Over the past month, the foreign exchange market has been characterized by a confluence of noise and uncertainty due to rhetoric surrounding a possible trade war, investigations into Russia and other geopolitical risks. While all these points of uncertainty have the ability to move the markets, we ultimately hold the view that underlying fundamentals remain unchanged and for the USD to remain pressured.
We acknowledge over the short term, the divergence trade (USD bullish) appears to be reforming with the Fed tightening process on track while other banks appear to be pausing their cycle. Over the medium term, we continue to expect above average trend synchronized global growth to continue and allow the rest of the world to continue with their early cycle rate normalization shift. As a reminder, early stage rate tightening is more constructive for a currency than late stage tightening (USD), implying a weaker dollar under a synchronized tightening scenario. Moreover, several persistent USD negative factors such as the twin deficits and central bank diversification away from the USD are expected to remain as consistent headwinds.
With regards to the noise and uncertainty mentioned above, it is notable how the dollar failed to appreciate despite a relative outperformance in surprise indices as well as its decorrelation from traditional drivers such as rates and risky assets as many dollar pairs as well as the DXY index have moved sideways for the past month.
Looking forward, it is likely that the elevated uncertainty from the variety of global and US specific risk factors will persist for some time. Key risks include the US-China trade relationship renegotiation occurring under the threat of a large tit-for-tat trade war, a potential change to the Korean peninsula’s political status quo and the specter of the Special Counsel’s investigation. Given all these uncertainties, a USD rally would likely require increased clarity, if not a resolution, of these uncertainties.
The euro spent 2017 as the one of the biggest winners among major currencies but has been stuck in a 3 cent range over the past 3 months. While we are still constructive on the euro over the medium to long term, we have to acknowledge that macroeconomic data over the past month has been soft implying a flatter/slower trajectory upwards on for EURUSD.
However, as with all data, details matter. Heading into the year, many economists were projecting the Eurozone economy to continue its relative outperformance. In our view, underlying fundamentals remain intact and without a convincing economic explanation as to why the economy would stumble, the hope is that Q1 data was impacted by relatively severe weather as well as data noise. This point was aided by the most recent Eurozone PMI reading which broadly beat expectations and supports the view that growth should revert back to 2.5% from the spring onwards. Moreover, the most recent ECB meeting reiterated the central bank’s view that inflation will converge to goal and expectations for growth to continue.
Growth numbers aside, it is important to remember that the bullish case for the euro also stems from the eurozone’s strong structural numbers. The Eurozone has one of the best underlying balances of payment positions among G10 countries and the best among G3 countries and this structural support most likely helped the euro remain resilient despite one of the weakest patches of macro data in recent years. Although it is important to note that fund flow has turned from a tailwind to a headwind in recent months as equity and FDI flows have flipped to a net outflow through the first two months of the year, spotlighting a potential risk to EURUSD should global equities fall.
From a valuation perspective, we acknowledge that short term interest rate differentials may be signaling a euro overshoot. However, it is important to point out that this measure needs to be looked at in the context of monetary policy, i.e. the potential exit from QE. Keep in mind that in 2015, when the ECB entered into QE, the exchange rate undershot interest rate fair value by over 15%, suggesting that the current ~6% overshoot isn’t an insurmountable valuation.
Year to date, the GBP has been one of the G10 top performing currencies and GBPUSD hit a post Brexit high around the middle of April. The pound’s outperformance can be attributed to multiple factors including a reduction in hard Brexit risks as an agreement in principal has been made on a two year Brexit transition and increased confidence in the BoE’s ability to tighten and unusually strong seasonal factors. Moreover, speculative positions have switched from record shorts to multi-year record longs.
However, since the middle of April the GBP has lost ground due to a combination of soft economic data (i.e. soft GDP data) and comments from the BoE implying a delay to its next rate hike. Furthermore, the macroeconomic background remains less than stellar as the U.K.’s economy is characterized by high inflation and low growth. Ultimately the composition of nominal GDP growth matters as inflation driven by FX appreciation undermines the case to tighten in the absence of meaningful growth. Prior, the market has been able to ignore this weak growth it had confidence the BoE determination to normalize rates but this narrative has changed as BoE comments have caused the markets to reprice a May hike from a certainty to a coin flip and flattened out the rate path, all of which has pushed the GBP lower.
Even in the case where the BoE raises in May, chances are the hike will be a dovish one implying the interest rate support has peaked pending a pronounced pickup in growth. Lastly, the transitional deal referenced above has yet to be finalized and the tricky Irish border issue remains unsolved so while the non-negotiated Brexit risk remains small it is not zero.
But it’s not all bad news. The House of Lords and House of Commons approved a motion for the government to pursue a customs union as part of the Brexit negotiations, which raises the likelihood of a soft Brexit. Net on net, Brexit risks appear muted but still remain. More importantly, in the short term expect the BoE action to be the bigger risk.
From mid December 2017 through the end of January 2018, the CAD appreciated over 4.6%. This was then followed up by a ~6.75% over the next 6 weeks, which was then followed by another ~3.9% appreciation than preceded a significant weakening to where we stand now. These wide swings have largely been driven by changing sentiment regarding USDCAD’s risk premium as the market processes the evolving US trade policy stance/NAFTA negotiation and reflects Canada’s very large trade exposure to the US. This push/pull dynamic is likely to continue in the near term as the factors driving this--NAFTA optimism, oil prices providing support, and BoC dovishness providing pressure—will continue to persist.
The bull case for the CAD revolves around the potential for a risk premium repricing as the potential for a near-term NAFTA breakthrough appears to be increasingly improving. Ongoing oil strength, specifically in the local heavy crude, has been supportive of the CAD. Over the past two months, WTI crude is up over 10% but local West Canada Select is up over 45% during the same time period. Even if the recent price action turns out to be temporary, it does provide a near term base for the looney.
Over the medium to long term, the dovish tone set by the BoC last month reiterates the view that the BoC will lag the Fed in normalizing rates. At its more recent policy meeting, the BoC noted that “higher interest rates will be warranted over time, although some monetary policy accommodation will still be needed.” Moreover, the bank reiterated that it would be cautious with future policy adjustments. With this in mind, we would like to note that data implies that the recent bout of CAD weakness was an unwinding of risk premium and not the pricing on of a more aggressive BoC, leaving not a lot of monetary policy left to “unwind.”
The JPY kicked off the year as one of the top performing major currencies as US politics drove safe haven flows to the yen and scandals around PM Abe raised questions on the stainability of Abenomics. However, since the end of March, the script has flip with the JPY becoming one of the G10’s worst performing currencies as overall risk sentiment has improved despite trade war fears between the US and China persisting.
With regards to the rest of the year, we maintain last month’s view that the JPY has a bias to weaken through the end of Q2. As Japan enters its new fiscal year, Japanese investor and corporate appetite for foreign assets should reemerge after bringing back funds for the close of the fiscal year and Japanese monetary policy, unlike other G10 countries, should continue to be accommodative. Moreover, Japan has cleared two key hurdles that open the way for USDJPY to move higher.
The first hurdle was the Treasury department’s semiannual report on FX policies of major trading partners on April 13th. While this report noted that on a real effective exchange rate basis, the JPY was trading below its 20 year average the JPY is currently stronger than it was at the end of 2017. Moreover, the tone of the report’s criticism of Japan was unchanged from the prior report, implying that Japan has cleared this hurdle.
The second hurdle is the US-Japan summit between President Trump and PM Abe. At this summit, both countries agreed to start talks on developing a new “free, fair and reciprocal” trade deal. Moreover, the US administration didn’t step up its tone on the trade deficit between the two countries or against a soft JPY which also implies that a runway for a weaker yen.
On the flip side, the scandals swirling around PM Abe merit monitoring as it has caused approval ratings for Abe’s cabinet to fall material and raise questions on the sustainability of Abenomics. If approval ratings continue to slide, it is possible that Abe would be forced to have his Finance Minister resign and ultimately lead to PM Abe declining to run again, both of which should lead to a stronger JPY. Additionally, keep an eye on the BoJ’s yield curve control policy as there is a material chance for a change in the bank’s yield target sometime this year.
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.
To this end, we would like to point out recent comments from the RBA in its March statement where officials softened their tone on domestic growth. Originally RBA commentary indicated that it expected GDP growth to pick up to “...a bit above 3% over the next couple of years.” Now that statement has softened to expectations for the Australian economy to “…grow faster in 2018 than it did in 2017.” This is clear a much lower target to hit. This is all to say that the AUD is unlikely to see any support from a monetary policy perspective in the near term as well as a likely widening of the negative policy rate spread between the US and Australia.
While we have confidence in our AUD outlook, risks to our thesis presents itself through an unchanged terms of trade profile and relatively strong Chinese economy that influences the Australian materially. Given this, we note that increases in market volatility, i.e. moves in global equities and rising global rates, tend to drive market participants to reconsider their carry preferences, a change that is AUDUSD negative.
After a period of strong growth in China, assessments on the Chinese economy are being evaluated. Nominal growth lost momentum in Q1 the qoq growth of 2% represented the slowest quarterly growth pace since the first quarter of 2016. Combined with the recent 100 bps cut in the reserve requirement ratio from the PBoC, it is reasonable to conclude that authorities may be becoming uneasy with their growth assumptions and are easing financial conditions accordingly.
The wildcard to all this are the trade tensions rhetoric that remains prominent. However, as mentioned in other commentaries, trade actions taken so far (i.e. tariffs) appear to be more of a negotiation move than progression towards an actual trade war. Given this, we would still like to point out that emerging market currencies (including the CNY) tend to appreciate over the medium term as part of the resolution to lower trade tensions.
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