A monthly commentary/summary that discusses our broader, long-term currency analysis.
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Andrew Kositkun Head Trader - Foreign Exchange
2019 was a year that was characterized by geopolitical uncertainty that was never resolved and rebound in global growth that never came, although there have been signs of a bottoming in some economic zones. Looking at 2020, many of the same themes remains. Brexit and US-China trade remain unresolved and the US Presidential election and the impeachment overhang are added to the mix.
Regarding the Presidential election, the impact on the USD will be determined by 1) who the front runner is, 2) that person's policies and 3) the ability to implement these polices (Senate and House races will play a key role). As of now, there is too many variable to make a meaningful assessment. On a broader level, the key issues for the USD are as follows: 1) whether and to what extent does the global economy reflate and 2) whether the "mid cycle" adjustment from the Fed provided a launching pad for the next leg up or if it is the start of a full easing cycle.
While the clearing of some of the issues surrounding US-China trade and Brexit are market positive, the recent developments on this front doesn't represent a greenlight for a broad and forceful reflation of the global economy. It is still unclear what the eventual trading relationship between the UK and EU will be and the US-China Phase 1 deal appears to only marginally rollback tariffs. The more certain thing is that the global economy is late cycle. While the lower level of growth and easier monetary conditions can support growth, the global economy is in a more fragile position and monetary policy is losing its effectiveness.
Overall, there is scope for USD weakness against specific currencies but the prerequisite for broad USD weakness remains a sustained rebound in global growth. Until this is realized, the USD likely remains in a sideways range.
Our euro outlook has the euro higher by the end of the year but this is more due to a lessening of negative drags on the economy than a recovery in economic activity. While a slow recovery, and not a full throated one is expected, the euro's cheap valuation, record setting balance of payment tailwind and positive Brexit developments should be sufficient for a modest euro recovery. Even in the case where the European economy continues to struggle, the balance of payment surplus, that is around 5.7% of GDP, should continue to provide support. Given this, the euro's structural support can only do so much. A meaningful recovery for the euro would still require a convincing and sustained uptick in economic performance.
With Christine Legarde taking over at the ECB, hopes for fiscal support have risen. Clearly the realization of additional fiscal policy would be a positive for the euro. But even in the case that additional fiscal measures are not take, fiscal policy could still turn supportive for EURUSD in 2020 as the fiscal tailwinds in the US fade.
With regards to monetary policy, there is limited space for further action and the Legarde will likely be more cautious to further expand the balance sheet. However, the ECB's commitment to keep conditions accommodative still provides some support. In contrast, the Fed is currently on hold but more likely to ease as it has more space to do so.
The outlook for the yen is generally range bound as US-Japanese interest rate differentials remain stable.
Against this backdrop, there are a couple of factors of note. The first relates to the consistent and strong demand from Japanese investors for foreign assets. With Japanese interest rates anchored, there is a structural aspect to this selling as investors are practically forced to move money overseas in search of yield. This should continue to provide support for USDJPY.
Additionally, a narrowing in US-Japan inflation differentials and a decline in yen-funded carry trades should both serve as shock absorbers to any changes in risk sentiment. This should limit the swings in JPY and further supporting the range bound view.
Internationally, trade and Brexit should still have an influence on USDJPY. While the Conservatives won a majority in parliament and the Withdrawal Agreement is expected to pass, trade negotiations remain. With trade expected to be the more difficult negotiations, headline volatility should remain. On trade, a Phase 1 deal is still expected to be completed but Phase 2 should be more contentious with a near term resolution unlikely.
Given these points, the bias is for USDJPY to trade near the top end of its range with neither monetary nor fiscal policy likely to be a key driver of the currency in 2020. Specifically on monetary policy, the BoJ expects the government's recently announced fiscal plan to have a positive impact on the economy. This gives further credence to the thought that the BoJ is on hold in the near term.
When the GBP spiked higher after the Conservatives won a convincing majority, the direction of the move was expected but the magnitude was a bit surprising. While a strong majority should enable the UK Parliament to finally pass its Withdrawal Agreement (WA), the markets appeared to be conflating the removal of political uncertainty with the economic damage from Brexit being repaired.
The reality is that the market still lacks clarity around what the eventual trading relationship between the UK and the EU will be. The passage of the WA certainly represents a step in the right direction but hard Brexit risks remain should the UK and the EU be unable to reach a trade agreement. For scope, should the UK leave the EU at the end of January, as expected, it will have 11 months to negotiate a free trade agreement. For scope, these trade deals take multiple years to negotiate, making the current timeline highly ambitious.
As a result, the expectation remains for the Conservative government to seek an extension of the transition period, given the long-run risks of too-early an exit versus the cost of violating its campaign pledge. However, this is unlikely to happen until just before the 1 July 2020 deadline to request one, to preserve credibility around their campaign promise. As such, expect economic headwinds to persist as businesses refrain from investing as uncertainty remains high. While the GBP is expected to remain supported, expect GBP gains to be capped and volatility to become elevated around ~June until the extension request is made.
In a year that was characterized by continuous global growth downgrades, trade uncertainty and central bank insurance cuts, the CAD impressed with its performance. A key reason behind this outperformance has been the Canadian economy's resilience that as allowed the BoC to go against the global central bank easing trend. As a result, Canadian rates are now at the top of the G10 space.
Looking ahead, the tailwinds that helped the CAD in 2019 are set to fade in 2020. While the expected passage of USMCA does provide some support, the Canadian economy has already slowed its rate of growth. Moreover, two key sources of growth (net exports and oil and gas production) benefited from temporary factors. Canadian exports have an outsized dependence on the US economy and oil production got a boost from an easing of production limits in Alberta. Without any upside drivers to offset the fading boosts, the sluggish global economy should weigh more on the Canadian economy in 2020 that in did in 2019.
If this scenario plays out, the BoC would be forced to play catch up and could result in a sharp repricing as CAD longs are near 1 year highs. However, any CAD weakness is likely to be limited as its relatively high yield should serve as a decent buffer especially if Canada just reverts to trend growth from above trend. It should be noted that this high yield could turn into a liability should growth sharply decelerate as the BoC has considerably more room to ease than its peers.
The AUD spent 2019 drifting lower. With the headwinds behind last year's AUD weakness persisting, the expectations are for the AUD to remain pressured however there are factors that should provide near term support.
Australia has experienced stubborn shortfalls in both inflation and its full employment targets. Moreover, the global economy remains under pressure. Notably, with the RBA's policy rate currently at .75%, one more 25 bps cut should bring the prospect of unconventional policies front and center as the RBA will want to avoid being close to zero. Should unconventional monetary policy measures (such as QE) be realized, this could be a significant differentiating factor as other central banks (ECB, BOJ) are reaching the limits of QE.
On the trade front, the US and China agreed to a Phase 1 deal although the tariff reductions ended up to be fairly modest. While a Phase 1 deal is a good thing for the markets overall, there are some negatives for Australia. China's increased purchases in US goods will result in a decrease in purchases elsewhere, with Australia a prime candidate. The reduction in trade tensions reduces the chances for fiscal stimulus in China, which would have been AUD positive. Lastly, a Phase 2 deal remains elusive. With the more contentious issues included in Phase 2 discussions, it is reasonable to expect trade uncertainty to persist. As such we continue to see the AUD pressured with the downside limited by the AUD's cheap valuation.
With regards to monetary policy, the RBA is expected to "reassess the economic outlook in February 2020. This suggests that February is a potential point for a further cuts, however the easing bar is likely higher than before with only 50 bps of easing left before it reaches the 0.25% lower bound.
Following the sharp deceleration in GDP growth from Q1 to Q2, Chinese growth stabilized in Q3. That said recent data has been mixed. High frequency domestic demand indicators remaining sluggish in recent months but there have been signs pointing to near term stabilization with an uptick in loans that should support manufacturing and consumer consumption.
Recent CPI data showed a rise in inflation but this is largely due to a sharp spike in pork prices. As such, expectations remain for the PBoC to continue with its accommodative stance as illustrated by PBoC Governor Yi Gang indicating the central bank would increase credit support and push for a further decrease in loan costs.
Recent headlines suggest that a Phase 1 deal between the US and China is imminent. While the deal remains unsigned, both sides have incentive to strike a deal so it should get done. The bigger question surrounds the details of the deal. While tariff rollbacks are expected to be part of the deal, the reported magnitude is quite modest. For perspective, it would take the average tariff rate from ~14.4% to ~13%. Interestingly, the USMCA deal included a currency clause for the countries to maintain a market determined exchange rate. The US, Mexico and Canada already do this, meaning this clause was include more to set a precedent for future trade with other countries, i.e. China.
Overall, the 2020 outlook for China remains positive but risks remain.
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