The dollar has been on a broad based decline since the beginning of the year and that trend has continued through the month of August. On the data front, the U.S. inflation printed its fifth consecutive month of soft core inflation, feeding into the market’s skepticism of the Fed’s ability to raise rates further. Additionally, there is a sense of heightened political uncertainty in Washington D.C. as the Russian investigation should hang over the administration for the foreseeable future. All of these factors have combined to push U.S. interest rate spreads back down to pre-election levels despite 50 bps of rate hikes since the election.
Once Congress returns to Washington D.C. after the Labor Day weekend, it will be faced with the complex task of raising the debt ceiling as well as passing a budget. However, both of these tasks have been further complicated by President Trump’s public criticism of GOP leadership. Lastly, the Fed announces its next rate decision on September 20, and while the market is pricing in a next to zero chance of a rate hike, the Fed has telegraphed its intention to begin balance sheet normalization (by not reinvesting funds) in September. However, give the succession of inflation misses, there is uncertainty surrounding all policy changes.
With questions arising around the Fed’s ability to raise rates and without material pro-growth policies, it is becoming increasingly difficult to build a case for dollar strength as political risk factors should keep the dollar pressured.
Euro strength has been one of the strongest themes this year, with the euro versus the USD up nearly 14% on the year. The move for euro strength has been supported by 5 consecutive months of downward inflation surprises in the U.S.—something that has only happened once in the past 20 years. Additionally, President Trump’s falling approval ratings and public criticism of GOP lawmakers keep risks surrounding the complicated debt ceiling debate elevated.
Heading towards the end of the year, further euro support may arrive in the form of an ECB taper announcement that many in the markets are expecting to come this autumn. If the ECB does taper, this should be EUR supportive, especially if U.S. inflation remains soft and the Fed remains on hold. However, it would be a mistake to think that there is one-way traffic for the euro.
On the European side, concerns stemming from the stronger euro have started to emerge. With the ECB focused on inflation, it would seem reasonable to expect them to be monitoring the EURUSD exchange rate as a stronger euro depresses both inflation and growth. As a result, it is quite possible that the euro’s rise could delay a taper announcement, extend the wind-down process or lead to the ECB telegraphing a long period between the end of QE and the initial rate hike. Beyond the ECB, it appears that the markets themselves are showing concerns over euro strength as cross border flows into European equities are falling drastically. On the U.S. side, five consecutive months of downside surprises could be followed by a couple of months of upside surprises, leading the markets to reprice in rate hikes.
With regards to politics, political risk could shift from the U.S. to Europe during Q1 2018 as the Italian elections are slated to be held at a time when euro longs are likely to be near record levels. However if the Italian elections return a result that leaves an EU referendum as a low probability event, the path towards a rate hike becomes clearer.
The GBP continues to be one of the trickiest currencies to forecast as its future is up to a variety of variables, all of which have uncertain outlooks. Clearly, politics have been the dominant driver of the currency over the past year; the umbrella issue of Brexit uncertainty was further muddied by an indecisive snap election result that has implications on both Brexit as well as fiscal and, potentially, monetary policy.
In the short term, economic data, and the associated effect on monetary policy, should be the dominant driver for GBP direction. Earlier this year, rising inflation led to a period of GBP strength as the markets started to price in hopes for a Bank of England (BoE) rate hike.
As we have touched on before, we don’t believe the market’s take on the BoE’s most recent rate decision as straightforwardly hawkish as there is uncertainty surrounding the BoE’s reaction function. It’s not simply higher inflation equals higher rates as concerns from the Brexit overhang keep the bias for accommodative policy in anticipation of economic weakness.
On the economic front, data flow has started to show signs of weakness (lackluster 2Q GDP, still stagnant manufacturing defying stronger business surveys, the weakest housing market in four years, and an unexpected dip in core CPI), validating many concerns voiced by the BoE. Inflation, while still above target, has shown signs of peaking/pulling back as the BoE has forecasted. Moreover, the BoE has downgraded its growth forecasts as uncertainty continues to weigh on firm and consumer decisions. Even employment, which has provided some positive data, ultimately supports an accommodative BoE as wage growth not only hasn’t picked up but has also fallen on a real or inflation adjusted basis. Net on net, for the possibility for rate hikes to be credible, we feel that the MPC will need to see growth accelerating, not just inflation and neither of these two conditions appear to be happening.
However, it’s not all bad news for the GBP. In last month’s forecast we touched on how PM May’s weakened government increases the chances for a softer Brexit and that appears to be happening. It has been reported that many in May’s government, including some of the strongest “hard” Brexit proponents, are now supporting the idea of a transitional deal, implying a “softer” Brexit and lowered long-term risk; however, the slow progress thus far does raise concerns on the probability of finalizing deals before the hard deadline. Regardless, in the short term, the realities of a softer economy should matter more than the rising hopes for a softer Brexit.
The CAD remains a relative story with the relative pace of policy normalization between the U.S. and Canada playing the role as the primary driver for USDCAD. As it stands, the markets are pricing in a different pace of policy normalization in the U.S. and Canada despite there being a lot of similarities between the inflation picture in the U.S. and Canada.
As touched on in the USD section, U.S. inflation has undershot for 5 consecutive months but inflation in Canada has undershot expectations in a similar magnitude; this is actually in line with what you would expect from these two economies as they are intertwined and geographically close. Moreover, while Canadian unemployment has dropped considerably, its change remains roughly in line with the employment developments in the U.S.; but notably, the Bank of Canada still notes that there remains slack in the economy where as the U.S. is already below some NAIRU (non-accelerating inflation rate or unemployment under which inflation should rise) estimates.
Yet despite these broad similarities, especially with respect to persistent inflation undershoots in both countries, the markets are pricing in a higher likelihood for another rate hike, through the end of the year, for Canada than for the U.S.; this implies that the markets believe the BoC and the Fed are operating under different reaction functions. This is possibly due to the market’s perception that Fed rate hikes are inflation based versus the BoC’s reaction function which can be argued to be more growth based as it still needs one more hike to fully remove the 50 bps in emergency cuts from 2015. After the BoC fully reverses its 2015 emergency cuts, it is likely that the BoC’s reaction function will return to an inflation based one, but this reassessment will likely take time.
Finally, NAFTA re-negotiations have begun in earnest, 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.
Unlike an increasing number of global central banks which appear to be preparing to pull back on monetary support, the Bank of Japan (BoJ) remains committed to providing extraordinary support to the markets. Specifically, the BoJ is committed to holding its 10-year yield near 0.0% so U.S. rates should remain a key determining factor in JPY direction.
An analysis of USDJPY’s sensitivity to U.S.-Japan spreads show an increased reaction function with a 10 bps change in yield spread implying a 2.6 yen change now versus a 1.8 yen change back in May/June. To this point, the USDJPY’s decline from mid-July through the beginning of August can be attributed primarily to a decline in U.S. yields driven by ongoing concerns over the Russian investigation as well as diminishing hopes for Fed rate hikes.
Since the beginning of August however, unwinding of JPY shorts and geopolitical factors—specifically North Korea—have been the key drivers. With regards to North Korea, tensions have recently heightened with another missile test over Japan being met by a fresh round of rhetoric from both sides. With September 9 marking North Korea’s Foundation Day, it is likely that tensions will be further heightened through another show of North Korean military might.
Given the geopolitical turmoil on the Korean peninsula, market participants have accelerated their unwinding of short JPY positions, adding another tailwind to JPY strength. However it should be noted that while JPY shorts have been reduced, aggregate shorts still remain at elevated levels, implying further room for JPY strength.
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.
To this end, the Reserve Bank of Australia (RBA) made a concerted effort to create distance between itself and other more hawkish central banks, both through its most recent statement as well as by verbally pushing back on the market’s hawkish narrative. However, the AUD did move up on, in our view, the mis-interpretation of the RBA’s July minutes.
Ultimately, I think that the AUD will decline on shrinking rate differentials and a weaker trade profile. Additionally, Chinese economic data was weaker in July and a buildup in iron ore inventories seems to suggest that the current iron ore price level may be unsustainable. Moreover, the RBA has indicated in its August minutes that an appreciating currency would be expected to “…result in a slower pick-up in economic activity and inflation than currently forecast” indicating a dovish bias should the currency materially strengthen further.
However, with the USD in the midst of a broad weakening trend and uncertainty surrounding soft U.S. inflation and wage growth unlikely to be resolved anytime soon, the AUD has likely to have settled into a higher trading range versus at the beginning of the year.
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