Risks for euro strength revolve around the U.S. election and a dovish Fed. Risks for euro weakening revolve around political risk with a constitutional referendum in Italy and elections in France, Germany, and the Netherlands. On balance, the market’s perception of a dovish or hawkish Fed in light of mixed U.S. data remains a key influence on EUR/USD. Brexit has had a less than expected impact on European survey data, but we view this as merely a shift in the timing of the impact, i.e. shifted towards next year ahead of the Dutch, German and French elections. The E.U.’s current account surplus continues to provide support for the single currency.
Forecast risks remain biased towards GBP weakness based on evidence of an aggressive Bank of England (BoE) reaction function, evidence of damage to the economy from Brexit, and the possibility that foreign investors could require more of a premium to compensate for the accelerated decline in U.K. yields and an extended period of economic uncertainty. Upside risk comes from a short squeeze on record shorts if the economy proves more resilient than expected and/or the BoE’s Autumn Statement in October/November signals a more significant relaxation of fiscal austerity. The key event risk on the horizon comes from the government invoking Article 50 sooner than expected.
Recent weakness in oil prices had a muted impact on CAD as the market didn’t see it as a broader deterioration in other commodities or a shift in Bank of Canada (BoC) policy. However, weaker than expected Canadian economic measures—retail sales, trade data and GDP--have renewed concerns over an economic recovery, skews towards CAD weakness, and presents concerns about the economy’s ability to hit the BoC’s growth target. In summary, conditions to breakout from the recent range bound trading include a hawkish Fed slant combined with a dovish BoC and a broad weakening of global commodity prices.
Bank of Japan (BoJ) action or inaction, depending on your point of view, disappointed markets driving the currency down to its current range. The next key event will be the BoJ’s monetary policy meeting on September 20-21 with the markets watching for the outcome of the bank’s comprehensive assessment of the developments in economic activity and prices under “quantitative and qualitative easing (QQE)” and “QQE with a Negative Interest Rate.” Qualitative easing targets certain assets to drive down their yields. Quantitative easing is unspecific and intends to drive down yields across a spectrum of assets. In the short term, expect USD/JPY to be range bound with Japanese investor appetite for foreign securities offset by FX hedges. However more active hedging by the Government Pension Investment Fund and other public institutions are adding to JPY buying pressure.
AUD briefly sold off after the Reserve Bank of Australia’s (RBA) 25bp rate cut but quickly recovered those losses partly due to Australia’s interest rate narrative. Australian yields may be at historic lows but are still relatively higher than elsewhere in the world, which plays into a growing sensitivity towards outright yields vs. relative yields. Commodity prices—iron ore and coal—have provided support to the currency. However, it is unclear how much longer the support can continue, especially in light of recent comments from the vice chair of the China Iron & Steel Association and further expected RBA easing. With other central banks near their lower bound, any further cuts from the RBA will erode Australia’s yield advantage, leading to a weaker AUD.
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