A monthly commentary/summary that discusses our broader, long-term currency analysis.
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Andrew Kositkun Head Trader - Foreign Exchange
The USD has retraced back from its highs seen at the end of March but the bias still remains for dollar strength. A sharp reassessment of the negative economic impact from the virus and the resulting distancing measures drove safe haven demand that was exacerbated by USD liquidity issues.
With the Fed and other central banks stepping in with massive amounts of stimulus, it isn't surprising that markets have stabilized and recovered some of its losses. Similarly it isn't surprising that the USD gave up its gains resulting from the reasons cited above. However, risks still remain for further USD demand as deleveraging of over 12 trillion in USD denominated debt continues.
Moreover, while equity markets have staged an impressive recovery from the lows seen at the end of March it is important to remember that the equity market is not the real economy. This is especially true as unpresented policy action has underscored the disconnect between market pricing and underlying fundamentals. The fact remains that the shape, depth and duration of the negative economic impact from COVID-19 remains unknown. This argues for defensive FX stance with safe haven assets, such as the USD, forming the core of this defensive strategy.
With regards to politics, Sanders' concession reduces the risk premium that stems from the risk of unconventional polices. However, politics will still play a role on the USD's path as there is enough policy differentiation between Trump and Biden where the party in charge will still make a difference. Given the timing of events, and polling that shows a toss-up between Trump/Biden, it appears that politics could reemerge as COVID-19 stress starts to abate.
Back at the beginning of March when equites started selling off, EURUSD spiked higher. While the euro strengthened during a risk off move, it is important to remember that this price action represented the one time unwinding of euro funded carry trade and was not the result of the euro being a safe haven.
Looking ahead, the bias still remains for the euro to weaken. The USD still remains the top funding currency and should receive a bid as global deleveraging continues through the duration of the recession. Additionally, the euro remains particularly vulnerable to COVID-19 related growth concerns. While there are multiple reasons for this, the inability for European leaders to unite behind a forceful stimulus response is the most important one. The lack of a single fiscal union underscores a key concern for the long term viability of the single currency.
Numbers wise, the ECB's QE program will likely total to ~9% of GDP which pales in comparison to the Fed's unlimited QE, especially if you also account for the Fed's other liquidity facilities. Looking at a measure of broad liquidity, the US has injected an amount totaling ~6.5% of GDP versus 2.2% of GDP for the ECB. Given that the US economy entered 2020 in a better position than the euro area economy and the US benefits from a forceful stimulus package, the US economy is in better position to rebound post lockdown.
While massive amounts for Fed liquidity could ultimately undermine the USD, this is likely to happen after the current crisis has passed. For now, the worst global contraction since the 1930s should be EURUSD negative through the greenback's anti-cyclical qualities.
After the extreme volatility seen in March, USDJPY price action has been much more subdued in April. This pullback in large exchange rate swings, that had decoupled USDJPY from interest rate differentials, coincides with signs of a slowing in the global spread of the virus and extraordinary stimulus from governments around the world. As a safe haven currency, expect the yen to continue to be effected by virus headlines with the range bound currency reflecting the push/pull dynamic of some countries extending lockdowns and others reopening. To this end, the ability for countries to reopen without a second wave of infections will be a key currency driver.
Domestically, yen selling due to the desire for foreign assets continues to be a persistent theme. In past commentaries we commented on how unattractive domestic yields created an almost mechanical demand for higher yielding foreign assets. Recent flow data confirms that with flow data showing little appetite to repatriate funds back to Japan as has typically been the case during global downturns. Moreover, with the Government Pension Fund increasing its foreign fixed income allocation, expect other pension funds to do the same. Although with Japan extending its state of emergency to the entire country, it is possible trading volumes will decline but the overall picture still remains one of net yen selling.
When it comes to whipsawing price action, it is hard to find a more dramatic change in fortunes than the one that the pound has been on over the past two months. During the March when markets were suffering from a lack of liquidity, the GBP sold off hard with cable cratering ~14% in less than two weeks. As remarkable as the GBP's fall was, the subsequent recovery was equally as dramatic.
These extreme swings are illustrative of the mixed ramifications of COVID-19. On the positive side, the UK's response was impressive as the government delivered one of the largest fiscal responses globally. Additionally, the UK's debt position allows for above average fiscal loosening. On the negative side, the UK still has the worst current account position in the G10. Due to COVID-19 related rate cuts, the UK will have to fund this current account deficit with no interest rate advantage. Moreover, with the current crisis health related, it is still unsure how much the imposed stimulus will support the economy especially with the lockdown extended into May.
These countervailing factors makes it hard to determine a clear directional bias from COVID-19 alone but adding in Brexit factors should tip the scale to pound weakness. Virus headlines have overshadowed Brexit talks but hard Brexit risks still remain. Both sides remain far apart and the UK government remains insistent on wanting to extend the transition period despite having only a handful of months left before the extension request needs to be made. If the UK government is truly set on leaving by the current deadline then the probability for a limited deal or no deal exit has risen, with both options negative for sterling as the disruption in trade will compound COVID-19 issues.
On a year to date basis commodity currencies have been the top underperformers in the G10 space. However, the CAD has been a relative outperformer despite a sharp drop in oil prices. Despite this there are reasons to believe the CAD will underperform moving forward.
Even before the current crisis, Canada had one of the worst balance of payment positions (BoP) in the DM with it current account and FDI deficit nearly double that of its nearest peer. This becomes even more of a concern when you consider that "currencies and deposits" was a key category seeing inflows. If 2019's surge in cash inflow was driven by Canada's position as a high yielder, the subsequent collapse in Canadian yields puts cash inflows into deposits at risk and throws a big question mark around an important source of external financing.
Further, Canada's position as a high cost producer of oil puts it at greater risk than other oil producers. The current oil price war is being waged in order to balance out long term global supply. Given Canada's high cost of production, its producers should be among the first tranche of producers that have to consider their long term viability. This means that low oil prices are not simply an issue of unprofitability but also of outright shutdowns. To this point, some producers have already shutdown production which risks long term damage to the oil sand's future value. With energy extraction accounting for nearly 20% of Canadian goods production, it will have a material impact on the Canadian economy. This is especially poignant when you consider than Canada lacks an idiosyncratic offsetting factor such as Norway's sovereign wealth fund.
USDCAD has rebounded off its lows but oil prices remain depressed. This suggests that CAD has room to adjust down to the level of oil as crude remains a long term anchor for the currency. Finally, negative dynamics in the oil sector should also exacerbate BoP issues. Oil accounts for 80% of Canadian exports. Any reduction in trade will hit an important factor keeping the current account deficit from being worse than it is.
Over the past month, AUDUSD has been the clear top performer in the G10 space. This performance has been driven by relative COVID-19 outperformance, bulk commodity performance and a strong stimulus response as a percent of GDP.
Within the G10, Australia ranks first with regards to process along the COVID-19 infection cure. Moreover, Australia also ranks favorably across a broad range of statistics including infection rates, testing rates and mortality rates. This all argues for an earlier staged removal of social distancing measures and other government restrictions that would benefit the economy. Moreover, key commodity prices in Australia's export basket remains relatively elevated despite the extreme levels of volatility. Iron ore prices in particular has held up fairly well, outperforming other commodities such as oil. This helps explain why the AUD has outperformed other commodity sensitive currencies such as the NOK and CAD.
With regards to stimulus, Australia's response, as a percentage of GDP has been very strong. The RBA has cut its rate down to the effective lower bound and committed to keep rates low until significant progress is made on employment and inflation. Additionally, the RBA embarked on unconventional policy measures, for the first time, by targeting a 3 year yield. However, as market conditions have improved, the RBA has tapered its government bond purchases. To the extent that relative central bank balance sheet dynamics influences currencies, the RBA's QE-lite approach should be supportive of AUDUSD.
In total, the factors above should continue to provide support for AUDUSD and help it range trade in the near term. Should equity volatility continue to decline and should Australia's COVID-19 infection rates continue to fall, scope remains for a drift higher later this year.
The overall view on the on the yuan remains neutral. By virtue of being hit by COVID-19 first China has led the world, timing wise, in re-open its economy. However, USDCNY has been range bound as domestic economic activity has been subdued and the negative demand shock on a global level has been material. This last point has been illustrated by high frequency activity indicators showing a slowdown in trade flows from early April onwards. Moreover, US-China tensions appear to be ramping up again with the US threatening action against China over the coronavirus. While talks on the US said remain preliminary, the fact that it is being talked about remains a concern. Clearly the global economy has enough issues with an escalation of tensions between the US and China.
On the positive side, lower oil prices and a shrinking services deficit does provide a bit of an offset to export pressure and reduced capital inflows. China is an oil importer so it will benefit from lower crude prices. For example, should oil prices stay around $15/barrel for a prolonged period of time, China will save ~1% GDP to its current account. Additionally, the reducing in outbound tourism should alleviate CNY selling. Combined these two factors should help to alleviate some of the stress on CNY FX and prevent a major reserve drawdown such as the case in 2015/16. As a final note, PBoC intervention activity appears to be modest but we continue to expect the PBoC to take actions as needed to achieve currency stability.
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