A monthly commentary/summary that discusses our broader, long-term currency analysis.
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Andrew Kositkun Head Trader - Foreign Exchange
The USD weakened sharply at the beginning of March as markets priced in aggressive Fed cutting. On this dimension the Fed did not disappoint as it cut rates down the zero lower bound. However, the dollar has subsequently rallied and is significantly higher, especially against most commodity and EM currencies.
Taking a step back, a stronger USD despite 150 bps of emergency rate cuts isn't a surprising result. Keep in mind that the Fed's cuts came against an unfolding global crisis that has prompted synchronized global easing. This point is clearly illustrated by the steady stream of monetary and fiscal policy announcements that has come subsequent to the Fed's emergency cuts. Put another way, the Fed's actions are more representative of severity of the global threat than any US specific concern.
The more relevant question is whether policy maker actions will be able to reverse the negative growth case currently priced in by the markets. Unfortunately the historical evidence isn't encouraging. As a result, the bias remains for defensive/safe reserve currencies such as the USD. The USD remains attractive, despite not having a balance of payment surplus, for various reasons, including the US's strong fiscal and monetary response that areas such as the Eurozone has been unable to match.
On a political front, Joe Biden's emergence as the Democratic front runner has helped justify the pricing out of the risk premium due to Sanders' more unconventional policies. With a narrowed field and a decent amount of delegates awarded, expect the back and forth swings between moderates and progressives to dissipate.
Heading into 2020, the markets were forecasting a positive, albeit mild, trajectory for EURUSD. While the expectations were never for a full-throated economic recovery in the EU, the expectation was for a slight improvement in economic activity to allow structural factors such as a cheap valuation and positive balance of payment positioning to allow the euro to appreciate. What has actually happened was a move in the opposite direction. The European economy finished 2019 weaker than expected and has only gotten weaker as COVID-19 concerns have hit the global economy.
While we acknowledge that EURUSD did strengthen materially from the end of February through mid-March, this was due to markets pricing in aggressive Fed rate cuts and the unwinding of euro funded carry trades. With the Fed having cut to its zero lower bound and a significant portion of euro funded carry trades covered, EURUSD correlation to equity markets has reverted back from negative to positive.
As a result, the expectation moving forward is for the euro to trade back in line with its weakening fundamentals, especially if the EZ remain unable to coordinate a strong fiscal response. As touched on above, the European economy entered into 2020 weaker than expected. This fragility makes the European economy particular vulnerable to the COVID-19 crisis that could very well lead to a prolonged economic downturn. Beyond the obvious negative economic impact, the resulting economic pain has the possibility of revitalizing dormant EUR breakup risks.
Since China announce the first known case of human to human transmission of COVID-19, the JPY and CHF are the only two G10 currencies are up against the USD. Given the safe haven status of the JPY and CHF, this isn't a surprising result. What might be surprising is the relatively orderly move that USDJPY has had relative to the sharp drop in the equity markets
Due to the belief that the current COVID-19 crisis still has a way to go before things improve, we anticipate continued safe haven demand. However, over a longer horizon scope still remains for USDJPY to drift higher.
One particular source for a weaker yen comes from portfolio outflows that lead to yen selling. So far data continues to show strong demand from Japanese investors for overseas risk assets. The key question is whether or not this unhedged demand will continue through the rest of the year. Given the expectations for Japanese long-end rates to remain negative for the foreseeable future, the likelihood that Japanese investors selling foreign bonds and bringing funds back to Japan is low. As such, the net fund flow direction should continue to be a net unhedged outflow that will keep USDJPY towards the upper range of the level implied by interest rate differentials.
The pound had been one of the most idiosyncratic currency stories with Brexit talks dominating the narrative. That all has changed with the COVID-19 crisis putting increasing pressure on all aspects of the global economy. This one-two punch of Brexit/COVID-19 pushed GBPUSD down to its lowest levels in over 30 years and while cable has recovered some, both should continue to weigh on sterling for the foreseeable future.
In the near term, the virus becomes the more pressing concern due to its acute nature and the delay in Brexit talks that should lead to an extension of the transition period. However, this does not mean that the UK is off the Brexit hook. Emergency action from the BoE to cut rates due to COVID-19 concerns only serves to underscore the UK's large current account deficit the currently runs around 4% of GDP and does not align with the UK's low yielder status.
Ultimately the UK will still have to contend with the reality that its trade stance is very far apart from the EU's and the associated hard Brexit risks that come with a difference in terms of this magnitude. Overall, the base case still remains for a negotiated exit but the risk is skewed to the downside. Keep in mind that simply having a deal does not automatically equate to a positive outcome. For example, a goods only deal (which has been talked about) will lead to a sharp drop off in service exports. While this type of deal will be better than a no-deal scenario, it is hardly a good economic outcome.
Heading into 2020, the BoC had one of the highest policy rates in the G10 as a strong 2019 allowed the BoC to avoid taking out insurance cuts that other central banks needed to do. Because of this, there was already an expectation that the BoC could be pushed into catch-up cuts should Q1 growth not rebound after a soft Q4—a view set before the virus outbreak became a concern.
Clearly with COVID-19 concerns hitting domestic and global growth hard, Canada is faced with concerns on two fronts—idiosyncratic ones within the domestic economy and global ones due to COVID-19. Against this backdrop, it isn't surprising that the BoC has taken decisive action in cutting its rates due to a slowdown in growth.
Another area of concern for the CAD is the oil markets. Clearly the fall in oil is a negative for the economy, but of increasing concern is the non-linear negative impact of oil under the break-even level due to shut down and corporate/balance sheet stress on broader financial conditions. Further exacerbating the situation is Canada's large basic balance deficit (current account and capital account). This basic balance deficit makes the CAD vulnerable to underperformance during period of prolonged global growth headwinds.
The Aussie dollar has been one of the hardest hit currencies due to its sensitivity to global growth. Given the weak domestic growth picture, persistent global growth headwinds and implications of unconventional monetary policy, pressure on the AUD is expected to continue. As a reminder, the Reserve Bank of Australia joined the QE club this past month, using yield curve control to fix its 3-year yield.
Of the different factors that influence AUDUSD price action, the most influential will likely be global growth forecasts. To this point, COVID-19 concerns have driven a string of downward revisions to global growth forecasts. While we do acknowledge that government authorities around the world have primed the markets with unprecedented levels of monetary and fiscal stimulus, it is important to remember that this is a public health crisis more than a financial one.
As such, it is difficult to envision the beginning of the end, let alone the end, of this crisis until there is visibility on when this virus outbreak will be under control. Until then, expect AUDUSD to move along with market stress.
As touched on in other currency write ups, the COVID-19 crisis has been a main factor for every currency. However, the CNY does find itself on a different part of the infection curve. Because the outbreak hit China first, the number of new infections and the total number of people under medical monitoring is currently falling. This contrasts to Europe and North America where the number of new infections and people under medical monitoring is still rising.
As a result, the Chinese economy finds itself ramping up at a time when the rest of the world is shutting down/social distancing. This gives room for the CNY to outperform its peers. However, despite the economy starting back up there remain issues with the Chinese economy. As such, continue to expect fiscal and monetary levers to continue to be used to provide economic support.
Overall, the expectation remains for currency stability as this is what the PBoC strives for.
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