A monthly commentary/summary that discusses our broader, long-term currency analysis.
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Andrew Kositkun Head Trader - Foreign Exchange
At the end of 2019, the USD weakened on hopes that the de-escalation of US-China tensions would lead to an uptick in global growth that would coincide with an end to US exceptionalism. As it turns out, the January 1 turned out to be the YTD low for the dollar as it has steadily moved higher.
While we had cautious optimism that European and Asian data was turning the corner, the outbreak of the coronavirus was an unforeseen headwind that has overshadowed emerging signs of economic recovery. While the negative economic impact is expected to be temporary it is also expected to be non-trivial. Moreover the impact is expected to be focused in Asia and services, the two areas that have led the global recovery and kept global growth resilient. The relevant question for FX now becomes long and to what extent renewed uncertainty suppresses global growth. Until coronavirus concerns fade and global growth reemerges, expect the USD to remain supported due to the US economy's resilient performance, relatively high yield and the USD's anticyclical properties.
Adding to the list of factors supporting USD strength is the current administration's proposed move to allow tariffs as a remedy to currency manipulation. While it remains to be seen whether this happens, the reemergence of this proposal serves as a reminder that Trump's unconventional and confrontational approach towards international economic policies did not.
Politically, expect the US presidential election to play an increasing role in FX. On the Democratic side, the most important issue will be how votes view progressive candidates (USD negative) versus moderate candidates (USD positive) rather than voter preference for individual candidates within these groups. End of the day, signature programs such as Senator Sander's Medicare for all program cannot be instituted without Congressional approval. This make it important to also monitor Congressional races as they will speak to the ability for progressive Democrats to gain legislative approval for their proposed changes.
Heading into 2020, the mildly positive view on the euro was more driven by the expectations for lessening of economic headwinds than an expected rebound in growth. Two months into the year the US economy remains stronger than expected with Europe surprising the other way. Of specific concern is the German economy that is in danger of posting a Q1 2020 contraction. Not only is Europe starting 2020 from a weaker than expected position, but it also being hit by the coronavirus. Keep in mind that Europe is more sensitive to global shocks than the US. European investor sentiment will likely be sensitive to coronavirus risk given the shock to the euro area economy from the US-China trade war as well as persistent tariff threats to the auto industry. In light of actual and prospective economic headwinds, the euro is expected to remain challenged.
However, it's not all bad news for the euro as its long term prospects remain positive. The euro continues to benefit from structural support via a sizeable current account surplus and long term investment inflows. These dual factors represent a formidable support combination that is virtually exclusive to the euro among major surplus countries. Ultimately, these are secondary factors as they cannot fully insulate the euro from poor economic performance. While the Europe's current account surplus represents a tailwind, it is not immune to poor economic performance as continued shortcomings risks slowing or even reversing investment inflows. As such, without an uptick in economic performance, expect the euro to continue to drag due to its negative interest spread and factors discussed above.
The SARS-CoV-2 virus outbreak represents the one of USDJPY's key near term drivers. While there have been some positive headlines, uncertainties still remain around the length, severity and ultimate impact of the SARS-CoV-2 virus on the markets. Clearly the rise in outbreaks outside of China represent a key concern for the yen especially in light of the upcoming Tokyo Summer Olympic games.
As a safe have asset, the JPY did strengthen broadly in line with other safe haven currencies. However, in the context of a narrowing US-Japan yield spread, USDJPY's short-lived decline was one of the more muted safe haven appreciations.
USDJPY's decoupling from USD-JGB 10 year yield differentials has been one of the more notable themes in 2020 for this currency pair. Likely this is due to a seasonal uptick in unhedged portfolio outflows. While this uptick in investment outflows was expected, the magnitude was not. On a weekly basis, the notional amount of outflows seen at the beginning of 2020 was only exceeded twice in the last 10 years. Both of these cases occurred during Q3, a traditionally strong time of investment outflows.
The low interest rate environment in Japan has given investment outflows a structural dynamic. With few domestic options to gain yield domestically, Japanese investors pretty much have to mechanically send funds abroad. With this structural dynamic expected to stay in place, yen appreciation due to safe haven demand should be limited. It's also important to note that unhedged investment also appears to be rising, reflecting the shift of investment flows from non-banks. Banks tend to hedge overseas investment but pension funds, insurance companies etcetera tend to take more FX risk. As such USDJPY is likely range bound this year.
The GBP remains one of the most idiosyncratic currencies as it remains driven by Brexit more than any other factor. While there are widely divergent bull/bear opinions in the market, an argument can still be made that views can still get more polarizing due to the lack of precedent to guide where Brexit will lead.
On balance, we fall on the bearish side and feel there remains scope for the GBP to fall further as markets adjust to the reality of how difficult the negotiations will be. Last month, both sides have come out with their respective negotiating stance and this only served to crystalize how far apart the two are. Granted we are early in the process and like most negotiations, the majority of progress should come as the deadline approaches, it the gap between the two sides is notable.
It warrants mentioning again that the legal delivery of Brexit at the end of January did nothing to answer the questions surrounding the UK's future trade relationship with the EU. Brexit has already cost the UK economy but the final economic cost will not be known until a new trade agreement is finalized. The UK is currently attempting to gain greater autonomy over regulation, migration, state aid etc. The extent to which they able to achieve this and the extent to which EU trade is disrupted will play a large role in determining the GBP's fundamental value, i.e. whether it under or overvalued. What is known is that the UK has shifted from a high growth, high yielding economy with a large current account deficit to a low growth, low yielding economy with a larger current account deficit. This makes the argument that the GBP is undervalued the more difficult argument to make.
With the GBP stuck in the middle of uncertain negotiations, as it was for much of 2016-2019, the risk is that the inevitable negotiating noise will create intermittent downside GBP moves.
Since the end of January, USDCAD has traded with a bearish tilt due two main factors. The first was the dovish pivot from the BoC and the second was the SARS-CoV-2 outbreak that has threatened the global growth picture with particular impact on commodity (oil) prices.
On a certain level, the BoC's dovish pivot was expected as data had been underperforming. However, the markets were caught off guard by the suddenness of the move. Just two weeks prior to the BoC pivot, Gov. Poloz downplayed the weakness in economic data and reiterated his positive view on Canadian growth. This led to a swift repricing of rate cuts into the BoC's expected path as the expectation for an on-hold BoC was largely driven by BoC guidance.
Conversely, the SARS-CoV-2 outbreak caught the markets off guard and represents a headwind to global growth and oil prices. Since the virus outbreak started making headlines, oil prices have moved down sharply, hitting the CAD given its exposure to oil. However, when projected the impact of a fall in WTI prices on the Canadian dollar, it is important to look at the WCS (Western Canadian Select)-WTI spread. Supply constraints prevented WCS prices rallying at the end of 2019 like WTI prices did. Because of this WCS prices have fallen less than WTI prices since the virus outbreak, muting some on the negative impact from a fall in oil prices. Given this, WCS prices are close to the level where it could drop below the marginal cost of production, a development that would amplify the negative impact of lower prices.
Looking ahead, ongoing growth downgrades and general risk concerns from the evolving SARS-CoV-2 situation should bias USDCAD higher.
On a year to data basis, the AUD is one of the worst performing G10 currencies. The expectation remains for the domestic economy to underperform RBA expectations. This supports the market's view that the RBA will cut rates further this year despite being on hold at its first meeting of the year. Should these rate cuts take place, it should further widen the interest rate differentials with the US. It should also raise the possibility of unconventional monetary policy measure as the central bank approaches the effective lower bound.
The Australian economy currently faces a combination of headwinds. The ongoing bushfire crisis was already exerting downward pressure on a soft economy and the SARS-CoV-2 outbreak has only increased the pressure. Due to Australia's exposure to the Chinese markets and the importance of tourism flows (from China and elsewhere) to the overall economy, markets have used the AUD as a way to take a bearish view on global growth.
While the ultimate impact of the SARS-CoV-2 virus outbreak is still unknown it is clear that global growth will take a hit. As such expect local and global issues to continue to weigh on the AUD.
Recent headlines around the SARS-CoV-2 virus has raised concerns that the outbreak could be expanding outside of China. While the hope remains that the outbreak will ultimately be contained, the impact in China has clearly been the hardest hit country with the economic impact already at a material level. It then comes as no surprise that the majority of growth downgrades have centered on China. The lower projected growth for China more or less eliminates the expected Q1 2020 growth advantage over the US that was expected.
This is important because capital flows in China are sensitive to growth differentials. With these differentials narrowing, the risk of capital outflows are rising again. However, capital restrictions that have been put in place due to past capital outflow episodes should limit these outflow pressures. The other variable to consider is the positive balance of payment impact from reduced outbound Chinese tourism as it should reduce the service deficit. On the trade front, the virus outbreak likely supports the view of an extended cease fire. The optics of the US escalating tensions during a public health crisis, even during the election season, is not good.
In the end, the bias still remains for CNY to weaken in the near term but past disease outbreaks suggest that a sharp recovery is possible due to the transitory nature of the outbreak. Moreover, the expectations still remain for the PBoC to continue to seek stability with the currency and the economy.
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