A monthly commentary/summary that discusses our broader, long-term currency analysis.
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Andrew Kositkun Head Trader - Foreign Exchange
The USD continued to move lower this past month and has given up all of its March COVID-19 panic rally. The move lower in the dollar since the middle of March as raised some conversations around the possibility of long term USD vulnerabilities playing out making it important to note that USD has not been uniform. The USD has actually strengthened against ~30% of currencies, including most of the high yielding Latam currencies.
Instead, recent USD weakness appears to be a reflection of a few factors. The first is optimism around a V shaped recovery and the unwind of defensive dollar long positions. On this point, risk markets have been surprisingly resilient to rising infections but global activity is starting to show a pullback as the acceleration in infections continue. The second factor is optimism around an improved European picture. While this optimism is justified, a lot of the good news has been priced in.
The third factor, which is expected to persist longer than the other two, is the inability for Congress to pass a Phase 4 stimulus plan. Both sides remain entrenched in their position despite the US having fallen off a fiscal cliff of multiple weeks. The longer that the next stimulus package is delayed, the more of this assumed package will need to be backed out via near term growth downgrades. This ongoing drag from US fiscal uncertainty should keep the US pressured.
Regarding politics, betting markets continue to see a Biden presidency/Democratic sweep as the base case. Prior, a major source of uncertainty was the degree to which the Biden platform would adopt major progressive policy proposals. As it turns out, Biden's platform, while including some progressive principles, does appear to have taken more from the traditional Democratic playbook. Regarding the USD, increased taxation/elimination of loopholes should weaken the dollar as US growth pulls back. However, this could be offset by increased spending from items such as Biden's infrastructure plan.
The euro is up ~10% against the US since the end of March. This is powered by the market's increasingly negative take on the US (COVID-19 levels and fiscal cliff) and positive take on Europe (lower absolute level of COVID-19 infections and the EU's recovery fund). While these factors justify a repricing of the euro, Europe's economic track record over the past 2 years gave pause to how high the euro could go. In hindsight, the abrupt end to the US's interest rate and economic growth advantage; and the removal of European breakup risk due to limited fiscal sharing have been more influential than expected.
The question now becomes how much further upside is there. EURUSD currently sits near its long term average so an argument can be made that a discount of US exceptionalism and a reduction in euro tail risks have been priced in. For EURUSD to sustainably move into the upper end of its long term range, the European economy likely has to demonstrate its ability to outperform as it did in 2017. This remains a key uncertainty even with the US at a fiscal policy impasse.
Looking ahead it should be noted that COVID-19 delivered a onetime shock to US interest rate expectations and further material interest rate differential compression is unlikely. At present, the markets are pricing in a lift in rates for Europe and the US at roughly the same time despite the ECB being a laggard in rate normalization. This means the markets are unlikely to get the improved EUR-USD interest rate differential that is typically seen during EURUSD uptrends. It should also be noted that Brexit risks via a relatively disruptive exit still linger. Given this, EURUSD upside will be supported by market participations continuing to diversify away from the USD and into their structurally underweight euro position.
The yen has been broadly range bound since the end of March as offsetting flows have dampened USDJPY's sensitivity to broader market risk. Over the medium term, the expectation remains for the yen to outperform the USD and see USDJPY continue to drift lower.
USD is expected to remain pressured and this should allow the JPY, and other reserve currencies, to appreciate. As it stands, relative rates, inflation and current account factors all skew significantly in favor of a stronger yen. While there is acknowledgement that outbound investments could spur yen sales, the overall outbound volume has dropped from levels earlier in the year. With the persistent, one-sided investment outflows that have characterized the last several years turning more balanced, yen sales are no longer an idiosyncratic source of JPY weakness.
This reduction in outbound investment flows has been driven by a couple of factors. The first is the ability for pension funds to finance foreign fix income purchases through sales of foreign equities. Additionally, Japan continues to diversify out of US treasuries. As an example, Japanese purchases of Australian debt in Q2 was larger than the total amount purchased during the four years through 2019. This type of diversification should have more room to run as European debt purchase have held steady.
Regarding politics, PM Abe has announced his resignation for health reasons meaning his political party needs to hold elections for a new leader and PM. Whoever the LDP chooses as its next head will serve as Prime Minister until September 2021, which is the remaining term of Abe. While the Abe's resignation garnered a lot of headlines, his successor isn't expected to change much on fiscal policy. Monetary policy should remain consistent with BoJ Governor Kuroda's term running through 2023.
The pound has rallied over the past month on the back of euro gains and a pullback in the market's expectation for negative BoE rates. As a result of this rally, the GBP target rates have been raised in a mark to market exercise but reservations remain on the GBP's underlying prospects.
These reservations are based on the following factors. The first is the higher COVID mortality rate, relative to other major economies, which led to more stringent and longer lasting lockdowns that has put the UK economy into a deep hole. The second factor are questions around the sustainability of the recovery given the outsized impact of stimulus on the UK's fiscal position. This makes it likely that the UK will be saddled with one of the largest fiscal drags when the government attempts to lower its debt load next year.
The third factor is the Brexit overhang. With little progress made on talks, there is a material risk that the UK and EU will be unable to agree on a meaningful trade deal. This would expose the UK economy to a shock as radically shift towards less favorably. Finally there is the issue of the UK's continued reliance on foreign capital without an interest rate advantage that should continue to weigh. It should be noted that imports have collapsed more than exports during the lockdown leading to some of the largest trade surpluses on record which has supported the GBP. As things normalize, the UK should return to its normal trade balance position.
Near term expect COVID infection rates to be a key driver. Infections have started to rise again in the UK and the risk is for rising infections to stall what is already a relatively slower recovery. Further, the UK has a higher level of work from home which is likely impeding the recovery and the path of the virus clearly impacts the timeline for work normalization.
As a final point on Brexit, the massive COVID-19 related GDP drop, which makes the worst case Brexit decline seem second order, has shifted the market's focus from Brexit. However, COVID-19 should be a temporary factor versus Brexit which has a long lasting impact. This fact should refocus the market's back to trade talks as the transition deadline nears.
Over the past two months, the loonie has strengthened against the USD. However, this has predominately been due to a weaker USD than CAD strength. During the same time period, the CAD is weaker against ~75% of the other G10 currencies.
This relative underperformance has been driven by elements of Canada's poor balance of payment position. As an example, the recent bounce in oil prices has not benefited Canada's trade account. The rise in oil prices is in part due to supply cuts, especially from high cost producers such as Canada. As a result, net oil export revenues remain depressed despite oil prices retracing a significant part of its YTD loss. Further, international transaction data shows that a sharp slowdown in fund inflows as very large repatriation inflows during the global market panic has started to reverse.
Regarding monetary policy, the Bank of Canada has formalized its accommodative stance by adopting conditional forward guidance that keeps rates near zero until the inflation target is reached. By doing this, QE appears to be de-emphasizing QE. However, it should be noted that the BoC is still committing to 11% of annual GDP pace, which puts the country at the top of the G10 in terms of balance sheet expansion as a percent of GDP.
The Trump administration also announced, last month, the removal of Canada's exemption to the 10% tariff on imported aluminum. When compared to the depth and breadth of past tariff actions, this latest move is more notable for its signal than its direct impact. Unfortunately the signal is that trade tail risks remain as long as Trump remains in office.
The Aussie has continued to rally since our past currency outlook and hit its highest level since early 2019. The drivers of this rally remain the same for prior months: correlation to rising risk markets, a weak USD and buoyant commodity prices. While the risk remains for AUDUSD to move higher in the near term, medium term headwinds continue to build.
The COVID-19 situation has worsened over the past couple of months with Victoria taking the brunt of the outbreak. With new COVID-19 cases spiking, increase restrictions have been put in place across the state of Victoria which includes Melbourne. While these lockdowns are local, they do create economic headwinds on a national level with higher frequency data is starting to reflect this. As a result of this, several forecasters have lowered their GDP outlooks.
On the policy front, the flagship JobKeeper program has been extended although eligibility will be tightened and payment rates reduced. Nevertheless, this is a key development as government programs have played a key role in supporting the labor market. On the trade front, limited global supply and strong steel production, mainly in China, should continue to support iron ore prices. While the AUD has lost some of its sensitivity to commodity prices, they still support positive balance of payment flows.
Over the medium term, headwinds come from geopolitical tensions with China that continue to linger. This pressure has been building ever since Australia called for an investigation into the origins of COVID-19. So far China has responded by placing import restrictions on goods that have a relatively benign impact on the Australian economy but the threat for more material actions remain. This uncertainty should weigh on the economy and could prevent investments such as mining companies from pursuing capex to take advantage of high iron ore prices.
A strong balance of payment position and ongoing USD weakness form the base for a stronger CNY over the medium term. With capital inflows, especially from the bond side, expected to continue and the expectation for continued improvements in the current account it is possible to for CNY to add to its gains.
Regarding the current account, trade data continues to surprise to the upside. Part of this reflects China's position as a leader in the export of COVID-19 related protection goods. But there also sign of a pickup in consumer demand amid a slow recovery in global demand. As for capital flows, US-China interest rates differentials sit near all-time highs. This has drawn record inflows as the global search of yield is heating up in the current lower for longer interest rate environment. To this point, international bond inflows have become a meaningful capital account line item in recent years and could see further upside should Chinese bonds gain inclusion in another bond index at the FTSE's inclusion review in September. In light of these constructive cyclical backdrop and persistence around USD headwind factors, CNY's medium term outlook skews bullish.
As in past CNY outlooks, geopolitics remains a risk with the US-China relationship remaining a focus in the run up to the election. Notably, recent price action around the closure of consulates, sanctions on government officials and other US-China action shows that an escalation in US-China tension is not fully priced in. Nevertheless, the market consensus remains for these chronic tensions to continue to broaden out and have long term implications but not lead to a breakdown in the Phase 1 deal or fresh tariffs in 2020, a key directional driver for CNY. This means that headline noise should result in spikes in USDCNY but the downtrend should return as these headlines fade. Additionally, the delay in Hong Kong's September legislative council election by one year temporarily removes one potential geopolitical flashpoint.
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