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 weakened since our last currency forecast as it remains torn between positives and negatives. On the USD bearish side, re-opening optimism and rebalancing away from the USD has kept the greenback pressured. Conversely, USD supportive concerns comes from the fear that the initial surge in activity data and stimulus measures could be masking the enormous challenges facing the global economy in overcoming the COVID-19 shock. On balance, further USD weakness near term is possible but skepticism is warranted over the medium term. It is difficult to reconcile a challenging global backdrop with a sustained downtrend with the USD. That is why the bias remains for a range bound dollar.
Complicating the USD outlook is the spike up in US COVID infections. Recent USD price action shows increased infections to be a drag on the USD as US growth should be impacted greater than global growth. However there is a reluctance to fully accept this as it has yet to fully play out. Other countries are starting to re-open and could experience a similar uptick in infections. Further the time lag between new cases and increased deaths has grown longer. This means that additional bad news could be on the way. Should fatalities increase, the hit to growth prospects and resulting market risk off should support the USD. Given this, markets appear content to look through these factors and focused on positive news from reopening of economies and positive economic surprises. This results in a shift in bias towards USD weakness in the near term.
Political risks are also likely to take increased importance as we get closer to the November elections. A combination of events have weakened Trump's chances of re-election and increased the odds for a Democratic sweep. According to betting odds, the chances of Biden defeating Trump has risen significantly. Unencumbered Democratic control of the policy making and execution process in Washington is a relatively new possibility as Democratic control of the Senate has previously been seen as very difficult. Clearly this increases the chance of transformative policy change rather than an incremental one.
While the political party that leads the country is always impactful, it is more so this time around due to the COVID-19 situation and adds to the USD's vulnerability. To this point, we did get a more detailed look at Biden's plan. While it did appears to be a "moderate" plan, it also has elements that are relevant to the USD such as a partial repeal of the Tax Cuts and Jobs Act.
The EUR has been strengthening since the middle of May and has moved to its highest level in nearly 2 years. This move has been supported by some key factors. The first is the proposed European recovery fund that was realized last month. Beyond the amount of support provided, the deal also includes a degree of fiscal burden sharing. This development has reduced the risk for renewed populism/sovereign stress from peripheral countries that could throw the viability of the single currency in question. It is important to note that there is still a long road from what has happened and full-fledged fiscal union. Nevertheless, the recovery fund proposal does eliminate, at least in the short term, a reoccurring risk factor and supports the euro as an alternative currency for those looking to diversify away from the USD.
The second factor is the swing in domestic political risks that are picking up in the US as they are fading in Europe. Betting markets are showing improving odds of a Biden presidency and a Democratic sweep of Congress. This risks the possibility for less centric policies than what was expected pre-COVID. The final factor supporting the euro is the market's optimism around the global recovery that has weakened the USD. As touched upon in past commentaries, the degree to which this relentless optimism has persisted in the markets is remarkable in light of the mounting list of uncertainties. With economies continuing to loosen restrictions, expect economic data to also improve. This means it will likely be a few more months before attention turns to concerns around the quality and extent of the global recovery.
While these factors do put a floor under the euro, there are still reservations around a bullish euro stance. The prospects of the Euro area economy remains key to the euro's prospects. Even prior to COVID-19, the Euro area suffered from persistent economic underperformance. Should this underperformance continue, the euro is vulnerable to retracement. Further, it still remains to be seen whether Europe can re-open and avoid its own second wave of infections and actually outperform the US. Rising US infections makes near term outperformance possible but suitability is another matter. Ultimately this won't be known until economic data begins to normalize around late summer/early autumn.
On a month over month basis, USDJPY has been relatively range bound. Looking forward, the yen likely range trades through the end of the year with a bias for yen strength towards the end of the year. COVID-19 effects have led to nearly all central banks around the world cutting rates down to the zero lower bound. This puts real, rather than nominal, interest rates in the driver seat. With inflation expectations in the US greater than in Japan, real rates will rise faster in Japan than in the US and support yen appreciation.
Further supporting the narrative for near term stability is investment flow data. Prior, the pace of outflows was moving at a historically high rate. More recent data shows that outflows are still occurring at a sustained pace, albeit at a more moderate pace. Nevertheless, the reduced investment outflow dynamic, relative to prior periods, should still soften any sharp USDJPY declines whether driven by COVID-19 or other factors.
Finally politics is also a wildcard. PM Abe's term as head of his party runs through September 2021. This flags a non-trivial risk for a change in leadership that will impact the yen. This makes it important to monitor cabinet approval ratings.
Highlights over the past month or so include the UK government officially declining to extend the transition period deadline, mixed messaging from the BoE (total QE amount increased by monthly amount tapered), the re-opening of the economy, the completion of the EU Rescue package and incremental fiscal stimulus.
While the GBP did strengthen on the month, the overall view on the pound remains bearish as the GBP remains relatively more vulnerable to COVID effects than other G10 currencies. The UK's projected 2020 fiscal deficit as a percentage of GDP is relatively larger than other DM countries as the UK economy is being propped up by massive spending that can't go on forever. Additionally, the UK has one of the largest foreign financing requirements in the G10. This reliance on foreign financing leaves the pound vulnerable to the impact of depressed yields from the BoE's stimulus programs. While negative rates are not yet seen as the base case, they cannot be ruled out. Should the BoE pursue negative rates, it will be interesting to see how the GBP reacts to this. It seems reasonable that the reaction will be negative as the BoE would in essence be putting a tax on foreign financing.
As with everything else, Brexit has been overshadowed by COVID-19 related factors. But this doesn't mean Brexit is no longer a factor. With the UK declining the option to extend the transition period, negotiations are entering an intensified final 4 months with both sides still far apart. This puts the GBP at the mercy of Brexit headlines and potentially sharp swings in volatility as markets try to price in the probabilities of potential outcomes. Base on the most recent timeline, both sides now have until November, at the latest, the resolve a long list of issues that have thus far shown little room for compromise. The hope remains that the pressures of needing to strike a deal will push both sides to finally budge but risk remains for markets to increasingly price in a hard Brexit result as we move closer to the end of the transition period and GBP price action becomes more idiosyncratic.
Over the last month, the Canadian dollar has been fairly range bound against the USD but has underperformed the rest of the G10. This is notable as the ongoing background is still one a buoyancy due to the market's focus on re-openings and outperformance from G10 cyclical currencies. The CAD's relative underperformance is likely reflective of drags from the energy sector and Canada's balance of payment issues.
Canada has benefited from historic level of portfolio inflows in March and April that has supported the currency but are likely temporary. Inflows ticked up in March as Canadians repatriated overseas investments in March and increased again in April. The April increase also coincided with a spike in government debt issuance. Debt issuance has since normalized so inflows should taper. In the absence of strong portfolio inflows, the CAD is likely to remain under pressure as it remains one of the largest deficit currencies.
A similar dynamic is happening with trade. Canada's trade balance surprised to the upside in May after printing a near record deficit in April. But as Statistics Canada noted, the rebound in exports in May was met with a decrease in imports due to longer shipping times. This suggests that there could be pent up demand for imports. If so, this would result in a uniquely elevated summer drag on the CAD that could explain its sluggish performance relative to other G10 cyclical currencies. This aside, the ongoing deterioration in net energy exports represents the key driver behind the shift in Canada's net trade and should remain a source of pressure on the currency.
Regarding monetary policy, the new BoC governor has expressed an openness to further stimulus by noting the country's balance sheet is relatively small compared to its peers. A possible next step would be to expand QE. Granted QE hasn't been shown to be a definitive negative for currencies but it would, at a minimum, exacerbate Canada's existing vulnerabilities.
Over the last month, the Aussie dollar has continued to strengthen as risky assets continue to recover. With markets taking a glass half full view and focusing on the re-opening, commodity prices have also been well supported. Given this, Australia's relative outperformance on the virus is starting to lose its luster. Infections numbers are rising again and have forced certain areas in Australia to re-impose lockdowns. While the lockdowns are local they do create economic headwinds on a national level. Higher frequency mobility data is beginning to show this with work hours remaining flat over the last month after steadily rising since the end of April.
On the policy front, monetary policy has remains relatively unchanged leaving incremental news coming from fiscal policy as the JobKeeper program has been extended. Looking forward, expect the policy mix to lean more toward fiscal rather than monetary. On the trade front, the AUD has been supported by the recovery in China with China's pickup in steel production supporting commodity prices. These factors could provide support in the near term. Although it should be noted that the AUD is one of the currencies most vulnerable to a correction in global equity prices.
Over the medium term Australia's growth model faces challenges from weaker population growth and growing geopolitical tensions with China. 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.
Near term, the yuan appears to be supported due to a weakening USD and a more dovish than expected response from the US on China's recent moves in Hong Kong. In particular, markets were concerned that the harsh rhetoric between the US and China could lead to a breakdown in the Phase 1 deal. Thus far, tough rhetoric has remained just that with both sides indicating the intention to honor the Phase 1 deal. Additionally, a new round of tit for tat escalation does not appear on the horizon.
While skepticism is warranted that risks will fully recede over the medium term, the easing of tensions and optimism for an economic rebound should provide a floor for the yuan near term. This bounce back in economic data is illustrated by China returning to YoY GDP growth. Additionally, both bonds and equities have seen increases in inflows. Foreign bond buying specifically has picked up recently. This has the potential to increase, should the expectation for greater total returns be supported by further appreciation. Further, the difference between US and Chinese rates and growth rates appears to have moderated capital flight pressures.
But as indicated above, risks around US-China relations are likely to linger on multiple fronts until the US election. Rising anti-China sentiment across the political spectrum makes a tough on China stance a possible way to score political points should Trump be trailing in the polls. The tail risks around this should limit CNY appreciation. To the extent that US-China tensions continue to ramp up in the coming months, expect pressure to build for a weaker yuan.
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