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USD

The DXY (USD index) is relatively unchanged since last month.  However, risks remain as the trade conflict between the US and China has escalated while other trade disputes remain unsolved. 

Growth divergence between the US and the rest of the world remains a theme, implying a near term bias for a stronger dollar but at a much more muted level relative to earlier in the year.  However, it should be noted that US outperformance has recently pulled back.  The counter to this are the recent downgrades to EZ growth forecasts.  At the end of the day, if growth ex-US continues to be soft, expect rising rates to support a stronger USD especially against EM currencies. 

Policy and political risks also remain.  On one hand trade tensions have benefited the dollar.  On the other hand, fiscal stimulus from earlier in the year is set to fade.  While Tax Reform 2.0 is a likely key campaign topic, it is unlikely to be realized.  Additionally, the Mueller investigation and the midterm elections should continue to hang over the USD. 

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EUR

From mid-August, when the euro crashed down, driven by many factors including concerns over European bank exposure to turn Turkey, to late September, the euro has staged a recovery. 

While part of this is recovery has to do with the market correcting its overreaction to possible Turkish contagion, it is important to note that the issue of USD denominated funding in the EM space remains.  (As the USD strengthens, loan liability in local currencies increase.) 

The more important headwind to the euro has been its economic underperformance relative to expectations and relative to the US’.  While economic performance has been a drag, data has picked up and the ECB still remains on track to normalize rates.  Additionally, flow factors have improved with inflows into equities and FDI picking up.  These factors, combined with the area’s current account surplus have combined to support the euro.

On a political front, Italian concerns remain.  While the Italian budget came in under the 3% EU red line, the final implied amount of 2.4% was a material increase of the rumored 2% target.  As a result, the Italian government is losing the trust of the markets.  Moreover, it is important to watch how the rating agencies interpret these developments as their ratings determine Italy’s ability to access low rates.  Given this, on average, Italy has a two rating notch buffer before it loses its 'investment grade' rating.  Point being, while there are risks, they are fairly manageable. 

Ultimately the more important issue could be the erosion in trust.  The markets were viewing the finance minster as a backstop against unsustainable policy measures but he lost the budget battle.  If market trust erodes further, the lens to which the markets view the projected 2.4% deficit could change to the downside, especially with full details—ie growth rate assumption on tax revenue—not yet out.

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GBP

September was a good month for the GBP, on a price perspective, as it moved up significantly, hitting a 2.5 month high.  However this strength in the GBP was accompanied by an uptick in volatility as UK politicians returned from recess and Brexit talks enter the final months with many contentious issues unresolved. 

While the GBP has move up on positive Brexit headlines, it is difficult to feel confident in this move as it means.  Case in point, it remains unclear on what progress has been made on the Irish border issue that needs to be settled before a withdrawal agreement can be struck.  On a positive note, the EU has hinted at an increased desire to avoid a no-deal Brexit with Germany softening its stance on requiring a clear statement of intent on the relationship between the UK and the EU to accompany the withdrawal agreement.  Keep in mind the withdrawal agreement and political declaration are two separate things with the latter the more difficult agreement. 

Over the near term, focus will be on whether an exit deal is able to be reached.  If a deal is reached, the markets will then focus on whether parliamentary approval can be secured, whether PM May can survive and, most importantly, what the new economic reality between the UK and the EU will be.  Ultimately if an exit deal is reached, there most likely will be relief rally, but it is important to remember that an exit deal is just a first step and does not remove all uncertainty around Brexit. 

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JPY

Since the publication of last month’s currency outlook, the JPY has been the worst performing G10 currency.  Looking ahead, the JPY is likely remain stuck in a tug of war.  Trade war concerns and uncertainty should continue to add safe haven flows and strengthen the JPY. 

However in the near term, a step back in trade tensions—US/China escalation on the low end of the spectrum and Japan avoiding auto tariffs—has helped the JPY weaken.   Moreover, continued strong demand from Japanese investors for overseas assets have been a steady source of JPY selling.  Japanese companies recorded a record level of outflows last year and the trend has continued this year.  The same holds true with equities as Japanese investors remain net buyers of foreign stocks.  Lastly, with Japan a net importer of energy, the sharp increase in oil prices hurts Japan’s trade balance and decreases its current account surplus.    

With regards to trade concerns, talks between the US and Japan have started and while China is the main focus of US trade negotiations, Japan does have many areas for which the US could key on.  Japan’s trade surplus with the US is double that of its total surplus and the US treasury continues to point out that the JPY is cheap relative to its 10 year rolling average.  On this point, keep an eye on the Treasury’s semi-annual trade report slated for mid-October.   

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CAD

In recent commentaries, we cited NAFTA negotiations as a key driver for the CAD.  This was confirmed as the CAD strengthened sharply after the United States-Mexico-Canada Agreement (USMCA) was announced.

While an agreement has been struck among the three countries, legislative approval is still needed from all three countries.  While both republicans and democrats have been supportive of a trilateral deal, in all likelihood it will be voted on by the US Congress after the midterm election when the body’s composition will be different than the current version.  Given this, the USMCA agreement does reduce trade uncertainty.

Key elements are as follows.  With the auto industry, the US gains concession on domestic content and minimum wage requirements.  Canada and Mexico gained protection from against tariffs should the US impose auto tariffs.  Additionally, the originally proposed 5 year sunset clause has been changed to a 16 year deal with a review and chance for extension after 6 years.  Moreover, the chapter 19 dispute mechanism remains.  The deal does not resolve the dispute of steel and aluminum with those tariffs staying in place.  

Prior to the deal, the markets were already pricing in a ~90% chance of an October BoC rate hike and this has increased to 95% post deal.  So while the deal didn’t materially change the market’s pricing for the next BoC hike, it does increase the BoC’s ability to keep pace with the Fed.

With regards to oil, crude prices in CAD continue to trade at a discount due to supply and transit constraints, limited the benefit to the CAD from higher oil prices. 

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AUD

YTD, the AUD has remained on a downward trend, driven by divergence between the RBA and Fed, as well as slowing Chinese growth and trade concerns.  Short AUD remain at elevated levels and has been used by the markets as a hedge for trade war fears. 

While all these factors that pressure the AUD remain, the argument for a less bearish AUD revolves around the following factors.  The first is the USD.  While the USD has outperformed since April, tailwinds to the US economy should fade.  Moreover, recent domestic data and RBA commentary has been more bullish.  Finally, fiscal stimulus is expected in China, as evidence by an uptick in government bond issuance that historically leads to infrastructure spending.  This should provide support for Chinese growth and support stability in the broader EM space. 

Politically speaking, Australia experienced another leadership change with PM Turnbull losing his leadership to Scott Morrison.  While Morrison is seen as a “status quo” choice that help provide relief to the markets, this latest bout of leadership turmoil opens up the prospect of a government change at the next election.

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CNY

After a period of sharp depreciating pressure on the CNY, the currency has stabilized a bit. 

The reintroduction of the counter cyclical adjustment (CCA) factor may be the most significant sentiment stabilization step.  The CCA factor is designed to offset the influence of higher (CNY weaker) spot closes on the next day’s fix.  This factor had been in use before being deemphasized in January of this year. 

Additionally, the increase in government bond issuance implies fiscal stimulus/infrastructure spending in the upcoming months.  This should help with slowing growth but it will likely require a realization of growth improvement before the markets reach a sustained period of CNY stability.

Near term, trade tensions should remain the key focus.  Tensions have been escalated with the latest round of tariffs and retaliation.  Clearly how talks evolve will influence the CNY with another escalation with the US tariffing an additional $267 billion of Chinese goods driving the USD higher and CNY lower.  Keep an eye on the G20 meeting in November as Trump and Xi are likely to meet.  

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This report is for general information and education only and was compiled from data and sources believed to be reliable. City National Bank does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of City National Bank as of the date of the report with no obligation to update or notify of inaccuracy or change. This report is not a recommendation or an offer or solicitation to buy or sell any financial instrument discussed. It is not specific investment advice. Financial instruments discussed may not be suitable for the reader. Readers must make an independent investment decisions based on their own investment objectives and financial situations. Prices and financial instruments discussed are subject to change without notice. Instruments denominated in a foreign currency are subject to exchange rate fluctuations, political and economic risks, and other risks. The Bank (and its clients or associated persons) may engage in transactions inconsistent with this report and may buy from or sell to clients or others the financial instruments discussed on a principal basis. Past performance is not an indication of future results. This report may not be reproduced, distributed or further published by any person without the written consent of City National Bank. Please cite source when quoting.

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