Since our last currency forecast, the USD (DXY) has moved up in a material way. While we still maintain our medium term view that the USD will resume its downtrend, we acknowledged the dollar’s recent moves through revisions to our target levels for a select number of currencies.
We are holding off on broad changes to our FX forecasts, despite the big move in the dollar, as we see the USD’s current move as a shift in our baseline assumption rather than a change in our base case. In our opinion, for a multi-quarter uptrend in the USD to manifest itself, it would require upcoming economic data to confirm that and impending global downturn/US exceptionalism. While we acknowledge that these risks exist, for now we continue to hold the view that the second half of the year will be characterized by broad and synchronized above trend global growth which will set up early cycle rate normalization around the world.
In our view, the dollar’s most recent move was a normalization of the market’s extreme short dollar positioning aided by a sharp rise in US rates and concerns about recent economic data from around the world. The shift in market positioning has many of the characteristics of conventional deleveraging of FX positions and, if this is the case, then the unwinding of USD shorts could be maturing as ~65% of shorts have already be unwound. This positioning unwind, as well as concerns over softening global growth momentum, helps to explain why the USD continued to strengthen during the first half of May despite US 10 year yields moving sideways.
Finally, persistent US policy and political risks remain and provide justification for a continued USD discount. While NAFTA negotiations have been constructive, it appears that talks are at an impasse with the US insisting on a sunset clause and Canada steadfastly refusing to do so. Moreover, with tariff exemptions tied to NAFTA progress, the US’ decision to implement tariffs implies limited progress on NAFTA, and in fact, headlines now suggest that NAFTA won’t be done in 2018. Additionally, trade issues with China are far from over despite the recent progress and in light of recent actions on the EU, Canada and Mexico, targeted actions on China (due June 15) now merit more serious consideration.
Plainly, trade fears have become more acute and the possibility of a trade war has become much more real. Lastly, the Mueller investigation continues and the US-North Korean summit is scheduled for mid-June.
In last month’s forecast, we touched on the uniformly weak economic data out of the Eurozone during Q1 2018. Since then, the euro has continued to weaken as US yields continue to rise. The key question that remains to be answered is whether or not the downturn in economic activity is an aberration or a start to a prolonged downturn.
To this point, we would like to note that Eurozone economic data has firmed up but has yet to show any definitive sign of recovering. Nevertheless, as outlined in last month’s outlook, our base case still remains for economic activity to rebound back to above trend growth as the most recent soft patch was likely distorted by severe weather and technical factors. However, while we maintain our constructive medium term view, we have adjusted down our target level to acknowledge EURUSD recent price action.
Risks to our above trend growth belief comes from four key areas—1) an extended stall in the EZ’s economic expansion which delays the ECB’s normalization timing, 2) further convergence of FX with interest rate differentials and a hawkish Fed, 3) US corporate repatriation accelerating and 4) the non-mainstream government in Italy stoking breakup fears.
With regards to the first point, the lack of an economic explanation for the EZ’s sudden economic slowdown supports the view that the most recent soft patch is a temporary slowdown. Moreover, PMI data has recovered and continues to signal above trend growth albeit market expectations for the first ECB hike have likely been pushed back. Secondly, interest differentials have regained their importance in the FX world and partly explain the dollar’s strong rebound, but the USD’s recent move has largely eliminated the euro’s overvaluation relative to rates, making things more neutral. However, it is important to note that position is not neutral and could be a source of future EURUSD weakness should data from the EZ fail to improve over the next couple of months.
The situation surrounding US corporate repatriation is a bit murkier as there is little visibility to future plans for corporates to bring back overseas funds. Empirical data indicates that the pace of repatriation slowed in April versus March. However, this could be a self-fulfilling prophecy as a stronger dollar encourages repatriation and repatriation encourages a stronger dollar. Given that euro sales accounted for a third of the estimated FX repatriation flow, this factor bears watching.
Finally in Italy, risks still remain. Italy has been able to put together a government which has removed the risk of new elections and a larger Eurosceptic majority. Moreover, the Italian government has stated it doesn’t want to leave the EU. However, the new government has plans to expand the already large Italian debt situation which is something that the EU won’t like and sets up a confrontation. Net on net, the risk of Italy leaving the single currency currently appears to be a tail risk event. For now, we see events in Italy and Spain as more noise and sources of near term volatility than a fundamental change to the euro. Finally, the implantation of tariffs further adds to global uncertainty and, in light of recent actions from the US, the EU, Canada, Mexico and China (official list of US tariffs due June 15), trade war implications have become a real threat.
The British pound has been one of the worst performers among the G10 currencies over the past month, reversing its relative outperformance prior to this month. This underperformance over the past month, which has erased all of the GBP’s YTD gains, was driven by a variety of reasons. The first driver has been the pivot from the Bank of England where it not only paused its rate hiking cycle at its last meeting but also signaled to the markets that there was less urgency to hike. While the BoE continues to signal that another hike is probable this year, the bank has become more data dependent. This change in tone is due to the economy softening (growth assumptions for 2018 lowered to 1.4% from 1.8%), inflation coming in softer than expected and FX pass through inflation fading.
This pivot towards data dependency is important because over the last number of months, the GBP has decoupled from economic data, i.e. slowing growth, as the market placed its faith in the BoE’s determination to raise rates. However, given that the BoE has held rates, partially due to a weak Q1, this assumption has been debunked.
Beyond a change in monetary policy stance, the GBP has also been influenced by Brexit uncertainty as well as a series of M&A activities, making forecasting the sterling that much more difficult. As we head down the backstretch of Brexit negotiations, there remains a lack of clarity around possible Brexit outcomes during what should be pivotal months. With less than 10 months to go until the UK is scheduled to leave the EU, the UK government’s strategy remains in flux. The prime minister remains under pressure from certain members of her cabinet that desire a harder Brexit, and at the same time, she is experiencing legislative pressure for a softer Brexit from advocates in parliament. It is worth noting that there has been an increasing cross party push towards a soft Brexit in both houses of parliament.
A key issue splitting the government is the custom’s policy. The PM would like to create a custom’s “partnership” which hardline Brexiteers fear will be a backdoor way to continue membership in the single market. Moreover, the final customs solution will be key to resolving the Irish border issue which is critical to whether the withdrawal and transitional arrangements can be finalized with the EU before the 2 year negotiating period runs out. Looking ahead, keep an eye on the EU summit scheduled for June 28-29 as GBP volatility could pick up in front of this political event.
Through the beginning of May, the Canadian dollar was one of the worst performers against the USD among the G10 currencies but over the last month, the CAD has been a relative outperformer. This oscillation with USDCAD has been an ongoing theme throughout the year; it has been primarily driven by changes to expectations surrounding Canada’s macro backdrop such as Canada’s trade relationship with the US (NAFTA), expectations around pace for BoC rate normalization and whether or not Canada can sustainably solve its oil bottleneck.
With regards to NAFTA, principle negotiators have continued to signal progress and hopes for a “deal in principle” ran high throughout the month of May; however, headlines indicate that time has run out to get a NAFTA 2.0 in front of the current US Congress for approval, meaning the can has been kicked down the road. Aside from timing, many contentious issues remain. US tariff exemptions were tied to NAFTA progress, therefore the US implementing tariffs implies limited progress and a materially increased withdraw risk for the US. One key issue is the US’ insistence on a sunset clause which Canada finds unacceptable. Recent actions by the US combined with the retaliatory response will likely raise ongoing NAFTA risks.
With regards to monetary policy, the BoC surprised the markets at its April meeting with its perceived dovishness, however rhetoric leading up to its May meeting has been more hawkish and while the BoC kept rates on hold at its May meeting, it was a decisively hawkish hold. Specifically, the bank removed reference to monetary accommodation needed to reach its inflation target and removed reference that it will “remain cautious.”
This hawkish pivot, along with rising oil prices, has allowed the CAD to remain flat over the past month versus the broadly stronger USD. Moreover, the CAD resilience has also been aided by positioning that was less stretched (prior to the current USD rally) than many of its peers.
Looking ahead, it appears that the CAD will continue to stay in the same range (1.22-1.30) that it has spent most of this year in. With momentum behind US data surprises fading, it is likely that the BoC and Fed will be on similar normalization paths with the CAD moving up and down by the ebbs and flows of relative cyclical economic performance.
Since our last monthly forecast, where we were looking for the JPY to weaken, the JPY has depreciated and moved above 111 on the interbank market as US yields have made a sharp move up. It is important to note that the correlation between USDJPY and US-JPY 10 year yields has been reestablished with rate differentials widening to a 10 year high and USDJPY moving to a four month high.
In early May, the JPY strengthened as short coverings in the markets supported a stronger yen. However, for the near term, we hold a bias for the JPY to weaken. The case for further JPY weakness revolves around a series of factors. The first is the increase in demand for foreign bond investments (although the amount of JPY selling due to investments in foreign bonds will be heavily dependent on hedging decisions by Japanese investors during a time when hedging costs remain high). Additionally, Japanese corporates are expected to remain active and reengage with foreign direct investments as we move deeper into the new fiscal year, which should drive additional JPY selling. Finally, there are the possible equity investment outflows from Japanese investment trusts as they net sold foreign stocks in 2016 and 2017 only to buy them back in May/June.
On a geopolitical front, things remain a bit murky. A risk off mentality is supported when the US pulled out of the Iran nuclear deal. Moreover, rhetoric leading up to the June US-North Korea meeting should support continued uncertainty and, of course, there are trade issues surrounding US and China which, despite recent progress, are unlikely to be resolved in the near future, leaving open the possibility for tensions between these two countries to intensify. The material risk in trade war fears should also benefit the JPY with safe haven flows. Finally, domestic politics remain unresolved as the land scandal surrounding Finance Minister Aso continues to turn up new details.
Lastly, on the monetary policy front, keep any eye on the BoJ towards the end of the year. While the central bank kept rates on hold during its last meeting, it did remove its timeline as to when it would achieve its 2% inflation target. One possible interpretation for this is that the bank is setting itself up to change its 10 year yield target, possibly at the end of this year, before hitting 2% inflation.
As with last month’s commentary, we maintain our current view that 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.
Given this, the AUD has been one of the top performers, within the G10 currencies, during a period where the USD dollar has continued to strengthen. This performance has been aided by relatively healthy growth in China and a relatively resilient terms of trade profile as the broad index of Australia’s key commodity export prices have been relatively well supported. Additionally, valuation metrics for AUDUSD that use interest rates differentials show the Aussie dollar to be close to fair value.
Ultimately, our view for the AUD to continue its downward path revolves around a modulating domestic economy and policy divergence. Growth momentum that built in 1H should fade in 2H as the first half benefited from a boost in net exports that shouldn’t happen in the second half. Additionally, tighter lending standards and credit growth should cause consumer consumption to slow. Lastly, while the RBA is forecasting gradual improvements to inflation and unemployment, progress should be slow. This leaves the RBA on a holding pattern during a time where other G10 countries are forecasted to begin/continue rate normalization.
We have moved to a neutral stance on the CNY due to a number of factors. Traditional valuation metrics for the CNY suggests that it is fairly valued against a backdrop of persistent trade tensions. We acknowledge the recent progress made, i.e. a truce in which the US and China outlined an agreement for China to increase imports of US goods and services in exchange for the US not to impose additional tariffs on Chinese exports. But the US’s recent actions against the EU, Canada and Mexico as well as the tariffs on $50 billion of Chinese goods shows that the “US-China trade war on hold” was really a temporary thing. The US has shown a willingness to use tariffs as a tool and not just a negotiating tactic, and simply having ongoing negotiations is not enough to avoid US tariffs.
USDCNY fixing data trends over the past 12 months suggests that Chinese authorities are encouraging a stronger CNY during on-going trade tensions, but it is unlikely that they will encourage significantly more strength. On the flip side, China has raised the outbound investment quota limit for domestic investors (CNY bearish) in an effort to maintain a balance with its capital account. There have been inflows into China as local stocks and bonds move towards inclusion into major indices. Lastly, the PBoC’s reserve requirement ratio cut signals a desire from authorities to maintain accommodative conditions.
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