After the US economy had a strong first half of the year, many in the markets were questioning the sustainability of continued US outperformance for the rest of the year.  As we move into the last month of Q3, it appears that US economic exceptionalism has indeed continued into the second half of 2018.  As a result, we have moved up our USD target in acknowledgement of growth divergence with the rest of the world, trade tensions and EM risks that have been supportive of the USD and should continue to do so.   However, while we moved up the USD target, we continue to see headwinds for the USD implying a decent possibility that US performance could converge with the rest of the world towards the end of 2018. 

Recently, an increasing amount of idiosyncratic risks around the world has underscored the USD’ strength.  While risks have been particularly acute in the emerging market space (Turkey), there are also risks in developed markets.  Increasing chatter for a “no-deal” Brexit and the potential for a fiscal conflict between Italy and the E.U. have raised uncertainty and increased vulnerability to the euro, the world’s second most important currency.  The net result has been USD strength due to its safe haven status and cyclical outperformance. 

Furthermore, trade risks still remain.  NAFTA talks have resulted in a bilateral trade deal between the US and Mexico but the desire is for a trilateral agreement including Canada.  Additionally, there still remains many obstacles/steps such as passage through legislative bodies in the respective countries and addressing the red lines that have been the downfall of prior talks.  With regards to China, the public consultation period for US tariffs on an additional $200 billion of Chinese exports ends September 5 meaning they could be implemented at any time after that.  If these tariffs do go into effect, it would be a quadrupling of the amount of imports subject to tariffs and could warrant continued moves into safe haven assets. 

Given this, uncertainties come through President Trump’s comments on monetary policy and USD strength, which is a break in historical precedent.  While Fed Chair Powell has taken the majority of President Trump’s criticism, the tools for the President to intervene and weaken the USD generally goes through the US Treasury and Secretary Mnuchin.  Mechanisms aside, the President’s ability to weaken the USD appears limited.  Finally with Labor Day in the rearview mirror, midterm elections should gain more focus.  The current assumption is for Republicans to retain control of the Senate and Democrats to control the House.  Clearly if the Democrats are able to also gain control of the Senate, the implications regarding the Mueller investigation could be much greater depending on what the investigation produces and when it concludes. But regardless of which party controls Congress, an ongoing Mueller investigation warrants a USD discount.        

DXY table
DXY graph


It’s been a tale of two cities for the euro this year with the currency strengthening at the beginning of the year only to drop sharply in April and then take another leg lower in August as the Turkish situation switched from chronic to acute.

However the euro’s underperformance extends beyond emerging market issues.  Heading into the year, the Eurozone was outperforming the US and was expected to continue to do so this year.  However this was not the case.  For reasons that are not entirely clear, the economy in the Eurozone slowed in Q1.  While Q2 rebounded with stronger growth, the markets have been underwhelmed by the pace of the recovery and the follow through especially in contrast to the US economy which has been growing faster and with better momentum. 

Adding to the headwinds facing the euro are building concerns over a fiscal budget clash between Italy and the EU.  With the coalition government in Italy set to release its 2019 budget, markets will be watching to see what percent of GDP the deficit will be.  This is important because Italy’s credit rating could be subject to downward revisions that could put the country’s ability to access lower rates in jeopardy.  Moreover a deficit greater than 3% of GDP will trigger push back from the EU and reignite conversations around leaving the euro.  It should be noted that indications are for a projected deficit around 1.7% of GDP, well within the level that would trigger a mandatory EU response.  

With respect to Turkey, the concern revolves around the exposure European banks have to Turkish loans, especially to loans not denominated in Turkish lira and subject to the lira’s sharp depreciation.  On this point, we would like to note that while the total exposure is material in absolute terms, it is less than 6% of the capital base of European banks so even if all the loans were fully impaired, there shouldn’t be a systematic failure.    

All these factors discussed leads us believe the euro’s recovery should be pushed back to the end of 2018/into 2019.  While US growth is currently strong, it is reasonable to believe that it would pull back and ultimately converge with a solid Eurozone economy as temporary US economic tailwinds fade.  

EUR table
Euro graph


Over the past month, the GBP has been one of the G10’s worst performing currencies as soft economic data and, more importantly, increased rhetoric surrounding a “no-deal” Brexit perpetuate in the market.   Case in point, the Bank of England raised rates in August and the GBP subsequently weakened over 3% before recovering as the markets were more focused on “no-deal” headlines. 

End of the day, the GBP has proven extremely difficult to forecast as the alternative outcomes are so drastically different (disruptive no-deal vs. continuation in the single market) and because it’s so difficult to assign probabilities to the different outcomes.  Moreover, with a deeply divided UK Parliament, which has to approve any deal, it is still unclear exactly what the UK wants, let alone what the EU is willing to accept.  While the UK’s Brexit stance continues to evolve, as it stands, it appears that the current UK strategy would require the EU to compromise on the four freedoms (free movement of people, goods, services and capital) that the EU has stated it is unwilling to compromise on, implying further negotiation difficulties. 

Regardless of the ultimate probabilities around deal/no-deal/extension, it appears that the markets have materially increased its probability for “no-deal” as well as started to question whether or not there is a base case as no particular scenario has a clear high probability.  All of this results in the GBP continuing to be pressured.    

Looking forward, Brexit developments are likely the most important driver of the GBP.  Recently it has been reported that the EU is prepared to offer the UK a strong deal but headlines like this have had a tendency to fade so until something solid happens this just remains a headline.  Keep an eye on political party conferences in September and October.  These meetings should provide insights into whether PM May is in danger from hardline Brexiteers in her own Conservative party and also to see if the Labor Party will be supportive of a second referendum.  Labor meets September 23-26 and the Conservatives meet September 30 to October 3.  On the EU side, keep an eye on September 20 when the EU leaders hold an informal meeting and October 18 which is the EU council meeting as potential inflection points. 

GBP table
GBP graph


After a year of stop and go trilateral NAFTA negotiations, the US and Mexico announced a break through on a bilateral basis.  While, as of this writing, the full details of the US-Mexico agreement have yet to be released, it represents a positive shift in sentiment.  The CAD strengthened to reflect this despite Canada not being part of the deal and that is a key caveat. 

Congress authorized President Trump to renegotiate a trilateral deal, not a bilateral deal, under the trade promotion authority for a fast track process, putting into question the validity of a bilateral deal.  Even assuming that Canada does join the deal, Congress still has to approve a revamped NAFTA.  Given the mid-term elections in November and a busy congressional schedule, it isn’t clear that Congress will be able to get to NAFTA.  Even if it does, details have yet to be finalized so it’s not a forgone conclusion that there will be enough votes, either in the current Congress or the new Congress after the mid-terms.  So while any progress is good news and even an unenforceable deal in principle reduces risks, including the US pulling out of NAFTA, there are many hurdles that remain for a quick resolution and it’s very possible NAFTA isn’t resolved in 2018. 

On an economic point of view, positive data surprises with payrolls, inflation and GDP has helped the currency strengthen in August.  However, while there is potential for further strong performance, markets are always quick to readjust expectations with economic surprise indexes mean reverting after a string of economic surprises.  Case in point, after surprising strongly to the upside, GDP data has pulled back.  Ultimately, foreign exchange rates are based off relative valuations.  As a result, to the extent that Canadian outperformance benefited from US outperformance, it will be difficult for markets to price in more bullish expectations for Canada relative to the US. 

Moreover, the CAD’s recent outperformance leaves it vulnerable to NAFTA risks.  Case in point, markets are currently pricing in a ~90% chance of another rate hike this year from the Bank of Canada.  This means risks to rates are asymmetrical to NAFTA disappointment as there is more room to unwind hike pricing than to add to it.  Given our expectations for prolonged NAFTA discussions, expect the CAD to remain pressured by NAFTA concerns until 1H 2019 when a resolution is more likely. 

CAD table
CAD graph


The JPY continues to trade in the same range it has been in since May and over the last month, it has been one of the top performers among G10 and major emerging market currencies. 

In our opinion, there are a couple of key factors that argue for JPY strength should it break out of its current range.  The first factor is monetary policy with the Bank of Japan (BoJ) fine tuning its monetary policy at its July meeting.  While what the BoJ actually did was relatively minor, it does add to the market narrative that the BoJ could turn more hawkish as officials become increasingly concerned over the side effects of extended easy money polices.  Additionally, negative market sentiment resulting from trade conflicts (NAFTA, EU, China etc.) as well as emerging market concerns (Turkey etc.) have led to risk off flows into safe haven assets.  The issues with Turkey will not be solved quickly and despite progress with Mexico, there still remains much work to do on NAFTA, let alone with the EU and China.  All of this implies that the markets should remain volatile.

Moreover, the US and Japan held their first trade talks last month under the headline of FFR (Free, Fair, Reciprocal) that ended without new developments.  Among the issues is the US’s desire for a bilateral deal while Japan wants the US to rejoin the multilateral TPP.  With the next meeting scheduled for September, the JPY is set for more volatility especially if the US expresses unhappiness at the JPY’s value which it sees as cheaper than the JPY’s 20 year average.  Finally there the LDP’s leadership election at the end of September.  While PM Abe is expected to win the election and no major changes to monetary policy is expected should Abe lose, the possibility of a leadership change could lead to yen appreciation should polls get tight. 

The counterbalance to all this is the strong Japanese demand for foreign assets, which has led to a steady stream of JPY selling.  As the primary sellers have been corporates, there is less need to buy back JPY and selling demand is contract based thus consistent and not tied to sentiment.

jpy table
JPY graph


The AUD consistently moved lower throughout the year and continued to do so this past month.  In addition to the issues facing the AUD YTD, political drama that ultimately resulted in a new Prime Minister (the 6th  PM in 8 years) pushed the AUD down to nearly a two year low.

On a structural basis, the view of monetary policy divergence between the Reserve Bank of Australia (RBA) and the Fed has played out as evidenced by the negative policy rate spread between the two countries.  Given the US’ economic outperformance this divergence is expected to widen as the Fed is on track to raise rates two more times this year against an RBA that is widely expected to remain on hold well into 2019—a view reinforced by recent economic data.  Furthermore, a slowing Chinese economy implies weaker commodity demand from Australia. 

While this supports our view that the AUD will remained pressured, there are a couple reasons that moderate this view.  The first has to do with the upcoming US midterm elections for which control of the House of Representatives is expected to swing to the Democrats.  If this were to happen, talks of impeachment could intensify, especially if the Mueller investigation were to return something substantial.  As history has shown, the USD tends to underperform in these situations.  Additionally, there appears to be a pivot with the US trade negotiation strategy with tensions easing with the EU and progress made on NAFTA, especially with Mexico.  If further progress is made/the White House pulls back on confrontational rhetoric ahead of the mid-term elections to preserve stock market gains, the USD could lose some of its safe haven flows.  Along these lines, we would like to note that short AUD positions are at levels not seen since 2015.  These levels have increased despite the Australian economy remaining unchanged and the RBA holding an optimistic assessment of medium term growth, illustrating that short AUD is the hedge of choice for EM, China and trade conflict concerns that could also ease if White House rhetoric also eases. 

AUD table
AUD graph


After spending the first 5 months of the year consolidating, the CNY accelerated its losses from mid-June through the end of July as trade tensions with the US flared up due to concerns over the negative impact of trade tensions exacerbating existing concerns over China’s slowing economy. 

While it is important to note that China tends to look at currency stability through the lens of a currency basket, USDCNY has stabilized since the start of August and has in fact appreciated since the middle of August despite no resolution to the ongoing trade conflict between the US and China.   

This change in fortune is partially due to recent USD weakness but also due to steps from the People’s Bank of China (PBoC).  To this end, there is fine line between easing financial conditions, something the PBoC has done to support a slowing economy and acknowledge trade conflict related headwinds, and a rapidly depreciating currency triggering capital outflows leading to tighter liquidity.  Based on recent actions where the PBoC raised the cost to sell CNY forwards and reintroduced a counter cyclical factor in its fixing, it appears that the market has found the PBoC’s pain threshold for yuan weakness.  However more important than the actions is the signal that China could do more to keep the CNY from depreciating too rapidly.     

While sentiment around trade talks have improved with the US making progress with the EU, Mexico and Canada, the talks with China have made much less progress with reports that President Trump is back implementing the next round of tariffs soon after the public commenting period is over.  This means the CNY should remain pressured more than it was in August but not to the same extent as in June/July. 

CNY table
CNY graph

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