A monthly commentary/summary that discusses our broader, long-term currency analysis.
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Andrew Kositkun Head Trader - Foreign Exchange
Over the past month, the USD moved higher but still remains much lower than it was at the beginning of July. It should be noted that the nature of USD weakening has evolved relative to April-June. In the April-June period, USD weakening was relatively broad based with 85%-90% of currencies gaining against the USD. Subsequently there has been more differentiated performance with the euro bloc no longer leads the way likely as a result of highly positive European growth momentum out of Europe turning more neutral.
With the directionality and magnitude of broad USD performance tied to other macro markets reflective of the global economy, the USD could be in for consolidation if global risk sentiment weakens due to fading growth momentum, rising geopolitical risk or a resurgence in COVID-19 cases during flu season. On the other hand, should a vaccine be available earlier than expected, a more complete return to economic normalcy could user in a material move lower for the USD.
Regarding monetary policy, the big event recently was the Fed's formal adoption of an average inflation targeting framework. While this was a key shift, it is unlikely to be a sustained drag. Ultimately the framework does not lead to a material change in actual monetary policy action. If anything, the markets have already priced in a lot of the Fed's well signaled announcement prior to the formal adoption. Further, the Fed's shift in its inflation framework is due to factors that are relevant globally, meaning all major central banks have or will have to make similar responses. This means the Fed's shift is not a major cross-country exchange rate differentiator.
Fiscal policy, however, should be a USD headwind with the US falling off a fiscal cliff for what should be a prolonged period of time and lead to growth downgrades. After Congress failed to reach a last minute agreement as key elements (i.e. enhanced unemployment benefits) of the CARES Act expired, the hope was for a quick resolution after the August recess. This hasn't happened and expectations have shifted to no additional stimulus until after the election.
On politics, expect the elections to have increasing influence on the USD. Currently the narrowing of polling in key swing states means there isn't a key frontrunner. This leaves scope for USD swings if and when markets begin to price in a more definitive outcome.
The euro has been consolidating under its long run average since the end of July. While the view remains for some residual upside potential due to continued reserve currency rebalancing due to the move in rate spreads, reservations remain around the ability to materially move higher from a macro perspective. Without the benefit of a valuation argument, any move higher in the euro will require the economy to outperform and there are questions around Europe's ability to do this.
Europe has rebounded from the COVID-19 shock but this recovery has little predictive power on the ability to sustain strong growth. To this point, positive growth momentum in Europe has already started to neutralize. Keep in mind that the EU recovery fund reduces breakup risks but does little to lift absolute growth. Further, near permanent negative euro rates and the possibility for a QE upsize continue to be headwinds. For all the headlines around the Fed's move towards average inflation targeting, it is Europe that has the bigger inflation problem. This is reflected through the markets pricing in the first full ECB rate hike in 2027, 2 full years after when it expects the Fed to hike.
As such, the interest rate compression due to COVID-19 was more a one off adjustment than supportive of trend appreciation as interest rate differential appear frozen for the foreseeable future. So while this doesn't argue for the euro to be cheaper, it also doesn't argue for it to be higher. The case for further consolidation also goes beyond valuation and fatigue in speculative position. It also comes from data flow which has pulled back in Europe but continued to improve in the US. Additionally, Europe is now seeing an uptick in virus infections and that should exacerbate the loss of economic momentum in the euro area.
On the ECB, the bank did not directly challenge euro appreciation at its last meeting, this shouldn't be interpreted as a large tolerance for further gains. It did mention the exchange rate in its statement for the first time since 2018 and is monitoring the currency. For now this likely doesn't mean anything regarding policy but that could change should the economy or inflation falter further. Lastly, politics remains a wild card with the contentious US elections and Brexit risks weighing.
The yen has been moving sideways since the end of April with a bias for a drift lower. Looking ahead, the bias still remains for yen strength. The US-Japan nominal 10 year yield spread has been remarkably steady but real rate differentials paint a different picture that skews into the yen's favor and supports a continued move lower even with continued outbound investments.
Recent headlines out of Japan have focused around politics with PM Abe's resignation. Chief Cabinet Secretary Suga will now take over for Abe and serve out his current term that runs through September 2021 with the possibility of early elections to solidify the new PM's position. Regarding policy, Suga has emphasized an intention to remain true to Abe's policy mix of fiscal stimulus, monetary easing and structural reform making Suganomics closely aligned with Abenomics.
Regarding monetary policy, Abe's resignation likely has no impact of BoJ leadership although it would not be altogether unexpected for BoJ Governor Kurdoa to leave early as no Governor has even served two full term. Nevertheless, any replacement shouldn't make a major change to monetary policy.
Abe's departure could impact the US-Japan relationship as Abe's close relationship with Trump was a notable element of Abenomics. Should uncertainty rise amid a further deceleration of outbound investments, it would combine with real rates to pull USDJPY lower. Regarding outbound investments, they continue but are running at a more moderate pace especially when compared to the historically high rate seen in the first quarter of the year. August saw JPY2 trillion of outflows into debt, which is down from a run rate of triple that in Q1. This means that a hurdle to yen appreciation has been lowered but not completely eliminated.
The GBP, along with other high beta currencies, has a strong August despite concerns around COVID-19 economic damage and the lack of progress on Brexit talks. This optimism/complacency has been shattered following the UK's government's decision to introduce its Internal Market Bill that puts key elements of its Withdrawal Agreement with the EU at risk. This development has forced market participants to refocus on the material prospect of a no deal exit.
Should this happen, the GBP would not only have to contend with a significant hit to GDP but also the likelihood of negative BoE rates and larger QE. Further, the decision by the UK government to revoke parts of an international treaty undermines the pound's status as a reserve currency that, in large part, ironically comes from believe in the rule of law in the UK. Finally, the UK's ability to strike a trade deal with other countries will also be complicated.
When it comes to the GBP forecast there are a lot more variables than normal. This results in a forecast that is highly subjective and subject to a wide margin of error. Given this, next month could bring a lot more clarity on what the base case should be. The effective deadline that a free trade agreement needs to be agreed on in order for ratification by year end is mid-October. While the EU Council is also mid-October, this is not a drop dead deadline but certainly represents a key signpost if a deal is ultimately reached.
Given this, Brexit risks still skew asymmetrically do the downside. The GBP is roughly 8% above its post referendum low when Brexit fears were most acute. This implies further room to price in risk premium for a hard Brexit. Further, it should be noted that the GBP is likely to undershoot than overshoot estimates as a no deal will trigger multiple non-linear consequences including negative rates in a capital importing country, foreign capital flight risks and political unrest via another Scottish independence referendum.
Beyond Brexit, other issues to keep an eye on includes whether or not the government jobs support program gets extended, the possibility of tax increases and the rising pace of COVID infections. The UK benefited from more fiscal support than nearly all countries but the resulting fiscal overhang and re-tightening of controls should slow an already slow recovery.
After a period of underperformance the CAD has outperformed most of its G10 peers during the late summer months. This past month saw USDCAD completely recovering its pandemic losses and return to where it was in January. Yet, despite this recent outperformance USDCAD still remains the third worst outperformer on an YTD basis. With the CAD's relative catch-up and normalization move largely finished, further gains should be limited by Canada's unique vulnerabilities to the COVID-19 shock.
Economic data continues to show a normalization of international trade as lockdowns loosened and businesses normalized. But with this normalization comes Canada's trade deficit. As would be expected, Canada's energy sector remains an outsized drag on the country's trade balance. While there is scope for improvement, US energy demand is fading and infrastructure remains an issue. The means Canada's sizable trade and current account deficits should remain for some time if not outright expand.
Adding to the currency headwinds is Canada's dependence on foreign financing. It is likely that the surge in debt issuance is in the rearview mirror and that rates remains anchored near zero by a lower for longer BoC and global central banks. This raises the risk for insufficient yield incentive to draw enough foreign investment to cover the combined trade and foreign direct investment deficits. If this is the case then the CAD may have to adjust to balance international trade and capital flows.
On monetary policy, the Fed's shift to average inflation targeting has garnered a lot of headlines with the Fed's early announcement of this shift playing a role in CAD strength at the end of August. But over the long term it is hard to see how the Fed's inflation shift will be a driving differentiator for USDCAD as monetary policy is similar in both countries. As an illustration of this, both countries are running QE programs but the Fed's recent QE rate is ~5.4% of GDP versus the BoC's rate that is ~11% of GDP. So to the extent that the Fed's policy shift is to change inflation expectations, there is little to suggest a material shift in US inflation expectations relative to Canadian ones.
The AUD started last month at its highest level since 2018 but has since sold off in sympathy with the equity market selloff. In broad terms, the Aussie continues to exhibit a correlation with equity markets and this has pulled up the currency to expensive levels.
Domestically business and consumer confidence are tied to virus numbers, especially in the state of Victoria. Recent data has shown a deceleration in new cases but community transmission continues. This has prompted the government to extend the current lockdown by an additional two weeks and flags downside risk to Q3 GDP.
On the positive side, trade data has been supported by the Chinese economy recovery as expected. The country's current account surplus in Q2 was materially larger than expected at $17.7 billion, the largest on record. This result was aided by a rebound in Chinese GDP/industrial production that has supported the iron ore market to Australia's benefit. Additionally the services balance posted a rare surplus with education exports staying resilient. With services imports proving to be more sensitive to border restrictions, the currency support from the services surplus should continue as long as border restrictions remain in place.
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 forms the foundation for further CNY strength. China's export sector gains have stayed resilient over recent months and has started to show signs of broadening out beyond medical equipment. The recent bounce in capex activity should bode well for China in the coming months.
The two main drivers behind the growth of China's current account surplus—a drop in oil imports and a narrowing of China's services deficit due to a pullback in outbound tourism—should persist for the foreseeable future. Crude oil prices have fallen ~40% from where it was at the beginning of the year. Should it stay around current levels, this could add an additional ~$50 billion to China's current account surplus. Additionally, the flare up in COVID-19 cases around the world should keep global travel subdued. Per some estimates, travel is unlikely to return to pre-COVID level until 2024.
Further supporting China' balance of payment position has been bond inflows. US-China interest rate differentials currently sit near their all-time highs. This should continue to attract inflows as market participants search for yield in a global lower for longer environment. On an YTD basis, flows into Chinese bonds has totaled to ~$88 billion which puts the monthly rate at roughly double what it was in 2019. Overall it is expected that China's balance of payment position is expected to remain a surplus in 2021, something that has been historically associated with CNY strength.
Regarding the central bank, the PBoC has shown little signs of resisting currency appreciation. The error term from recent currency fixings shows the central bank to be largely neutral despite the USDCNY's rally. This could be reflective of China's "dual loop" development model that emphasizes domestic consumption. This policy biases the bank towards less official currency resistance in the absence of overt CNY overvaluation.
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