalization was on “autopilot” upset the markets. After the meeting, the market is priced in a less than a 10% chance of 1 hike in 2019.
Additionally, the disarray in Washington has also weighed on the USD. The longest government shutdown in history has been temporarily suspended. While we don't think the president will close the government again, little progress has been made over the border wall and his threat to do so can't be dismissed. Beyond the economic damage created by the shutdown is the more concerning signal this episode sends about the strained relationship between the divided Congress and the White House and their ability to come through with legislation as required.
The two key upcoming legislative events are the debt ceiling debate and ratification of USMCA (NAFTA 2.0). With regards to the debt ceiling, deepening trial politics makes us believe this will be a contentious process. The possibility of a fiscal accident as gridlock jeopardizes needed fiscal action and risks the possibility of a sovereign downgrade is real. The timing of these two issues, along with other Washington issues (Mueller) comes at a time when the US economy is slowing. This could then leave the USD exposed to vulnerabilities (twin deficits) that have always been present but masked by strong growth.
As a result, we maintain our view for a weaker USD but note that without convincing growth outside the US, which hasn't manifested, there are limits to USD weakness.
In our last outlook, we mentioned that we remained cautiously constructive on the euro in 2019 but expected the euro to remain pressured in the near term and the economic data has played out accordingly. Eurozone growth, which ended 2018 on a negative note, has kicked off 2019 by continuing its slide.
This persistent weakness in economic data, which put Italy in a recession and materially slowed Germany and other countries, forced the ECB into acknowledging that risks have skewed to the downside. With the persistence of weak data determining future action, we expect the euro to remain pressured in the near term. Correspondingly, market pricing for the timing of the ECB's first hike has been pushed further out. Additionally, it looks increasingly likely that the ECB will introduce new easing measures via a new targeted longer-term refinancing operations (TLTRO). TLTROs are to used ease private sector credit conditions and stimulate bank lending.
However, on balance, the ECB remains confident that the Euro-area would not slip into a recession as the labor market remains tight and some transitory factors suppressed growth in Germany. This positive outlook will be strengthened when an orderly Brexit and a resolution of the US-China trade is realized as expected.
As such, we remain cautiously constructive on the euro. The USD should weaken as a dovish Fed appears to be on hold for the foreseeable future and Washington drama over the shutdown, impeding debt ceiling debt and concerns over what the Mueller investigation could bring warrants a dollar discount.
We acknowledge that the current macro backdrop doesn't support a near term or convincing EURUSD upswing. But the euro remains undervalued relative to the US dollar so less mediocre economic performance is still supportive.
Finally we would like to point out that European parliament elections are scheduled for May 2019 and could become a risk factor, especially should populists gain a significant number of seats.
Brexit negotiations have been characterized by much activity but little actual progress. PM May finally put her Withdrawal Agreement (WA) to vote and suffered a defeat of historic margin. The government is now tasked with coming up with a Plan B as the March 29 deadline fast approaches.
Since the failed vote, the GBP has rallied to its highest levels in nearly 3 months. A couple of factors are behind this change in sentiment towards a softer Brexit. The first is the ruling from the European Court of Justice that gave the U.K. the unilateral right to revoke the Article 50 process. Additionally, the U.K. Parliament has taken steps to increase its influence over the final outcome as well as reduce the chances of a no-deal exit.
Given this, all we really know is that parliament is strongly against May's WA. What we don't know is what option would be able to garner majority support from MPs. Parliament recently voted on amendments to the WA obligating PM May to renegotiate with the EU however there is no consensus on a course of action. Critically, the EU does not appear open to further compromises even if there was consensus around a course of action. With time running out, it is looking increasingly likely that an extension will be needed. While unanimous approval from all EU states will be needed for this, all indications are that approval should be granted and should be GBP positive. However this is likely to be contingent on the U.K. having a plan, which it currently does not.
Ultimately we still see an orderly exit as our base case and, under the current timetable, see the GBP strengthening over a long term horizon as this is realized and uncertainty is removed. However in the near term headlines risks remain and that should cap GBP gains given the magnitude of the recent rally. Even if a WA is agreed to, the political and economic uncertainty surrounding Brexit won't be fully resolved. The key factor in determining the GBP ultimate long term value will be the Free Trade Agreement that replaces the single market arrangement. However, these talks can't begin until the U.K. legally exits the EU, making it possible that full clarity won't be known for years after Brexit legally happens.
On a month over month basis, the JPY finished the month of January pretty much where it started. However this high-level view masks the sharp volatility spike that strengthened the yen at the start of the year. The yen's ~4.5% one day appreciation was driven by uncertainty over the global economic picture (equity markets sold off sharply) and illiquid markets (longer than usual holiday season in Japan). Further adding to the JPY's strength has been the market's repricing for Fed expectations as it pauses to reassesses uncertainty and downside risks to global economies and financial markets. To illustrate the shift in Fed expectations, the markets pivoted from expecting two additional hikes to two cuts over two years at it most pessimistic point.
At the BoJ's latest meeting, it downgraded its inflation forecast. While a downward revision isn't unprecedented, the magnitude of the downgrade is notable. Additionally, the end point of the BoJ's forecast is as far as it has ever been below target since the start of extraordinary easing in 2013. This raises scope for further widening of interest differentials with the US as well as a trade balance that is moving increasingly towards a deficit.
From an investment point of view, we expect outbound investments to continue if the global economy continues to expand, albeit at a slower pace. Market data shows that 17 trillion yen in cross border deals were announced but only a fraction of that has been completed, implying that there could be a material amount of yen selling in the pipeline.
Downside risks for USDJPY comes from an escalation in US-China trade tensions, uncertainty around the Brexit outcome and political turmoil in D.C. While the government shutdown has been in the news recently, the more impactful debt ceiling debate is still pending and USMCA ratification process is still pending. Given this, our base case is that the global markets and economies will stabilize and provide scope for the JPY to weaken a bit further before strengthening into yearend.
Over the past two months, the CAD has been pretty much unchanged. However this seemingly benign performance masks a volatile two months where the CAD weakened ~3.5% only to gain all that back and then some. This volatility is reflective of increased concern over slowing global growth, a reassessment of global monetary policy and negative risks to the domestic oil economy.
Near term, USMCA ratification risk remains a key driver. While we believe that it will ultimately be ratified by all three countries, the road to ratification should be noisy. The recent US government shutdown, which is the longest in history, illustrates the contentious relationship between the Republicans and Democrats. This bodes poorly for a smooth process especially with the Democrats possessing multiple options to delay the process. The risk to delays mainly comes from the possibility that President Trump counters by withdrawing from NAFTA 1.0. This would start a 6 month clock, after which there will be a cliff edge fallout unless NAFTA 2.0 is ratified. Clearly such brinksmanship would elevate market uncertainty to the CAD among other assets.
Related to NATFA uncertainty is the BoC's rate path as the bank has acknowledged trade uncertainty as a limiting factor to rate hikes. Furthermore, monetary policy has been reassessed on a global level. While the Fed has garnered most of these headlines, the market has also reassessed the BoC as well. After a dovish Fed meeting last month, the markets are pricing in more hikes for the BoC than the Fed, however that's more a function of Fed expectations being low rather than BoC hikes being likely.
Ultimately we see near term CAD weakness based on the reasons above with the CAD ultimately strengthening after ratification of USMCA by the end of the year and acknowledge that the timing and final outcome remain uncertain.
After spending all of 2018 in a downward trend, AUDUSD has experienced a bit of a bounce to start the year but still finds itself lower than where it was at the start of December. This slight rebound has been aided by positive news on the US-China trade conflict, which has reduced the number of AUD short positions as the market uses the Aussie dollar as a trade war proxy.
Looking forward, we expect the pressure on the AUD to reemerge. Shipments of commodities out of Australia dropped sharply in line with the drop in Chinese Industrial Production numbers. With poor economic data continuing out of China, a rebound in the near term in unlikely. Case in point, the latest GDP data posted its worst growth rate in nearly a decade. Additionally, the current trade conflict reprieve is unlikely to last as minimal progress has been made on red line issues such as IP protection. As a result it is possible that we will see another round trade conflict escalation, which should rebuild AUD short positions and further pressure the Chinese economy.
Moreover politics remain a risk factor for the AUD. Former PM Malcolm Turnbull lost his leadership position last August. With instability within the government, the prospects of another leadership change at the next election remains materially high.
Lastly, the RBA's policy stance bears watching. While the central bank is seen to be on hold for the foreseeable future, comments from bank officials suggest the next move would be to hike rates. However housing data and economic performance data has softened. If the RBA were to change its eventually a hike message, expect market repricing to pressure the AUD.
After sharply depreciating last year, the CNY has been one of the top performing Asian currencies since the New Year. This appreciation has been driven by the December trade truce with the US and the positive developments in the subsequent trade negotiations. Additionally, the downward trend in the CNY's fixing term illustrates China's central bank desire for a resilient currency during negotiations.
Given this, the bias is still for the CNY to weaken due to the following factors. Assuming a trade deal is struck with the US, which is our base case, the Chinese economy is still weak. This implies additional domestic stimulus. Increases in local government bond issuance usually foreshadow fiscal stimulus/infrastructure spending in the upcoming months. There has also been efforts to supplement consumption through tax cuts and initiative to drive health care, tourism, and education. All these steps should result in increased consumption/imports and a further deterioration in China's current account position. Additionally, realizing a trade deal with the US should improve overall investor sentiment, reducing concerns of an impending downturn and bring the Fed back in play.
Near term, it will be all about how trade talks with the US evolve. While the recent news flow has been positive, little progress has been made on the more difficult issues such as IP protection and forced technology transfer. These issues hit at the core of the race between the US and China to gain and maintain global superiority and as such will not be easily settled.
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