Since the beginning of the year, the USD has been on a broad based decline but has stabilized over the past month as a more-hawkish-than-expected Fed reignited hopes of a December rate hike.
Given this, the USD is more likely than not to remain under pressure for the near future. The deal addressing the debt ceiling has provided a bit of relief for the USD as it removed the technical default and government shutdown risks. However, the respite should be brief as the government shutdown risk should reemerge around the New Year and could push back the timeline for tax reform efforts, lowering the probability for tax reform before the 2018 mid-term elections.
Moreover, persistently soft inflation and stubbornly low wage growth reinforces the market’s concerns on the Fed’s ability to enact multiple rate hikes against an increasingly hawkish global backdrop. Case in point, the Bank of Canada has delivered consecutive hawkish surprises and chatter continues to surround the ECB and the potential for an upcoming taper. Additionally, numerous domestic and geopolitical risks—i.e. North Korea, political turmoil in Washington D.C., natural disasters etc.—continue to weigh on the USD.
Ultimately, the USD finds itself in a tricky positon of unrealized potential. We acknowledge that there are many potential catalysts to drive USD strength, however, given the current landscape, the probability of a resurgence of the Trump trade remains diminished and U.S. inflation remains persistently low. Notably, the Administration recently released plans for tax reform. If material tax reform were to pass, it would certainly give a boost to the economy and the USD. However, there are many complications to the process and with a debt limit vote and mid-term elections on the horizon, a tax package that substantially adds to the debt will face stiff challenges. In the end, without inflation bouncing back convincingly and Congress making meaningful progress on tax reform, there is a chance for a meaningful USD rebound to remain muted.
Euro strength has been one of the strongest themes this year with the euro up versus the USD by nearly 13% on the year. Moving forward, monetary policy and politics should be the two main drivers of euro direction.
With regards to monetary policy, the question is whether to taper or not to taper. Indications remain for the possibility of tapering action in autumn, putting the ECB’s October meeting squarely in focus as a possible candidate for the ECB to begin its exit from its QE program. The key variable to this will be the ECB’s sensitivity to euro’s recent run of strength and the extent to which euro strength could delay a taper announcement, extend the wind-down process, or imply a significant pause between the end of QE and the first rate hike. While there are many variables at play, anticipation for a potential policy shift from the ECB should keep near-term support behind the euro.
Beyond the ECB, politics, specifically Italian and Spanish politics, provide additional uncertainty. Currently, market expectations are for the Italian election to result in a dysfunctional coalition government in which the prospect for an EU referendum remains a low probability event. A similar outcome is expected in Spain where the possibility for a referendum could result in near-term noise but ultimately prove to be a remote risk.
Lastly, there is the USD and the Fed’s rate hike path. As we touched upon in the USD section, the dollar remains pressured and it would require a few consecutive months of upward inflation surprises before the markets begin to price in additional rate hikes.
The GBP continues to be one of the trickiest currencies to forecast as its future is tied to a spectrum of variables, all of which have uncertain outlooks. Clearly, politics have been the dominant driver of the currency over the past year with the umbrella issue of Brexit uncertainty impacting the economy and monetary policy.
Specifically, Brexit is increasingly being seen as not an acute issue but a chronic long term problem for which the severity of its impact will become clear over the course of multiple years. Ultimately the total impact of Brexit will not only be determined by the final negotiated version of Brexit but also by uncertainty and associated business decisions—or delays in decisions—during the negotiation process.
News flow out of the U.K. has been generally positive with the U.K. government now more accepting of the need for a transitional deal to decrease uncertainty and soften the impact of the U.K.’s exit from the EU. However, openness to a transitional deal notwithstanding, the possibility of a hard Brexit that disrupts the economy still remains. The U.K. remains intent on controlling free movement of labor and the EU has made it clear that free movement is needed to be part of the single market; this is why a transitional deal may just be a delay in the economic consequences and not a bullish game changer for the GBP.
Moreover, news flow could turn negative as PM May and other ministers may need to address concerns from euro-skeptic members. Additionally, progress with Brexit negotiations have been slow with both sides unable to settle on the U.K.’s Brexit bill amount. Without this agreement, the EU has refused to begin discussions on more substantive issues such as a new free trade agreement which only serves to increase the uncertainty. Ultimately, we remain moderately negative on the GBP based on this Brexit related uncertainty.
When the Bank of Canada (BoC) surprised the markets with a second consecutive rate hike, Canada moved to the front of the rate normalization line as a second hike signaled a greater conviction to deliver a more sustained rate normalization path than market consensus.
The BoC’s decision to hike rates against market consensus and in front of critical data points was no doubt aided by a robust GDP print in which the Canadian economy delivered a 4.5% quarter-over-quarter gain. This growth breakout implied a true growth breakout as it came on the back of 3 quarters of 3.5% growth, which came after 6 months of 0.5% growth. Moreover, the internal drivers of growth—household demand, net exports and non-residential investment—are all sustainable sources of growth.
All of this has upended a key assumption from our previous forecast—that rate hikes in Canada would be constrained by the pace of rate hikes in the U.S. With the BoC’s latest move, markets appear to think that the BoC is comfortable to begin its rate normalization cycle ahead of the Fed. The counter is that a lot has been priced in and multiple BoC speakers have expressed concerns over the CAD’s strength as well as indicated that inflation could currently be overestimated. Additionally, there are still concerns over the medium term as it remains to be seen how higher interest rates impact the real estate market and its contribution to Canadian growth as well as the sustainability of oil prices at its current level.
Lastly, NAFTA re-negotiations are ongoing, and while near term impacts are minimal, it is worth noting that the political turmoil in Washington D.C. adds to the uncertainty surrounding the ongoing negotiations.
For the past couple of months, we have identified U.S. rates as a key driver for the JPY. Given that the Bank of Japan (BoJ) remains committed to providing extraordinary support to the markets and holding its 10-year yield near 0.0%, this should remain true.
However, over the near-term, developments on the Korean peninsula should be the main driver of the yen. Over the past few months, North Korea has become increasingly daring with its military actions with multiple missiles landing in Japan’s Exclusive Economic Zone in the Sea of Japan. Moreover, recent rhetoric between the U.S. and North Korea has become increasingly hostile with both the U.S. and North Korea threatening each other with destruction. While we acknowledge that North Korean actions have had a limited impact on the JPY so far, this could quickly change if boundaries continue to be pushed and tensions rise further.
Geopolitics aside, economics still matter. As touched upon, the BoJ remains very dovish against a global backdrop of increasingly hawkish central banks. Post the September Fed meeting, the probability of a Fed rate hike by December has moved up from ~35% to ~70% so it comes as no surprise that the JPY has weakened during the same timeframe and is the biggest laggard of all G10 currencies over the past month. Moving forward, the markets will keep an eye on U.S. inflation data and the results of the Japanese snap election. If PM Abe is able to consolidate his power, additional pro-growth policies are possible, and if U.S. inflation picks up, the markets could begin to price in additional hikes.
The AUD rallied up to multiyear highs this past month due to the improvement in economic data and sentiment out of China, as well as a run of positive domestic economic data. However, for the Reserve Bank of Australia (RBA), a stronger currency has been an unwelcomed development.
In the RBA’s view, a stronger currency could be expected to slow down the recent pick-up in economic activity and the RBA’s inflation forecasts. To this end, the RBA made a concerted effort to create distance between itself and other more hawkish central banks, but it is unlikely to intensify its verbal intervention anytime soon.
We continue to think that the AUD will decline on shrinking rate differentials. However, the AUD’s fall has been complicated by solid Chinese growth, resilience in the spot commodity market and lower conviction in the U.S. wage and inflation outlook. It should be noted that the narrative surrounding the USD has changed a bit after the September Fed meeting where the probability for a December rate hike increased from ~35% to ~70%. But as we have noted before, it will take a couple of months of upwards inflation surprises before the markets begin to price in multiple rate hikes.
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