Since our last monthly forecast, the USD (DXY index) has moved between periods of strength and weakness but on net is stronger for the month of February. We, however, maintain our bias to the dollar remaining under pressure as the factors weighing on the dollar remain intact.
The US economy is characterized by late cycle growth and rate hikes versus the majority of G10 economies that are in an early cycle policy normalization stage. This difference in policy normalization stages results in a difference in market reactions and reduces the support the USD should expect to receive from future Fed hikes--currencies tend to strengthen heading into hiking cycles and weaken during the late stages of these cycles. Moreover, the outlook for improved, synchronized global growth has been supportive of certain emerging market currencies as well as commodity-linked currencies at the detriment of the USD.
While we acknowledge that two rounds of fiscal stimulus have led to an upgrade to US growth expectations, empirical evidence suggests that the USD might not benefit from this. Notably, the USD continued to weaken following the passage of the US Tax Cuts and Jobs Act last December. A possible explanation for this is that the markets are assuming that the US’s growth potential remains unchanged and as such, the stimulus provided by tax cuts simply accelerates the end of the current stage of US expansion. As such, further fiscal stimulus, and its associated deficit spending, is unlikely to strengthen the dollar.
Moreover, adding further stimulus to an economy already operating near capacity is likely to reignite fears of an increase in inflationary pressures and follow on concerns on the sustainability of recent growth numbers. Finally, despite the recent upgrades to US growth, US GDP forecasts still appear ordinary when compared to growth upgrades elsewhere around the world.
Towards the end of 2017, City National FX published a Year Ahead report that anticipated a higher euro based on an improving European economic situation as well as an unwinding of the ECB’s unconventional monetary policies. As we move towards the last month of 1Q2018, we continue to maintain this view. If anything, our euro target might have overestimated the potential support the USD would receive from a more assertive Fed, resulting in a conservative yearend euro target.
As touched upon in a recent Global Perspectives, the bullish view for the euro has evolved to the market’s base view as the European economy has continued to perform. As a reminder, the euro area GDP has outgrown the US for the past two years and is set to continue this outperformance. This continued performance has driven some in the markets to pull forward expectations for the end of QE as well as the ECB’s first rate hike. Additionally, euro strength has been aided by the slow pace at which US corporates have been repatriating foreign profits.
We do acknowledge that euro positioning is near record long positioning, but there are arguments that suggest that the euro may not be as overbought as its positioning would suggest. As touched upon earlier, economic momentum in the Eurozone is strong with the EU set to outperform the US for a third year despite two rounds of fiscal stimulus in the US. Additionally, European equity inflows remain and the EU’s current account surplus are both at very strong levels.
Furthermore, while the euro is overshooting interest rate differentials, this is a trait common to most dollar pairs which suggests a broad dollar risk premium versus euro mispricing. Beyond a general dollar risk premium, the onset of QE drove a euro undershoot as the market moved away from euro exposure. As a result, it wouldn’t be unreasonable to expect a euro overshoot as we move towards the end of QE.
In the near term, keep your eyes on March 4th with both the Italian election and the vote in Germany to determine Merkel’s ability to form a government being held.
Year to date, the GBP has been one of the better performing G10 currencies. This performance has been aided by hopes for a transitional deal, which has reduced the Brexit risk premium, and a modest acceleration in UK growth which is an increase versus the prior measure; however, it is still materially slower then EU growth.
However, these positive factors paint a picture that is in stark contrast with the overall Brexit picture that remains very much unclear. With regards to the transitional deal, many sensitive and substantial issues remain to be finalized. Specifically, the Irish border and migration are two issues that are still unsettled. Given the fragile nature of the Conservative government in the UK, there is a narrow path to reach an agreement which has prompted the EU’s chief negotiator to signal the distinct possibility that a transitional deal falls through. Given this, the chances of a non-negotiated hard break from the EU remain a very low probability event.
Beyond the uncertainty of a transitional deal, there is also uncertainty around what the UK actually envisions as its post Brexit future. Currently the hard and soft Brexit factions within PM May’s government have remained relatively quiet; eventually, PM May will have to choose between a soft Brexit option with little changes or a hard Brexit option where everything changes and the UK gives up its single market access. Further pressuring PM May will be an EU Brexit treaty draft that ignores some of the PM’s most important demands. End of the day, until it becomes clear which direction the Conservative government will take its Brexit goals, and frankly even after its goals are clear, Brexit risk premiums should continue to pressure the GBP.
Lastly, with regards to monetary policy, BoE officials have signaled that rate hikes may be needed sooner rather than later, which has pulled up market pricing. However monetary tightening is more about reducing the negative real rates in the UK. As a result, we don’t believe the GBP will benefit from the appreciation normally associated with a hiking cycle.
In last month’s outlook, we identified the pace of Bank of Canada (BoC) normalization and NAFTA negotiation risks as two key themes which would drive the CAD, and we continue to hold that view.
With regards to the BoC and its normalization path, a strong run of economic data has caused the markets to pull forward its rate hiking expectations. However, it should be noted that last summer the BoC was working on removing its emergency cuts so its reaction function then and now are likely different. Additionally, while the BoC has recently hiked rates due to strong economic data, we would also point out that rate expectations are already pricing in additional hikes. This means that there will be a high hurdle for the CAD to benefit from further rate hike expectations as well as headline vulnerability to the CAD from any data disappointment.
The main caveat to CAD bullishness is the uncertainty surrounding the NAFTA negotiations with the possibility of a disorderly result weighing on the CAD. However, we acknowledge that this cliff edge risk has somewhat diminished with all sides acknowledging that negotiations will take longer, reducing the meaningfulness of the end of March soft deadline.
This NAFTA uncertainty plays into monetary policy via the BoC’s de-emphasis of “data dependency,” i.e. recent history has shown an elevated sensitivity towards risks and uncertainty with NAFTA. With the latest round of NAFTA negotiations leading to both bullish and bearish news, the BoC’s past comments advising caution on the pace of hikes appears to be a material consideration for the markets.
The JPY appreciated sharply in February, with USDJPY ultimately strengthening to its strongest since November 2016. The initial move of JPY appreciation was driven by the market’s risk off tone as global equities sold off sharply. Given the JPY’s status as a safe haven currency, this move was expected. However, after global equities stabilized, the JPY continued its strengthening momentum. A possible explanation for the second move appears to be related to fund flows. After the sharp selloff in the Japanese equity markets, it is possible that foreign investors have started to buy Japanese equities without FX hedging in acknowledgement to the JPY’s historically cheap real term level. Additionally, with JPY shorts at an elevated level, unwinding of these positions would have helped accelerate the JPY’s appreciation.
Another factor to keep in mind is the JPY’s seasonality during the back half of February as Japanese corporates have a tendency to repatriate profits towards FY-end. Looking at the past 5 years, on average, the USDJPY exchange rate finished the month of February lower relative to where it was on February 15. This same data series also showed the JPY higher, on average, during the first week of March than it was on February 15.
With regards to personnel, the Japanese government nominated BoJ Governor Haruhiko Kuroda for a second term and chose an advocate of bolder monetary easing as one of his top deputies. Both of these moves indicate that the BoJ is not in a rush to dial back its massive stimulus program. To this point, we would like to point out that Kuroda’s recent comments about a potential BoJ exit timeline from its current monetary policy program was conditional on inflation targets being achieved
Interest rate differentials were a key theme for the AUD in 2017 and we continue to believe this to be true for 2018. With the Fed expected to raise rates ~3 times and the RBA (Reserve Bank of Australia) expected to remain on hold for 2018, it is very possible that there will be a negative policy rate spread between Australia and the US. While recent empirical evidence shows that interest rate spreads may have lost some of their influence in the FX world, interest rates still matter.
Our belief that the RBA will remain on hold for the foreseeable future was reinforced when an RBA official noted that “…our circumstances are a little different. We are still some way from what could be considered full employment and our central scenario for inflation is for it to remain below the midpoint of the medium term target for the next couple years.” Put another way, the AUD is unlikely to see any support from a monetary policy perspective in the near term.
While we have confidence in the future direction of the AUD, there remains uncertainty around the timing of the move. The Australian economy is greatly influenced by the Chinese economy, and with Chinese growth solid, the pace of the AUD’s decline may be initially slow. However, we would like to note that if market volatility increases with a rise in global rates, market participants are likely to reconsider their carry preferences. To this point, AUDUSD moved sharply lower as global equities sold off earlier in February.
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