Prior to the French election, euro directionality served as a proxy for political risk. The market reaction function was for euro strength as Emmanuel Macron’s chances improved and for euro weakness if the chances of Marine Le Pen, the anti-EU candidate, improved.
Post-election, the market reaction function remained constant and the euro has rallied on the back of Emmanuel Macron’s victory as well as his commanding majority in Parliament that should pave the way for the reforms he wants to make.
Looking forward, Italy represents the next political risk event. Early indications gave the markets hope that Italian elections could be held as soon as October. Unfortunately for those hoping for an election, the collective will for early elections appear to be waning, resulting in a very fluid situation. Market angst over the Italian elections stems from the fact that Eurosceptic parties collectively poll near 50%. However, given the obstacles that need to be cleared before an EU referendum can be held, Italian politics might be more about euro volatility than direction.
Beyond reduced political risks, an improving economy and the resulting impact on the evolving ECB policy stance is a key factor driving the single currency higher. Specifically the markets have worked their way towards the prospect of a less dovish ECB policy stance which is clearly a tailwind for euro strength and key reason to be bullish euro.
The question is how soon does the taper start? Mario Draghi has been consistently dovish with his insistence that low rates are needed to stir growth but has recently acknowledged that the economy has made progress and less accommodation may be needed. Near term, however, we see more of a grind as the euro has strengthened markedly during Q2. Additionally, there is a negative loop between euro strength and lower inflation, e.g. lower ECB inflation forecasts and dovish comments that should cap near-term euro strength. Keep an eye on economic growth, politics and inflation.
In what is turning out to be an annual event, the U.K. is once again facing a political surprise. In 2016, the surprise was the Brexit vote. In 2017, the surprise was the failure of the Conservatives to win a large majority.
As the Conservatives were the defacto “hard” Brexit party, and given that they not only failed to gain a larger majority but they also lost their outright majority, it could be seen that the U.K. voted against a “hard” Brexit. So despite the GBP selling off in the near term due to increased uncertainty, an argument can be made for eventual GBP strength as the prospects for a “soft” have increased. To this point, PM May needed to strike a deal with the Democratic Unionist party just to form a government, further weakening her position and nudging her towards “soft” Brexit concessions.
Moving through the balance of the year, the outlook for the GBP is unclear depending on how Brexit talks unfold. Pro GBP factors include 1) the possibility for a more conciliatory approach to Brexit negotiations, and 2) reduced UK breakup risk given weak Scottish National Party support. GBP negatives include political uncertainty around the Brexit outcome and a weak government.
In our view, the biggest factor will be political uncertainty and how it will exacerbate an economy that is already starting to show signs of softening. On the monetary policy front, the Bank of England delivered a hawkish hold with 3 members voting to raise rates. However we believe this to be less hawkish than the headline would indicate as the majority, including Governor Carney, is much more concerned about downside risks over inflation concerns. Keep an eye on growth, inflation, and politics, specifically how Brexit talks evolve.
The key change since our last monthly outlook has been the Bank of Canada’s (BoC) shift in policy rhetoric. The abrupt and unexpected suggestion from BoC officials that it would actively consider removing earlier accommodation drove a material reaction in the markets. The CAD strengthened sharply and the markets went from pricing in a hike during the second half of next year to pricing in a hike for this year.
Specifically, on June 1, the markets assigned a ~13% probability for a July hike. Now that probability hovers around 82% with the CAD strengthening in tandem. The key question now is the sustainability of CAD strength. If the economy makes progress towards closing the output gap, short CAD positions continue to unwind and oil rebounds, then the argument for CAD strength gains momentum via a steady rate increase path.
However there is uncertainty surrounding the extent of upcoming policy normalization. Notably, the BoC’s three core measures of core inflation has been steadily declining since the middle of last year and that would imply lower for longer.
On balance the momentum is for CAD strength but with inflation likely to remain low, and with markets already pricing in a full hike by year-end, further near term strengthening may be challenging. Keep an eye on the BoC, inflation data, OPEC (oil prices) and U.S. trade policy (NAFTA renegotiations).
At the Bank of Japan’s (BoJ) last meeting, the central bank kept rates both its rate and yield control policy unchanged. Given that the BoJ is committed to holding its 10-year yield around 0%, U.S. yields continue to be a key driving force on yen directionality.
Even though the Japanese economy has been recovering — see the strong Q1 GDP result driven by both external and internal factors — there should be minimal risk to the BoJ’s yield target changing soon. The condition for changing the yield target is a shift to the balance of risks to growth and inflation.
When this standard is juxtaposed to BoJ’s officials’ negative outlook it appears there is still a ways to go before any policy change as it should require a couple quarters of upside inflation surprises to initiate conversations. Moreover, it appears that the BoJ desires an inflation overshoot to re-anchor expectations and compensate for past undershoots, so a change in the yield target is even further off than the BoJ’s target would imply.
In the end, Fed rate normalization and a fall in real Japanese rates due to the BoJ suppressing nominal rates gives a bias for a weaker yen.
Admittedly, recent price action for the Australian dollar has decoupled from the shrinking U.S./AUD interest rate differential. However, we still maintain that the shrinking interest rate differential, driven by a rate tightening Fed, will eventually re-exert its pressure on the AUD.
On the Australian side, the Reserve Bank of Australia (RBA) is expected to remain on hold for the balance of the year. Given this, credit rating downgrades on Australian financial institutions and major banks over the past quarter makes the deviation risk to the downside from the current on hold consensus.
Even in the case the RBA doesn’t ease, further Fed rate hikes (~55% chance of another hike this year) will shrink Australia’s interest rate advantage to a minimal level. Given Australia’s dependence on trade, specifically with China, the diminishing interest rate advantage, and associated support, in Australia makes it increasingly vulnerable to a downturn in China or global trade turmoil/protectionism. Further bearish moves in iron ore prices does not bode well for Australia’s terms of trade and implies further pressure on the AUD. Keep an eye on Chinese industrial metal prices and Australian inflation data.
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