FX Compass: Blue Wave Implications on Growth and the Dollar
Blue Wave Implications on Growth and the Dollar
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Andrew Kositkun Foreign Exchange Head Trader
This past week, the Democrats flipped the Senate by sweeping both Georgia runoff elections, and they now have full control of Congress and the White House.
With a majority in the Senate, Democrats now have control over the chamber’s legislative agenda, which raises the possibility for additional stimulus, as well as control over presidential appointment confirmations. Perhaps most importantly, the Democratic sweep allows for the use of reconciliation to set spending and tax levels without the threat of the filibuster. It is likely that the Democrats will use these powers to pursue several policy agenda items, including infrastructure, expanding green initiatives, and social goals such as access to healthcare and increased social and economic equality.
The expectation is for global assets to react positively to materially higher fiscal stimulus that is accompanied by less political brinksmanship. To the extent that 2020 U.S. dollar weakness was due to buoyant risk appetite, massive fiscal and monetary support and the expectation of a return to “normalcy,” then it is reasonable to expect further U.S. dollar weakness as a first-order effect of a Democratic blue wave.
However, the longer-term outlook of sustained dollar weakness is less clear. Back in 2017, growth divergence driven by the Tax Cut and Jobs Act triggered a repricing of the Fed’s rate path and attracted capital flows into U.S. assets. It is not unreasonable to see a similar outcome in 2021 as fiscally driven higher U.S. relative growth provides support for the dollar, especially if the U.S. yield curve steepens and rates rise relative to the rest of the world, and the Euro area in particular. Furthermore, potential worries over tax and regulatory shits under a blue wave could undermine risk appetite and drive demand for safe haven currencies such as the dollar.
Overall, the pricing out of some U.S. dollar risk premium is justified by the progress made toward the global recovery, but speculative positioning is increasingly one way, with a high level of optimism already priced in amid surging virus infections, slow vaccine rollouts and new COVID-19 strains. Taken together, these factors argue for a potential limit on U.S. dollar weakness, especially absent a surge in global growth disproportionately benefiting areas outside the U.S.
As for the reconciliation process, there are a few constraints worth noting. The first is that reconciliation cannot add to the deficit beyond a 10-year window. The second is that only spending, taxes and the debt limit can be addressed. Items that do not impact the budget, such as the minimum wage, cannot be included. Finally, Congress can only use the reconciliation directive once per fiscal year. This said, Congress has not passed a budget resolution for fiscal year 2021, meaning the Democrats could pass two reconciliation bills this year—one for fiscal year 2021 and one for fiscal year 2022.
One- to two-week view: It’s a new year but many of the same drivers remain. The single currency continues to hold on to recent gains as global reflation and U.S. dollar weakness provide support. Conversely, the blue wave/ripple has seen U.S. yields move higher, throwing a lifeline to the U.S. dollar on the margins. Given this, absolute yield levels are still low, and the Fed’s tolerance for rising yields is still to be seen. Furthermore, Europe is facing increased lockdowns that implies downside for Q1 GDP. Overall, the expectation is for consolidation on the cross currents describe above.
Three- to six-month view: The euro’s performance in 2020 was mainly driven by factors other than European economic performance. With the factors that pushed the euro higher in 2020 having faded or starting to fade, gains in 2021 should be harder to come by. Near-term optimism on a recovery in global growth helps the euro higher, but the single currency should dip into year-end as U.S. yields rise, the European Central Bank (ECB) continues to fight deflation and market focus shifts to questionable domestic growth fundamentals. In essence, it is difficult to see a sustained euro rally without European economic exceptionalism and the prospects of ECB rate hikes.
One- to two-week view: The twin issues of COVID-19 and Brexit should dominate the headlines in the U.K. On Brexit, the immediate economic impact from custom duties, cross-border trading, tariff duties, etc. should be more pronounced than progress on equivalence. On COVID-19, the emergence of a mutated strain that is more contagious and a third national lockdown are the focus. While it’s difficult to assess the impact of a lockdown, it’s anything but a positive for a country already trying to adjust to a new relationship with its largest trading partner. The impending discussion on negative rates will be interesting to watch going forward with the Feb. BoE meeting possibly a live one. On net, further dollar weakness is expected; sterling should lag other major currencies in the coming weeks.
Three- to six-month view: The path for the pound in 2021 will depend on the interaction between the realities of Brexit and the speed and extent with which the UK economy can recovery from the pandemic. On the pandemic, the UK economy’s underperformance arguably makes it one of the biggest beneficiaries of a vaccine. However, Brexit drags to growth and massive fiscal deficits represent counterarguments. A Brexit deal was reached but this result still represents a negative economic outcome. As a result, the pound is expected to drift lower after the initial relief rally as markets refocus on the fact that a skinny deal is still a fundamentally bad development.
One- to two-week view:The combination of stretched short U.S. dollar positioning and the reemergence of a Democratic blue wave has pushed U.S. yields higher and the yen weaker. In the near term, USD/JPY is likely to remain supported by blue wave dynamics, staying in its current range. However, the core view remains to add on rallies as USD/JPY should eventually move lower due to Japan’s real interest rate advantage and a relatively cheap yen versus the current level of yields. Regarding the blue wave, Democratic control of the Senate should be more relevant regarding the ability to control the agenda than the chances for more progressive policies. Regarding Japan, the country has announced a state of emergency for the Tokyo area. This could lead to some repatriation flows but it is unlikely to be significant.
Three- to six-month view: 2021 should bring yen strength as a real yield advantage and inflation spreads remain in the yen’s favor. While the Japanese economy should benefit from Asia’s relatively low COVID-19 infection rates, a persistent negative output gap means a lack of inflationary pressures. As a result, real yield spreads and relative U.S.-Japan inflation expectations support yen strength, as does a drop in outbound investments. The increasingly crowded low-yielding currency club has reduced the yen’s role as a funding currency, and the yen’s cheap valuation has deterred yen shorts.
One- to two-week view: The Canadian dollar continues to find support from the market’s positive outlook on global growth due to its cyclical nature and the firming up of oil prices. OPEC+ met this past week and broadly agreed to hold oil output, as Saudi Arabia will deliver unilateral cuts and other producers will either hold steady or make small increases. In response, oil topped $50 a barrel for the first time since February 2020. Bias remains for further loonie appreciation with rising U.S. yield providing the counterargument.
Three- to six-month view: The loonie should continue to be driven by market sentiment. For 2021, a global recovery should support a rebound in oil prices and the Canadian dollar. As such, the expectation is for the Canadian dollar to continue to strengthen as positive vaccine developments support broader risk sentiment and the ongoing global rebound. On the monetary front, the Bank of Canada and the Fed are unlikely to be major factors in the exchange rate, as policy actions out of both banks have been very similar.
One- to two-week view: Growth indicators continue to point to a continued recovery in the Chinese economy. Relative economic outperformance, a current account surplus and relatively high yields form the base for a bullish view and support a continued drift lower for USD/CNY. Eventually, COVID-19 vaccine distribution will allow the rest of the world to close the growth gap, but a persistent yield advantage and strong foreign investor inflows support further gains.
Three- to six-month view: China’s GDP growth outperformance, effective COVID-19 suppression, relatively higher interest rates and portfolio inflows should support the yuan. Tail risks to this narrative come through trade policy. Given this, the Biden administration should reduce tensions and rhetoric and pursue a more deliberate trade policy. Regarding the monetary front, the People’s Bank of China is unlikely to push heavily against further currency appreciation, due to the desire for greater yuan internationalization and two-way flexibility in exchange rates. Chinese yuan gains could potentially turn to consolidation at the end of 2021 as China’s relative growth outperformance slows and the tourism deficit starts to rise again.
One- to two-week view: Markets have picked up where they left off with optimism around medium-term growth trumping near-term virus concerns. Adding market risk appetite is the reintroduction of a blue-wave scenario in the U.S. that could see more stimulus. These forces, and positive economic news out of Australia, have helped push the Australian dollar higher. As long as markets continue to look through near-term risks and toward medium-term optimism, the Australian dollar should remain supported. While one recognizes and understands the consensus view for a weaker dollar, one also has to acknowledge that current levels are unattractive, so expect markets to wait for dips before adding new Australian dollar longs.
Three- to six-month view: Recent price action has been driven in part by the currency’s correlation with global equity markets. Once we are past the pandemic and risk assets start to normalize, the relationship between the Australian dollar and the stock market should fade and give relative monetary policy increased significance. This is important as the Royal Bank of Australia (RBA) has committed to catching up with other central banks, ensuring relative accommodation. The RBA’s commitment and capacity to expand relative asset purchases should reduce some of the appreciation pressures.
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