A monthly commentary/summary that discusses our broader, long-term currency analysis.
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Andrew Kositkun Head Trader - Foreign Exchange
The USD has proven to be resilient despite a pickup in risk sentiment. Equities continue to move towards new highs over the past month but the USD has not made new lows since bottoming at the end of March. Instead, the USD index has moved sideways over the same timeframe. This illustrates the market's preference to use the dollar as a defensive position.
Some of the key reasons why USD remains supported are as follows. While Fed action may have eased panic USD hoarding, deleveraging of cross border USD liabilities continue. Additionally, the FX markets tend to reflect underlying cyclical trends that remain weak. Other asset classes are more influenced/distorted by central bank actions. Finally, the aftershocks from the initial COVID-19 crisis such as geopolitical conflicts, oil production cuts etc. tend to support the USD.
Looking more specifically at central bank action we see that the Fed's actions have been unprecedented. However, the Fed's moves are similar to actions or expected action out of other G3 central banks. This means that Fed actions alone are not enough to be USD bearish especially in light to the USD's other anti-cyclical qualities. Lastly, negative interest rates shouldn't be a near term option in the US given the belief the Fed has in other tools and its lack of confidence in negative interest rates as a policy tool.
With regards to politics, the betting odds for the Democrats taking the Senate has risen from 30% to a coin toss. This put a Democratic sweep on the table which is an outcome that has increasing importance given the widening gap between post-COVID economic and social policies between the two parties. Rising odds for a Democratic sweep should result in a USD discount but likely doesn't manifest itself until closer to the election.
Recent euro stability over the past month somewhat hides the significant vulnerabilities facing the euro. The COVID-19 crisis has driven an increase in public sector debt and a decline in potential growth, two factors that should continue for the foreseeable future. Granted, the Eurozone isn't unique in having a deteriorating public finance picture due to COVID-19. However, the euro is uniquely vulnerable due to the uneven debt burden within the region and the absence of mechanism, or political will, to put the sustainability of high debt, low growth countries beyond question. The lack of a fiscal union has always been a design flaw in the European experiment and COVID-19 risks have only served to underscore this.
The conflict within the EU can also be seen by the recent ruling from the German Constitutional Court. While the German court didn't find the ECB's programs to be outside its legal limits, it just reject the European Court of Justice's assessment of the ECB's QE program and requested an explanation from the ECB. The immediate risk is that the German central bank would be banned from participating in ECB programs although this is likely a low probability/high impact event. The greater issue lies with questions of sovereignty as European treaties technically makes the ECB independent of national courts. Should the ECB respond, it puts other EU institutions at risk of being questioned by national courts but if it doesn't it risks political complications in Germany.
On broader level, the German court's ruling raises questions around the ECB's ability to take on the same balance sheet measures that other central banks are doing. This matters because without a deal to mutualize peripheral countries' debt, the ECB serves as the ultimate debt guarantor insuring debt stability and euro stability. The German court's ruling potentially weakens this ECB backstop and adds another risk to the euro. Given this, the European Commission has proposed an unprecedented stimulus plan that includes the pooling of national financial resources. For this to take effect, there needs to be unanimous acceptance and several countries have already expressed opposition. This all but ensures the proposed plan will not be the end state plan. Hopes are for an agreement by summer but clearly there are no guarantees. Depending on how things work out, this could be a game changer for the euro so certainly merits watching closely.
Over the past couple of years, Abenomics has been categorized by a bias for yen depreciation as the Japanese economy has been flooded with stimulus and low/negative rates. The risks now is for a mild reversal of this bias. This change is primarily driven by the difference in policy response to COVID-19 in the US and Japan. The difference in the speed and scale of the fiscal and monetary response risks a dramatic GDP growth differential between the two countries.
Investment outflows, which have been an idiosyncratic support for USDJPY, are also showing signs of moderating. Certainly these outflows should remain persistent overall. Case in point, recent data showed an increase in overseas equity purchases that should continue as funds plug equity gaps in their portfolio. However, the overall outbound flows are unlikely to continue at the same historically large levels that were seen earlier and imply less support than previously provided.
Moreover, the collapse in oil prices should help Japan's trade surplus widen as Japan is an oil importer. This reduction in outbound yen to purchase oil due to lower crude prices provides another offset to already reduced investment outflows. Assuming crude remains below its 2019 peak, expect a wider trade balance to be an incrementally important driver of yen strength.
The outlook for the pound remains bearish due to a combination of COVID-19 concerns, BoE easing measures and Brexit risks. The negative economic impact from COVID-19 and its associated lockdown are just starting to become apparent and there is increasing pressure on the BoE to fund it. These pressures will likely result in an expansion of the QE program and continued talks of negative interest rates.
Adding to all of this is the fear of a hard Brexit. The UK continues to maintain that it will not ask for an extension to the transition period. If the UK sticks to this and allows the end of June extension request deadline to pass, markets will have to price in no deal Brexit risks with the potential for some to see a no-deal as the base case. We have lowered our GBP outlook to reflect this increased uncertainty but emphasize that these targets don't incorporate a no-deal Brexit as the base case, leaving significant downside should this be realized.
Beyond Brexit, the economic outlook remains uncertain. The UK is re-opening its economy but it remains at the mercy of the COVID-19 infection curve. The UK's financial positon also remains a vulnerability. The country's open ended furlough scheme is now paying ~25% of private sector employees and puts the projected budget deficit at 16% of GDP. While this is not the worst in the G10 (US projected at 20%), it certainly is more than average. This fiscal backdrop puts the onus on the BoE to increase its QE program. Combining unprecedented fiscal policy and unprecedented QE with the need for large scale external financing makes the GBP one of the most vulnerable G10.
Over the past month, USDCAD has traded in a ~2% range but the bias still skews for CAD weakness. Canada's balance of payments status remains one of the worst in the G10. Historically, Canada has run a FDI deficit. This means that most of the current account deficit has to be financed by portfolio inflows. Since 2018, the "Currencies and Deposits" ledger has filled this gap, with inflows totaling to ~5.2% of GDP.
However, Canadian yields have collapsed as the BoC has taken yields down to the zero bound along with other countries. Without the yield advantage that Canada has previously enjoyed, the risk that the country will not be able to attract the foreign inflows needed to meet its structural external funding needs has risen. If investment inflows do slow down and FDI and equity inflows remain unchanged, the CAD will have to depreciate to compensate.
With regards to energy, prices have stabilized but it is important to remember that energy was expected to add $1 trillion in economic activity to the Canadian economy over the next decade. This means the energy still represents a headwind despite its stabilization. Canada's oil sector is a notoriously high cost one, making it one of the first countries that needs to adjust to lower oil prices and this has already started to happen. Energy exports is a major Canadian export and support for the current account. Should there be a pullback it would widen the current account deficit and further pressure the currency.
Canada's current account position also complicates the country's monetary and fiscal policy picture. High fiscal deficits necessitate debt monetization by central banks and QE disincentives inflows. What this means is that the BoC's asset purchases are a greater currency liability than other central banks pursuing the same actions are to their currency.
As a final point, the BoC Governorship will be transitioning with the risk being for more accommodative policies. At his introductory press conference, governor-designate Macklem touched on the possibility of negative rates, something the current BoC has pushed back on. Macklem's past speeches also advocated for more proactive polices making future BoC actions another possible bearish consideration.
The Aussie rallied strongly from the second half of March and through April. Since then the currency has been relatively range bound. Since our last monthly outlook, monetary policy remains unchanged. The RBA remains committed to keeping its policy rate low until "…progress is being made towards full employment and it is confident that inflation will be sustainably within the 2-3 per cent target band."
What has changed is the easing of restrictions as Australia has made significant gains around the COVID-19 outbreak. Another material change has been the escalation in tensions with China. Senior Chinese officials have expressed displeasure with Australia's support for an international inquiry into the origins of COVID-19 and have raised the possibility of economic retaliation. These potential measures come on top of alleged dumping issues that could see China impose an 80% tariffs on Australian barley.
Thus far the Australian government has played it close to the vest when it comes to potential Chinese economic retaliation but risks to Australian exports remain asymmetric. China remains sensitive to COVID-19 related issues and its use of economic measures to punish Australia is a real possibility.
Since its March lows, AUDUSD's rally has been driven by a relatively earlier return to economic normality, solid iron ore prices and RBA's "QE-lite" approach relative other QE programs. Chinese economic measure could nullify much of this, making it a potentially large source of downside risk.
US-China tensions have reemerged and has become a key market focus. Market reaction, thus far, to the steadily increasing hawkish rhetoric from both sides has been relatively measured. CNY volatility has ticked up some and USDCNY did sell off but has since recovered those losses.
This muted market reaction aside, the risk of renewed tensions does represent upside USDCNY risks. The global economy remains fragile, leaving all economies, including the US economy in a weakened position and less able to absorb fresh US-China tensions. Given this, the US elections are approaching and anti-China sentiment is rising with Trump's polling numbers slipping in some key battleground states. Currently the yuan is trading in its tariff neutral range. Should fresh tariffs be imposed or if the threat of tariffs becomes a high probability as elections approach, expect the yuan to weaken.
US-China tensions also have the potential to hit portfolio inflows that have slowed from the pace seen in 2018. These flows remain sensitive to risk sentiment and can quickly reverse should US-China relations sour whether due to COVID-19 origin issues or a significant delay in the Phase 1 purchase schedule. The hope remains that the pain experienced by both sides due to the 2019 tariff conflict helps cooler heads prevail. Clearly the addition of further disruptive policies (tariff hikes etc.) compounding the economic effects of ongoing virus related lockdowns is not beneficial to anyone. While anti-China sentiment is rising in the US, another equity market collapse during an election year is a substantial disincentive. On the Chinese side, the PBoC strives for currency stability, making the bar to deviate from the spirit and the letter of the currency clause agreed to in the Phase 1 deal high. Moreover, FX moves that exacerbate outflow pressures during a period of weak growth is counter to what China is trying to achieve.
But despite all this, the lesson from 2019 is that economic logic is not the best guide when projecting the path of US-China relations. This leaves markets in the unfortunate position of having to live with, and potentially price in risk premium, to account for US-China escalation in the run-up to this year's US election.
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