Our euro forecast has been revised up to show increased euro strength. Rising European yields, stemming from any indication of reluctance by European officials to provide additional easing, and the euro area’s current account surplus outweigh effects of a Fed rate tightening. Politics also continue to play a role in the exchange pair with Italy voting on a constitutional referendum in December and additional political risks in the Netherlands, France, and Germany. On balance, the European political risks are de-emphasized by the U.S. political risk attributed to the Presidential election and its associated trade implications in November.
Economic performance post-Brexit has been more resilient than expected, putting a squeeze on record GBP shorts and driving a spark of GBP strength. However, we see this resilient performance simply as a reshaping of the GBP’s path to reflect a less abrupt downturn and maintain our position of overall GBP weakness. To this end, the GBP has given back much of its gains and is trading close to its post-Brexit lows in the wake of PM Theresa May’s comments of a “hard” Brexit. The expectations of transitional effects, lower investments and strain from the significant current account deficit, to drag onto medium term growth remain intact. Despite the projected acute immediate shock failing to materialize, Brexit continues to represent a medium term problem as businesses adjust to new and uncertain trading arrangements.
A dovish bias was introduced through a dovish September Bank of Canada (BoC) meeting where the risk profile was shifted from “roughly balanced” to “tilted somewhat to the downside.” This was the first shift, in eight policy meetings, away from a balanced view. Given that, the market implied probability for a rate cut through Q1 2017 remains subdued. However, the dovish bias does increase downside risk sensitivity with the BoC exhibiting more data sensitivity. Hopes of an OPEC production cut helps oil, but details have yet to be finalized, meaning a cut isn’t a done deal. Given this, we don’t forecast a significant breakout above the past months’ trading range.
Our JPY view remains relatively unchanged as we expect it to be range bound. The outlook for multiple Fed rate hikes this year is low, so downside risk will mainly be due to dollar weakness as opposed to yen strength. At its most recent meeting, the Bank of Japan introduced “QQE with yield curve control” in an effort to steepen its yield curve with a target of “around zero” for 10-year government bonds. The main implication of the BoJ’s 10-year target isn’t the 10-year yield itself but the creation of more room to drive policy rates more negative while limiting damage to banks. However, there is still a limit to how low rates can go.
Commodity prices have been providing support to the currency. Factoring in commodity prices and absolute interest rates helps to explain the elevated price relative to interest rate differentials. This then raises the question as to how long commodities can continue to provide support. Against this backdrop, we note that developments in China’s iron ore inventories are supportive of lower prices at some point. The Royal Bank of Australia has already cut rates by 50 bps this year and is expected to be on hold for the rest of 2016, and similarly, the Fed will likely be on hold until the end of the year once money market reform and the Presidential election are out of the way. Therefore, monetary policy will most likely take a backseat.
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