A monthly commentary/summary that discusses our broader, long-term currency analysis.
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Andrew Kositkun Head Trader - Foreign Exchange
Since October of last year, the USD has been on a broad declining trend. To the extent that the USD strengthened in 2019 on risk aversion, it is reasonable to think that a reduction of these risks could weaken the USD in 2020.
To this point, a pullback in risks around US-China trade and Brexit, as well as signs of stabilization in global PMI data have provided a backdrop conducive to a weaker USD. Incremental easing measures, such fiscal stimulus and China's RRR cut have also provided to be a tailwind to global growth.
However, reservations still remain around expectations for broad based USD weakness. As we have touched on in past commentaries, a prerequisite for this would be a convincing rebound in global growth. Thus far, the improvement has been uneven with EM Asia more prominent than DM economies‑see Germany.
Additionally, many geopolitical issues such as renewed no-deal Brexit risks and a renewed escalation in Phase 2 negotiations between the US and China still linger. Even the Middle East, despite the de-escalation in acute tensions between the US and Iran, represent risks with Iran and North Korea restarting nuclear weapon development.
Domestically, the presidential election should start to play a more prominent role with formal Democratic primaries kicking off in February. However, the magnitude and impact of this will depend on who emerges as the front runner. Should a progressive candidate emerge, it could be argued that the markets would start to price in a USD discount. Given this, polling data is too close to draw any conclusions on what the impact on the USD would be.
Heading into 2020, the view was for a gradually upward sloping path for the euro. This mildly positive view on the euro is more driven by the expectations for lessening of economic headwinds than an expected rebound in growth. While the US economy is still expected to grow faster in absolution terms, the reduction in cyclical European headwinds should allow the relative gap to close. This should be enough for mild euro appreciation given the euro's undervaluation, strong balance of payment support and dollar discount.
Specifically on balance of payments, foreign inflows into equities have helped move the basic balance surplus to ~5.5%. This surplus should continue have an asymmetric impact on the euro. In the case of continued economic disappointment, expect the surplus to be a buffer to currency weakness. Conversely, should the euro area economy pick up momentum, the surplus should be a tailwind to currency strength. On the USD side of EURUSD, it is likely that the markets will begin to price in a political risk premium as we move to the teeth of the election cycle.
Ultimately, valuation and balance of payment support are secondary factors and cannot compensate for economic shortfalls. While European data has shown signs of stabilization, the recovery has been unconvincing. Moreover the negative interest rate spread between the US and Europe continues to be a drag and fiscal expansion is more likely in the US than the EU. Ultimately euro strength will be contingent on a pickup in economic performance. Because of this, euro bulls will need to be patient as the euro is likely to continue to languish in the near term.
For the past 3 years, the yen has traded in a range of less than 10% with 2019's range of 7.6% being the tightest range since 1980. For context, since 1980 to the start of Abenomics (~32 years) the yen has remained in a 10% range only twice. As we have moved into 2020, the yen has remained in a tight range.
The narrowing of USDJPY's range has been driven by a number of factors, including the narrowing of US-Japan inflation differentials, the decline in the yen being used as a funding currency and continued investment outflows.
With the BoJ sidelined for the time being and fiscal policy unlikely to have much impact as the total spending amount masks the disappointing amount of new spend, investment outflows should remain a key factor. Japan's investment outflows have increased dramatically over the past couple of years. This surge in outward investment correlates with low interest rates in Japan and implies a robust search of yield that is likely to persist.
Structurally low interest rates suggests that these flows should continue into 2020. All else equal, this should push USDJPY higher and helps to offset yen buying demand during risk off periods. Additionally, with interest rates low around the world, demand for the yen as a funding currency during risk on periods and the subsequent repurchase of yen during risk off periods have been reduced. This dynamic of systematic yen selling and the reduction of yen as a funding currency should prevent the yen from being overbought or oversold. This helps to explain the tight trading range and why the yen appreciation has been relatively mild, versus other safe haven currencies, during risk off episodes.
Of course that isn't to say the yen isn't a safe haven currency. It is simply to say that while the yen should continue to be impacted by changes in risk sentiment, the factors above suggest a high bar to break out to the range we've seen over the past couple years.
After about three and a half years, the UK has finally left the EU. While it is notable that the UK is no longer part of the EU, not much has changed with the UK moving into the transitional period.
Looking forward, the expectation remains for gains to be capped as cliff-edge risks remain. Some in the markets have argued that a reweighting of UK assets should lead to a stronger pound. While the market is underweight UK assets, the free trade arrangement between the UK and the EU is still unknown. Without knowing the nature of this relationship, it is impossible to assess both the economic damage from Brexit, the fair value of UK assets and the GBP's appropriate exchange rate.
As such, the evolution of trade talks between the UK and the EU will be a key driver. Currently the UK insists that it will not extend the transitional period. PM Johnson has doubled down on his stance by inserting a clause in the Withdrawal Agreement that legally prevents the UK from extending the transition period beyond the current December 2020 deadline. Additionally, the UK is looking for a deal that would minimize regulatory alignment with the EU. Both the timeline and the UK's regulatory demands are at odds with what the EU wants.
However, given the magnitude of the trade deal as well as the politics involved, it is likely that an extension to the transition period will be needed. Moreover, the UK will likely have to concede on regulations and movement of labor in order to gain on goods trade. But this pivot is unlikely to come in the near term. As such expect the GBP to remain under pressure as trade tensions heat up and uncertainty remains high. Keep in mind that a hard Brexit is still possible, especially with a parliamentary backstop no longer in play.
The CAD was one of the top performing G10 currencies in 2019 as the BoC's resilience against the global easing trend that has resulted in relatively high Canadian yields. It finally appears that the BoC's resilience could be cracking.
At the central bank's last meeting, it delivered a dovish hold with the bank removing "appropriate" from its description of the current overnight rate and acknowledging that Q4 weakness will likely spillover into 2020. This is significant as "appropriate" has been Governor Poloz's long held stance and signals a waning of the BoC's confidence in its outlook. Additionally, the bank was more positive on household debt which had been a reason why the BoC pushed back on insurance cuts in 2019.
Looking ahead, the tailwinds that helped the CAD in 2019 are set to fade in 2020. While the passage of USMCA does provide some support, the Canadian economy has already slowed its rate of growth. Specifically, net exports and oil and gas production, two key sources of growth in 2019, benefited from temporary factors that should dissipate in 2020.
Should the Canadian economy weaken as expected, the BoC would be forced to play catch up and could result in a sharp repricing for the CAD. Currently the markets are pricing in a similar rate path for the Fed as it is does for the BoC. This seems to be out of sync with data coming out of the two countries, leaving scope for Canadian rates to reprice and weaken the loonie.
The BoC created some optionality for itself by removing "appropriate" as the descriptor for its policy rate but it's premature to call it the start of an easing cycle. Ultimately the CAD's fate remains data dependent. As such, the CAD should remain one of the higher yielding G10 currencies. Although 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 view still remains for the AUD to remain pressured. Certainly the reduction in trade tensions and stabilization in global data provides some tailwinds to the economy but details matter. Iron ore prices are at elevated levels and coal exports are subject to Chinese quotas. Moreover, increased Chinese purchases from the US due to the Phase 1 agreement are likely to come at the expense of other trading partners such as Australia.
Domestically, the Australian economy continues to struggle with the past couple of months bringing negative bushfire headlines. Although it warrants acknowledgement that the fires could have been more negative. Clearly the environmental and welfare costs from the fires have been high but the immediate impact on growth has been muted. Affected areas have mostly been un-cleared land so the productivity and population density has been low, leading to a negative but limited GDP impact.
At the RBA's most recent meeting, the bank pushed back on market expectations for rate cuts but did acknowledge it stood ready to cut if needed. Given this, the expectation remains for further RBA cuts this year as the economy falls short of the RBA's goals. Additional RBA cuts will further widen the negative rate differentials with the USD and provide scope for further weakness. As a final point, the RBA is approaching the effective lower bound that raises the prospect of unconventional policies such as QE which should be AUD negative.
The big economic development for the CNY since our last outlook was the formal signing of the Phase 1 trade deal with the US. Broadly, the details of the deal didn't contain any surprises with the currency clause roughly in line with the US has agreed to with other countries.
While the bar for further yuan strength off the trade deal is relatively high, the broader backdrop (prior to the coronavirus outbreak) was supportive. Economic data momentum had been enhanced by a front-loading of government bond issuances and an uptick in infrastructure spending. Higher growth should ease capital outflow pressures which, combined with strong foreign investment inflows, should create a favorable balance of payment backdrop for the yuan.
On a broader level the removal of near term trade risks should allow the economic and flow factors referenced above to dictate currency moves. Additionally, Chinese authorities are likely to strive for currency stability to avoid jeopardizing further trade negotiations. However, over a longer timeframe CNY strength is likely to fade with the CNY expensive and tailwinds fading. With regards to the Phase 1 deal, the increased purchases from the US should shrink the Chinese trade surplus which, all else equal, should bias USDCNY higher. Finally, trade risks remain via implementation on Phase 1 and lack of progress on Phase 2.
Of course, all of this has been complicated by the coronavirus outbreak. Currently it is too early to accurately assess the full economic impact as it will be driven by the extent of the crisis. Past outbreak examples suggest that the economic impact should be acute but narrow and short lived with retail and travel most effected. Proactive policies actions, including liquidity injections, repo rate cuts and guidance for further support should help to mitigate downside risks.
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