USD weakness, especially against euro area currencies, has been a broad market theme over the past couple of months. A combination of market factors suggests that while the USD should remain pressured, it won’t necessarily be a one way path of depreciation.
The key factors driving USD weakness include a quicker-than-expected European Recovery Fund that provides needed support and reduces perceived breakup risks; difficulties around the US’ Phase 4 stimulus talks that risk the US falling off a fiscal cliff; and the upcoming US elections.
Conversely, USD positioning is extended to the short side, especially against the EUR, and has reversed its gains driven by the COVID-19 liquidity squeeze. European data beats have started to wane as rising COVID-19 infections are hitting parts of Europe versus declining (although still high) US infection numbers, and August seasonality tends to be for a strong dollar. Taken all together, further USD weakness is possible, if not likely, but it should be bumpier and more selective than smooth and broad-based with risks for retracement.
Further supporting this near term move for dollar weakness could be the reallocation of funds away from an overweight dollar into the euro on reduced euro fragmentation risks. However, over the medium term, a key driver of the greenback is relative return on capital for which relative productivity is a good proxy. Since 2011, US productivity has improved relative to other countries and particularly against the EM. Looking at a shorter timeframe does see the USD somewhat expensive to what would be implied by productivity differentials; this supports further near term USD weakness. But over the medium term, uncertainty around the effect of the next US administration’s policies, the ability for other countries to improve their relative productivity and COVID-19’s differentiated effects on relative productivity makes it unclear whether the multi-year USD trend has indeed ended.
The markets continue to hold a bias against the USD despite several unknowns. Given the markets strong conviction against the dollar and its embrace of the buoyant global risk on sentiment, further US dollar weakness is likely. However, the degree of the market’s conviction given the long list of known unknowns makes it prudent to be cautious around the USD’s ability to depreciation in a straight line.
The euro is on its longest run of weekly gains against the USD since 2004. While the factors that have driven the euro higher remain in place, there isn’t a clear catalyst for near-term upside. Real rate spreads have stabilized and upside surprises in European data relative to US data have also started to fade for the first time since mid-July. Additionally, the strong rally since the EU rescue plan was announced likely means that a lot of good news has been priced in. While further USD weakness is likely, it won’t necessarily be one way or broad based. August seasonality also tends to favor the USD. The view remains for the euro to remain supported, but markets could be in for a period of consolidation due to extended positioning, slowing economic data and rising COVID-19 infections in parts of Europe against decreasing (although still high) infection numbers in the US.
Cable was range bound this past week and is likely to remain so with summer markets upon us. To the extent that markets remain positive on risk, the GBP should continue to benefit. However, headwinds are building as illustrated by the UK increasing travel restrictions this past week. Brexit talks are set to resume again with both sides still far apart. With time running out, a skinny deal looks increasingly like the best case scenario. The issue with this is that a skinny deal includes many of the drawbacks of a no-deal exit. Expect GBPUSD to remain in a holding pattern between 1.30 and 1.32 as it has since the beginning of August.
USDJPY volatility sits at the bottom of the G10 table. This past week, USDJPY moved up to its highest level since the second to last week of July in sympathy with higher US yields. Should US yields continue to rise, it will continue to support USDJPY, but the overall view remains for consolidation with a bias for JPY strength. Real rates continue to support the yen due to the divergence in inflation expectations between the US and Japan. Additionally, a pullback in investment outflows also reduces what was a key idiosyncratic driver of JPY weakness.
USDCAD traded below 1.32 on the interbank market for the first time since late January and is one of the top performing G10 currencies in August. This performance has been driven by oil prices, a weakening USD and an overhang of short CAD positions. Domestically higher frequency data continues to show that the economy remains on the path to recovery. The resurgence in the reflation trade should continue to support USDCAD, but given the magnitude of the recent move, the currency could be running into resistance leading to the expectation for markets to sell into rallies.
July saw record foreign inflows into Chinese fixed income products that have supported the yuan. With the markets in yield-seeking mode, these flows should be fairly persistent. Chinese economic data also continues to show a continued recovery. On the negative side, rhetoric between the US and China continue to hang over risk sentiment. For now, the markets are content to look through the noise in the near term. This supports further currency stability but medium risks remain as US-China tensions should continue to rise as we move closer to the US presidential election.
The Aussie continues to be supported by higher commodity prices and broader market risk-on sentiment, but headwinds are starting to add up. This past week’s jobs report came in better than expected, and the country has recovered ~40% of jobs lost. However, the vast majority of these jobs are part-time positions and data doesn’t account for the renewed lockdowns. Overall, the AUD likely remains supported but it is difficult to get too excited about a move higher given the AUD’s elevated level, rising infection numbers domestically, and global economies transitioning from “easy” growth to a more difficult path.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Brexit talks kick off again
Expectations for rates to remain unchanged at 0.0%
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
US Empire Manufacturing
Expectations for a 15.0 print
US Initial Jobless Claims
Expectations for a 925K print
US Manufacturing and Services PMI
Expectations for a 52.0 and 50.8 print, respectively
Canadian CPI MoM
Expectations for a 0.4% increase
Retail Sales MoM
Expectations for a 24.5% increase
EZ Manufacturing, Services and Composite PMI
Expectations for a 52.7, 54.6 and 55.1 print, respectively
German Manufacturing, Services and Composite PMI
Expectations for a 52.3, 55.1 and 55.0 print, respectively
UK Retail Sales MoM
Expectations for a 2.0% increase
UK Manufacturing, Services and Composite PMI
Expectations for a 54.0, 57.0 and 56.7 print, respectively
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