The EUR/USD pair broke below the important 1.10 psychological level in part due to comments by ECB president Dragi dampening expectations that asset purchases will be tapered. Currently, the market is broadly pricing in a 6-month QE extension, at the current monthly rate, believed to be announced in December. Given these expectations, the bar is high for a dovish surprise with the risk being for disappointment to the hawkish side. A lot will depend on the technical tweaks to the QE program to allow an extension and the ECB’s forward guidance on the criteria for further extensions. Typically QE programs drive yields down to unjustifiably low levels on the belief that easy money policies will persist indefinitely. If and when the ECB hints that the easing cycle might be ending, the resulting bond profit-taking should prompt yield spikes and currency appreciation.
Resilient post-Brexit data has been overshadowed by concerns of a hard Brexit—which would prioritize lower migration at the expense of access to the single market place—driving the pound down to new post-referendum lows. PM May has also indicated that she would trigger Article 50 by March 2017, however the courts are set to rule on whether she can do so without a vote in Parliament. Investor focus has shifted towards the long term consequences of Brexit for growth vs. the immediate fallout which can lead to a decoupling of the GBP and economic data flow. Balance of payment challenges still persist and are two dimensional: 1) the U.K. needs to fund a record 6% of GDP current account deficit in a low interest rate environment with political uncertainty; and 2) the U.K. has gross foreign liabilities of greater than 400% of GDP, which creates a significant capital repatriation risk should foreign investors lose faith in the U.K.
The Bank of Canada’s (BoC) dovish shift in September has caused the market to build up short positioning against the CAD. However, OPEC’s surprise production cut announcement and subsequent oil price rally was well timed with respects to offsetting CAD weakening pressure, keeping the CAD range bound versus a more uniformed push for CAD weakness. The balance of risks still remain biased towards CAD weakness if the various risks—i.e. NAFTA repeal fears, oil prices fall, US-CA divergence— all occur at the same time. Canada remains the US’s second largest trading partner, and perhaps more importantly, the US comprises over half of Canada’s total trade, exposing the CAD to trade tension vulnerabilities, not unlike the Mexican peso, should polls tighten heading into the November 8th election.
The Bank of Japan’s (BoJ) new policy framework of QQE with Yield Control suggests that the BoJ’s monetary easing is getting closer to its limits and suggests that the BoJ currently prefers supporting financial institutions at the cost of a weaker currency through lower real interest rates. As a reserve currency, the JPY has exposure to US election risk via possible trade tensions, which is positive to current account surplus currencies as well as general policy uncertainty which is negative for investors’ risk sentiment. Expectations for a Fed rate hike have provided support for a weaker yen, however this driver is most likely reaching a near term limit. Historical/seasonal/technical patterns suggest that a correction for a weaker yen in the coming months is possible; overall we see further yen strength.
The Australian dollar has been the best performing G-10 currency so far in the second half of 2016 despite shrinking interest rate differentials. However, it appears that the AUD has decoupled itself from interest rate spread dynamics and is more driven by absolute rate levels. Given this, the AUD is at risk to anything that threatens the carry trade. Case in point, AUD/USD did not do well during the taper tantrum, and while it has been resilient to the global lift in long end yields, possibly aided by firming commodity prices, it would be difficult for AUD/USD to sustain its current valuation level should US 10-year yields move towards 2.0%. Longer term, the prospect of weaker Chinese growth via higher tariffs on Chinese imports could be bearish for AUD, given the currency’s position as a China proxy.
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