The script has flipped a bit for EURUSD. Heading into the year, the narrative was political turbulence and soft economic conditions in the eurozone versus economic momentum and hopes for significant pro-growth stimulus in the U.S. As we move through the year, political turmoil has emerged in the U.S. and concerns over the U.S. government’s ability to enact meaningful pro-growth policies have been building.
As a result, the U.S. dollar has given up all of its post-election gains. Meanwhile in Europe, elections in the Netherlands and France have resulted in pro-euro outcomes, and European economic data has shown signs of improvement—both of which have provided a tailwind for the euro and helped its sharp rise over the second half of May. ECB officials have acknowledged the pick-up in growth but continue to point to soft inflation data.
In essence, they are trying to be bullish and dovish simultaneously. Near term, the markets will be looking at the ECB’s June 8 meeting where risks will likely be characterized as balanced and the explicit easing bias may be removed. If these things were to happen, it would be euro bullish. However, near term, the impact could be muted by the expected Fed rate hike path. Moreover, any further near-term strength could cause a downturn in the ECB’s 2018 inflation forecast, inducing further dovish policy comments and capping any upward moves.
Long term, focus will be on the ECB and the evolution of its monetary policy stance. Specifically, if inflation begins to firm up along with the improving economic data, talks of tapers will grow louder and drive the euro higher.
Keep an eye on European growth, inflation and politics.
In a move that the markets were not expecting, Prime Minister Theresa May called for a snap election in hopes of strengthening her position in a complex political landscape. In theory, this decision should be positive for the GBP as it should reduce uncertainty in a couple of ways.
First, it should help the Conservatives widen their majority as they were polling very well at the time the snap election was called. Second, it would push out the next election to May/June 2022. Given that Brexit negotiations are expected to take years, resetting the election timeline allows for full discussion without looming elections undermining PM May’s position.
Lastly, it should force a conclusion to the Scottish independence question. In practice, things haven’t been as smooth as expected. In broad strokes, the snap election is positive insofar as it helps the Conservatives build a substantially larger majority, i.e. ~5 times the current majority. Unfortunately for the Conservatives, public opinion polls from April onwards have shown deterioration for them.
While the lead is still large, it currently doesn’t deliver the decisive majority PM May needs/expected nor is it the size that the market has priced in. Results of the snap election notwithstanding, we hold the view that the election affects the path to Brexit and not the ultimate outcome. As it stands, the bias remains for a hard Brexit and GBP weakness.
Consternation over the Brexit bill remains and neither side has shown willingness to compromise on key incompatible objectives—the U.K. has sovereignty over its borders and laws, and the EU wants to preserve the four freedoms, including the freedom of movement.
Keep an eye on current account related data, growth measures and politics.
Since mid-April through mid-May, CAD made a significant move weaker, driven by multiple factors such as concerns over weaker oil prices, the re-emergence of housing market vulnerabilities and the possibility of volatility with the U.S.-Canadian trade relationship. In fact, trade risks have arguably increased as the U.S. has started its 3 month consultation process with Congress that precedes NAFTA renegotiation talks.
Given the high level of integration that Canada has with the U.S., any disturbance/changes to NAFTA have the potential to be very disruptive. However, since mid-May, the CAD has rallied on the back of rising oil prices as the CAD has maintained a reasonable correlation with oil prices.
Keep in mind that oil price movement in the $50s is less significant to the Canadian economy than price moves below $30 and above $60. Furthermore, Canadian economic data has improved to the point that the BoC has been compelled to acknowledge it. However, on balance, the BoC still sees excess capacity and soft core inflation as descriptive of the economy and placed these details ahead of more positive economic data. Because of this, any BoC tightening appears to be somewhat off, implying further CAD weakness as Fed hikes increase interest rate differentials.
Keep an eye on inflation data, U.S. policy and OPEC.
Ever since the Bank of Japan (BoJ) instituted its 10-year yield target, we have argued that U.S. yields would be one of the primary drivers of yen direction. As would be expected, given our view, the correlation between USD/JPY and 10-year U.S. yields have significantly increased versus where it was around the time that “QQE with yield curve control” was introduced, providing a point of empirical evidence to support our view.
A strong Q1 GDP, driven by internal and external factors, should help ease BoJ concerns about Japan participating in the global recovery. However, despite the economic progress, inflation data remains stubbornly soft, leaving the BoJ far from its inflation target.
As a result, there is little reason to believe that the BoJ will shift its monetary policy any time soon, especially if the U.S. yield trajectory keeps the yen from strengthening too much or further weakness in inflation data forces the BoJ’s hand into further accommodation.
Keep an eye on U.S. fiscal policy, Japanese monetary policy and macro data surrounding the Japanese recovery.
The Reserve Bank of Australia’s May meeting minutes struck an overall neutral tone, providing a departure from the dovish tone in April. Given this, doves are still able to point to the RBA’s continued concerns over the labor and housing markets. Furthermore, softening commodity prices, concerns over Chinese growth, and Australian labor market risks represent concerns that make a rate hike difficult to imagine this year.
If anything, risk remains for a rate cut. With the Fed set to raise rates in June, and possibly another 1-2 times this year, skinnier rate differentials and commodity softness (specifically iron ore as Chinese steel production has weakened) should combine to pressure the AUD.
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.
Keep an eye on Chinese industrial metal prices and Australian Q1 data.
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