The Week Ahead: The Academic World Versus The Real World

Foreign Exchange: The Week Ahead
The Academic World Versus The Real World
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Andrew Kositkun
Andrew Kositkun
Foreign Exchange Head Trader
The US Federal Reserve will hold its September FOMC meeting this week.  The bank will leave its policy rate unchanged but will likely start shifting policy from stabilization to accommodation through stronger forward guidance that will link the zero lower bound to an inflation overshoot.

Speaking of inflation, Chair Powell, at the Jackson Hole Conference, announced that the Fed is moving to average inflation targeting which will allow for inflation overshoots and the Fed’s statement this week should reflect this.

While average inflation targeting may be an intellectual leap forward, it is likely to only be an incremental headwind for the USD.  Initial price action around EURUSD provides support for this view.  Immediately after the Fed’s announcement, EURUSD moved up higher than its long run average level but has since retracted these gains

There are a number of reasons to downplay the Fed’s change.  The first relates to inflation differentials—what matters more to the USD than absolute US inflation.  The spread between long-term US inflation expectations and that for the rest of the developed markets is only 10 bps higher than the 10-year average.  Put simply, a 10 bps shift in inflation expectations doesn’t represent a game changer for the USD. 

The lack of any concrete guidance on how the Fed intends to deliver this inflation overshoot is the second reason why the Fed’s announcement isn’t a game changer.  Thus far, the Fed hasn’t given any indication that it would move to new unconventional tools, such as yield curve control, to achieve high inflation.  Instead, it appears that outcome-based forward guidance will be the main tool.

Given that the markets have had a long time to prepare and price in the Fed’s landmark inflation shift and that the current forward curve doesn’t have a full rate hike priced in until 2025, enhanced forward guidance is unlikely to have much of an incremental impact.  If anything, the official conclusion of the Fed’s review could be anti-climactic.  Absent the Fed shifting to a new unconventional tool to supercharge inflation, the Fed’s shift shouldn’t lead to a crisis of confidence in the dollar.

Finally, low inflation is not a problem unique to the US nor is it even an acute one.  Moreover, the Fed isn’t the only central bank undergoing an inflation framework review.  Within the G10, the US is actually in the middle of the table of countries undershooting their 20-year inflation average.  Of course, how each country reacts to inflation undershoots differs.  But ultimately, central banks are unlikely to passively tolerate low inflation so there should be little monetary policy difference between the Fed’s new framework and that of other central banks.

FORECASTS

EUR

The ECB meeting came and went with the bank remaining unchanged on its policy rate and QE as expected.  Lagarde was asked about euro strength due to recent comments from ECB officials on the euro.  Her response was fairly perfunctory and discussed the relationship between exchange rates and inflation.  For now, the markets appear ok with the ECB monitoring the currency as long as the ECB doesn’t conclude it is a problem that needs to be addressed with policy tools.   Nevertheless, the lack of a formal ECB protest against a higher euro isn’t the same as a greenlight for euro strength especially with inflation turning negative.  Beyond monetary policy, the overall view remains unchanged.  On the bullish side, the USD remains under pressure and markets are optimistic on Europe on the bearish side, European economic surprises have pulled back, and infection numbers are increasing.  Ultimately, this all likely nets out to more consolidation especially in front of the Fed meeting.

GBP

Formal Brexit talks concluded without any progress as expected, but the bigger development was the UK’s introduction of its Internal Market Bill.  This bill puts into conflict key parts of the Withdrawal Agreement (i.e. international law) and has soured the mood around Brexit talks.  Subsequently, the GBP sold off as investors are forced to face up to the prospects of a hard Brexit.  Not only would the GBP have to contend with the economic consequences of a no deal exit, but it could also be facing negative BoE rates and upsized QE.  Further, any attempt to rescind parts of an international treaty would hit the GBP’s status as the world’s fourth reserve currency and complicate the UK’s ability to strike a trade deal with other countries.  There remain many moving parts, but this past week serves as a reminder that Brexit risks are asymmetrically negative for the GBP.  The BoE meets this week and will leave rates unchanged.

JPY

The LDP leadership election is set for September 14 with Suga widely expected to be Japan’s next PM.  Regardless of who is the next PM, fiscal and monetary policy are unlikely to materially change, but this is especially true under Suga.  Regarding fund flows, portfolio investment flows remain biased to net outflows but only moderately so.  This implies that the support from residents’ JPY sales has material weakened.  With evidence continuing to show the period of persistently large unhedged investment outflows giving way to a more balanced dynamic, USDJPY should continue to be range bound with a bias for strength.  The BoJ meets this week and will leave rates unchanged, leaving the Fed decision the next key catalyst for USDJPY.

CAD

T he BoC kept its policy rate, pace of the QE program and forward guidance all unchanged.  Regarding forward guidance, the bank reiterated that its policy rate will remains at the effective lower bound “until economic slack is absorbed so that the two percent inflation target is sustainably achieved.”  To further drive home the point of lower for longer, BoC Governor Macklem indicated the bank will be looking at average inflation targeting closely.  Overall the BoC’s decision is likely to be neutral for the loonie with the currency being driven by the global risk backdrop, oil prices and broad dollar moves in the near term.  The CAD has outperformed most of its G10 commodity peers during the recent period of USD weakness, as Canada's economic recovery remains on solid footing.  The expectation remains for the loonie to be supported with the risk for consolidation as the CAD is now near fair value.

CNY

Headlines around US-China tension continue to come out, but ultimately, the markets are viewing the recent actions/rhetoric from both sides as largely symbolic.  A strong balance of payment position and the market consensus for USD weakness form the base for a stronger CNY.  Capital inflows, especially on the bond side, have been strong and are expected to be persistent as the global search of yield continues.  Longer term, geopolitics remain a concern especially as we get closer to the US election, but for now, expect the yuan to be supported.

AUD

The overall view remains unchanged for the Aussie.  The currency’s correlation to equity markets helped pull AUDUSD to its highest levels since the middle of 2018.  Q2 GDP officially put Australia in its first recession in nearly 30 years with further Q3 downside risk coming from the virus’ continued spread.  USD weakness should support AUDUSD, but domestic headwinds and the AUD’s correlation to equities, that have turned shaky, should limit gains.

MAJOR CENTRAL BANK ACTIVITY THIS WEEK

9/16 Federal Reserve Expectations for rates to remain unchanged at 0.25%
9/16 UK Expectations for rates to remain unchanged at 0.10%
9/16 Japan Expectations for rates to remain unchanged at -0.10%

KEY MARKET MOVING ECONOMIC RELEASES

United States and Canada

9/15 US Empire Manufacturing Expectations for a 6.0 print
9/15 US Industrial Production MoM Expectations for a 1.0% increase
9/16 US Retail Sales MoM Expectations for a 1.0% increase
9/17 US Initial Jobless Claims Expectations for a 850K print
9/16 Canadian CPI MoM Expectations for a -0.2% decline
9/18 Canadian Retail Sales MoM Expectations for a 0.7% increase

Europe/Eurozone 

9/14 UK Unemployment Rate Expectations for a 0.2% increase to 4.1%
9/15 UK CPI MoM Expectations for a -0.6% decline
9/15 German ZEW Expectations and Current Situation Survey Expectations for a 69.8 and -72.0 print, respectively

Asia/Japan, and New Zealand 

9/14 Chinese Industrial Production YoY Expectations for a 5.1% increase
9/14 Chinese Retail Sales YoY Expectations for a 0.0% print
9/16 Australian Jobs Report Expectations for a -40.0K decline in jobs
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