The markets continue to hold a bias against the USD despite several unknowns. In the short term, the market’s conviction likely keeps the US dollar under pressure. However, there is some puzzlement to the extent of the market’s conviction given the long list of known unknowns. We discuss these key market variables below.
Consensus optimism on the global outlook
Market consensus is currently for a relatively mild recession and this is supported by a strong rebound in data during the re-opening. It should be noted that base effects are at work and the data is very noisy. To this end the US and Europe are already showing signs of a slowdown in data.
A vaccine by year-end / first half of 2021
While this could be the case as initial results have been positive, it isn’t a given as warnings from the scientific community indicate. Further, market participants don’t appear to be distinguishing between a vaccine by yearend and the first half of 2021. If the vaccine comes in 1H2021 the second wave risks are much more material.
The fate of US vs. European infections
A sharp rise in US infections has been behind the US selloff. While there are some idiosyncratic factors behind the US’s underperformance relative to Europe with some US states choosing not to shut down or re-opened too early, there is more to the story. Timing aside, re-opening will lead to rising infections so Europe should eventually see higher numbers. Ultimately the COVID situation may not as bad in the US and not as good in Europe as the market assumes.
The US elections
The only certainty is uncertainty with the USD’s reaction more tied to policy than the person. This is important as fiscal and trade policies are far from certain from both candidates. This uncertainty stands in contrast to market consensus for the election to be USD negative.
The EU recovery fund
Markets appear to think that the EU recovery fund sets a precedent on how future EU problems will be addressed but this isn’t a certainty. Legally speaking, the recovery fund is a one off response to a pandemic. While a similar approach can be used for future shocks, it isn’t a guarantee.
As these known unknowns play out, the USD likely continues to weaken given the market’s strong consensus so this isn’t a call for a bottom. In fact the USD remains overvalued, despite its sharp fall, when compared to its long-term equilibrium. However, the unknowns above do raise the question on whether or not the markets are too optimistic on the path forward.
The overall picture remains unchanged for the euro. Positive sentiment has been fueled by needed stimulus from the recovery package and a reduction in perceived breakup risks. These factors plus a divergence in virus control have shifted expectations for Europe to outperform the US in the second half of the year. On the other side, the factors driving US weakness also remain in place as the US struggles to find consensus on its Phase 4 stimulus plan. Taken together this should continue to support the euro as underlying USD bearishness remains but we could be in for some consolidation as EURUSD given the magnitude of the recent move. A worsening in global risk sentiment from US-China tensions and rising infections represents key risks for euro retracement.
The BoE held rates steady as expected but delivered a less dovish than expected hold. The bank expects its bond buying program to be completed by yearend and pushed back on negative interest rates for now. A less dovish than expected BoE, hopes around progress on Brexit talks and overall positive European sentiment has supported the pound. For context, a 10% rise in the euro has historically been associated with a ~6% GBP appreciation. The current trend for USD weakness/expectations for US economic underperformance should continue to support the GBP but Brexit developments and COVID-19 underperformance likely caps these gains.
The most recent leg down in USDJPY coincided with a fall in US yields. However, with the US-JPN 10 year yield spread around 50 bps the potential for further compression remains albeit on a limited basis. While the drivers of the recent move in USDJPY are likely to fade, further yen strength is still expected as more medium term fundamental drivers should take over. Real interest rate differentials continue to tilt in the yen’s favor as Japan and the US are faced with different inflation outlooks. Japan also continues to maintain a robust current account surplus and there has been a moderation in portfolio investment outflows. Expect the yen to remain in a tug of war between rising COVID/geopolitical tensions and positive economic news/positive vaccine news with a bias for USDJPY lower.
Over the past two weeks, the CAD has gained ground on the USD but underperformed its G10 peers which reflects on Canada’s unique vulnerabilities to COVID-19 shocks. Oil prices have recovered but remain well below pre-COVID levels. Uncertainty around demand makes further gains difficult with the potential for rising infections to see oil prices retrace. Additionally the US announced it would be removing the exemption to 10% tariffs on Canadian aluminum as of August 16. Despite all of the various negatives (rising US infections, signs the initial rebound is moderating, US-China tensions), the markets remain focused on a glass half full view which implies further USD weakness. Expect range trading with a bias for strength. However, should risk sentiment turn the CAD remains more vulnerable than other currencies.
July saw record foreign inflows into Chinese fixed income products that has supported the yuan. With the markets in yield seeking mode, these flows should be fairly persistent. Chinese economic data has also shown a continued recovery. The US and China are scheduled to hold high level meetings next week to discuss progress on their Phase 1 trade deal. Thus far markets have looked through the rhetoric from both sides but with tensions rising around Chinese companies, a scheduled visit to Taiwan by a senior US official and an impending US presidential election, headline risks remain. Expect 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 rise along with risk markets, but the currency is starting to feel toppish. It should be noted that global economies are transitioning from “easy” growth to a more difficult path as the initial re-opening bounce has passed. The AUD likely remains supported but it’s difficult to get too excited about a move higher given the AUD’s elevated level and rising infection numbers domestically.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to be cut 50 bps to 4.50%
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
US Initial Jobless Claims
Expectations for a 1.15 million print
US Retail Sales MoM
Expectations for a 1.8% increase
US Industrial Production MoM
Expectations for a 3.0% increase
Canadian Housing Starts
Expectations for a 200.6K print
EZ Q2 GDP QoQ
Expectations for a -12.1% decline
German ZEW Expectations and Current Situation Survey
Expectations for a 55.6 and -69.5 print, respectively
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