The Week Ahead: The Intersection of Truth and Myths
The Intersection of Truth and Myths
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Andrew Kositkun Foreign Exchange Head Trader
The narrative that the US is debasing or reducing the value of its currency has been circulating around the markets. The logic goes that massive monetary and fiscal stimulus is creating the risk of runaway inflation and a collapsing exchange rate. Ultimately, this could lead to the demise of the dollar as the reserve currency. Proponents of the USD-debasing narrative have pointed to a surge in gold prices and the USD’s persistent decline over recent weeks as evidence supporting their theory.
Without a doubt, US authorities have flooded the markets with fiscal and monetary stimulus. But easy fiscal and monetary policy on its own doesn’t create inflation. Accommodative policies boost demand, and if demand outstrips supply, then inflation is created. However, under the current environment, easy policy is filling in holes in the economy, preventing a deeper recession and not creating tighter capacity. Unemployment remains near its highest postwar levels and manufacturing is still well under full capacity. With a similar picture around the world, serious inflation risks appear unlikely.
A similar inflation dynamic holds with the massive expansion of the Fed’s balance sheet. To say that flooding the economy with money is inflationary oversimplifies the story. When the central bank buys government debt, it exchanges one liquid asset (bank reserves) for another (government debt). For this to be inflationary, banks have to lend out these new reserves, but the latest Senior Loan Officer Survey shows that banks are tightening rather than easing lending standards.
Taken together, runaway inflation is far from a certainty even with massive amounts of stimulus. This brings us to the notion that the USD could lose its reserve currency status. While anything is possible, it should be noted that the USD has been challenged many times in the past and survived for many reasons including the lack of an alternative. The euro lacks a large central government bond market and has a fragile monetary union. The renminbi is highly regulated and lacks a deep bond market. Cryptocurrencies are still an unstable store of value and regulatory questions remain.
The resilience of the USD’s haven status might best be illustrated by the 2008-9 crisis. Despite the US being the epicenter of this crisis, money still poured into US Treasuries—which was seen as the safest market. Throughout history, the US has done many things to undermine the USD’s status, but no risk premium gets priced into Treasury yields, reaffirming the USD position as a core currency. Certainly anything is possible, but the USD doesn’t appear at risk of losing its reserve status anytime soon.
PMI data out last week adds to the narrative that we are past the mechanical post re-opening economic bounce and have transitioned into a more difficult and bumpy path forward. A similar dynamic is seen in US data with labor markets also showing a pullback in momentum. Given this, the overall picture remains in place. US weakness due to the inability to pass the next round of stimulus and high infection rates should keep the USD pressured. On the European side, market sentiment continues to be positive on reduced breakup risks and the recovery fund, but COVID cases are rising and there has a deceleration in economic data. So while further gains are possible, we are likely to be in for a period of consolidation.
Cable finished last week with a decent amount of volatility as data flow remains mixed. The latest round of Brexit talks ended on a pessimistic note with the EU’s top negotiator saying a deal was unlikely. A skinny deal is increasingly the best case scenario which is a concern economically as it has many of the negatives as a hard Brexit. On the data side, PMI data came out better than expected in the UK but disappointed on the broader European level. The view remains that the mechanical post re-opening bounce has passed which leaves the path forward more unsteady. Case in point there are increasing concerns around employment especially with the government’s furlough scheme set to expire. USD weakness argues for cable higher but building headwinds likely limits gains.
Broadly speaking, USDJPY has been range bound in a 3 yen range since the end of March. The currency pair remains stuck between hopes for future stimulus and rising US-China tensions and infection rates. None of these factors are expected to change materially anytime soon so we are likely in for further consolidation. Longer term, the bias remains for the yen to appreciate with real rates favoring the yen and outbound investment flows dropping off where it was at the beginning of the year.
Over the past two weeks, the CAD has been one of the best performing currencies in the G10. Expect the currency to remain supported as data shows that Canada has been relatively more successful than its peers in re-opening. However, it should be noted that over the last three months, the CAD has underperformed nearly all of its G10 peers which illustrates the unique vulnerabilities to COVID shocks facing the country. Looking forward, expect overall market sentiment to be an important driver for the loonie as markets seek further clarity on geopolitical tensions and gridlock on US stimulus talks.
July saw record foreign inflows into Chinese fixed income products that have supported the yuan. With the markets in yield-seeking mode, these flows should be fairly persistent. Chinese economic data also continues to show a continued recovery. On the negative side, rhetoric between the US and China continue to hang over risk sentiment. For now, the markets are content to look through the noise in the near term. This supports further currency stability but medium risks remain as US-China tensions should continue to rise as we move closer to the US presidential election.
In the near term, expect the AUD to remain correlated to risk markets, which should keep it supported, however it is hard to get too excited with a number of headwinds building. US-China tensions continue to linger with Aussie-China tensions also in the mix. Additionally, widening rate differentials should continue to weigh on the AUD. On the policy front, the RBA governor has indicated that he wants a weaker currency, but FX intervention is unlikely as he also said the currency is fairly valued.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
No Major Central Bank Meetings
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
US Consumer Confidence
Expectations for a 93.0 print
US Durable Goods Orders
Expectations for a 4.4% increase
US Initial Jobless Claims
Expectations for a 1.0 million print
Canadian June GDP
Expectations for a 5.3% MoM increase
German IFO Business Climate, Expectations, and Current Assessment
Expectations for a 92.4, 98.0 and 86.9 print, respectively
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