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 U.S. dollar (USD) has consolidated in a sideways range. This recent price action likely reflects a shift in the global macro backdrop from one of reflation and stimulus to one of slowing growth momentum, fading fiscal stimulus, second-wave concerns and event risks.
With foreign exchange markets focusing on more macro events, U.S. dollar's performance is likely to be more mixed as the variables in the markets are not uniformly directional in impact on the dollar. Granted, the global cycle — vaccine hopes versus second-wave fears — does tend to be supportive of the USD, as it is the primary anti-cyclical reserve currency. However, the uncertainty around U.S. policy and politics should create cross currents. Over the past month, markets have become more comfortable with a Biden victory equaling USD weakness, but the reality is likely to be more nuanced as policies have offsetting impacts on the USD.
While a blue wave should lead to USD weakness, a resumption of a broad and sustainable multi-quarter downtrend in the USD is unlikely until there is enough confidence to price in a full return to economic normalcy. Notably, equity baskets that focus on COVID-19 winners and losers have not seen any retracement. This implies that the markets remain concerned that things could get worse from a second wave before they get better from a vaccine.
Since the end of July, the euro has been trading in a broad consolidative pattern. The question now is whether the sideways price action represents a pause before the uptrend continues or a neutralizing of euro-positive drivers.
Over a longer window, the euro's climb has been aided by interest rate compression and cheap valuations. These factors no longer exist, as nearly all central banks are near the zero lower bound and euro valuation sits near historical averages. This leaves the next leg higher dependent on European economic outperformance, something that rising COVID-19 numbers and European equities don't support.
A key near-term headwind facing the European economy is the risk in COVID-19 infections that have led to increased restrictions. Longer term, there is what the equity markets are telling us. Currently the near-record underperformance of European equities relative to U.S. equities is notable. Historically speaking, there is a 90% correlation between relative economic performance and equity market trends. This makes relative equity market performance a decent real-time proxy for long-term growth expectations.
One source of support for the euro is the adjustment in FX allocation following the collapse in U.S. interest rates. While this could provide support on the margin, it is important to remember that the slump in U.S. rates is a one-time shock. Even if the U.S. recovery is weak, U.S. rates don't have much room to fall unless the Fed changes its stance on negative rates. Overall neutral valuations, below-average rate support and questions around the European economy's ability to outperform suggest further range trading.
The yen's relationship with short-term risk has been more muted than it historically has been. The collapse in the yen's correlation to U.S. equities is likely related to a pullback in unhedged investment outflows out of Japan. Further decoupling the yen from changes in risk sentiment is the USD's increased attractiveness as a funding currency, relative to the yen, due to the Fed's zero-interest-rate policy.
Regarding investment outflows, the current pullback in outflows is likely to persist given that the government pension investment fund has largely finished its rebalancing. Looking forward, the expectation is for pension funds to rotate between debt and equity investments; i.e., use debt sales to fund equity purchases and vice versa, limiting the direct impact on the yen. With Japanese outflows expected to be more balanced through 2020 and into 2021, a significant source of downward pressure on the yen has been reduced.
Fund flow data from the Ministry of Finance also supports the bias for further yen strength. While aggregate foreign buying of Japanese bonds has slowed, purchases from China have hit a four-year high. Notably, China's purchase date indicates that a portion of bond purchases are official sector purchases done in the context of FX diversification. This means inflows should continue, regardless of the broader risk environment, providing a persistent source of support.
Over the past month, the pound (GBP) has been supported as markets continue to expect a deal and view negative headlines as negotiating tactics. Markets are now looking at mid-November as the de-facto deadline in order to get a deal before the transition period expires. While both sides are expressing cautious optimism for a skinny deal, Brexit talks and their impact on the GBP are rarely straightforward, with it difficult to assess what progress has been made toward a deal. To state the obvious, Brexit continues to be the dominant issue for the pound.
Even if you assume that Brexit risks have pulled back on the margin, the U.K. is still faced with economic risks due to its COVID-19 underperformance that has been exacerbated by the recent spike in cases, which has triggered a broader range of local lockdown measures. The loss of economic momentum in August's GDP data combined with increased social distancing measures is concerning, as it should, at a minimum, limit the relief rally should the U.K. and EU finally reach a deal.
Ultimately, the view remains that Brexit is asymmetric for the GBP. Given the issues at hand and the limited time left to reach a deal, the best-case scenario is a skinny deal that avoids a no-deal exit. In essence, the bull case for the pound is not a good deal but rather one that avoids the worst-case scenario of a front-loaded hit to the economy from a no-deal exit. This dynamic makes losses from a no-deal exit more severe than the gains from a narrow deal that excludes large parts of the service sector, including financial services.
The stark reality for the U.K. economy is that it has transitioned from high growth to low growth and from high yields to low yields. This reality suggests that GBP discount, relative to historical valuation measures, is warranted even when you assume a Brexit deal and especially so if it is a skinny Brexit deal.
Since the middle of September, the Canadian dollar (CAD) has been relatively flat against the U.S. dollar despite the greenback making gains against other cyclical G-10 currencies. However, this relative resilience is reflective of positioning adjustment as well as CAD outperformance.
During the summer, price action was dominated by the global growth narrative that led to USD weakness and a shift into the most cyclically sensitive G-10 currencies such as the Aussie dollar. In contrast, the Canadian dollar's positioning was more stagnant due to Canada's unique vulnerabilities to the COVID-19 shock. Thus, part of the CAD's recent move can likely be attributed to positioning that hasn't grown as crowded as other cyclically sensitive currencies.
Regarding U.S. politics, Canada's large trading relationship with the U.S. gives it a large stake in the U.S. election outcome. Keep in mind that the U.S.-Canada trade relationship has been strained over recent years due to trade negotiations and idiosyncratic tariffs against Canada despite a new trade deal (USMCA). Broadly speaking, a Trump reelection likely continues a combative stance on certain areas of the U.S.-Canada relationship and a Biden administration should lead to a more amicable relationship that removes hits to business sentiment from trade policy uncertainty.
Another area with direct consequences from the U.S. election is the Keystone pipeline, which is viable under a Trump administration but unlikely under a Biden administration. Energy transportation bottlenecks have historically put pressure on local crude prices relative to global benchmarks. The Keystone pipeline would help alleviate the energy transportation bottleneck that has weighed on Canada's ability to normalize its energy export levels.
Finally, on COVID-19, the recent acceleration in cases from a low base mirrors what is happening in Europe. While blanket lockdowns are unlikely, upticks in COVID-19 cases are a currency risk, as they represent a local cyclical drag and increase the chances of a risk-negative/USD positive environments as multiple countries fight infection spikes.
The Reserve Bank of Australia (RBA) kept its suite of policy rates unchanged at its last meeting. Given this, recent RBA commentary has been on the dovish side, leading markets to price in a ~75% chance of action at the RBA's November meeting.
One of the more interesting aspects of the RBA's October meeting was the increased focus on employment. To be clear, the labor market is important, but the RBA's statement made it clear that the bank was placing even more weight on employment numbers. To this point, recent labor market numbers showed the first labor market contraction since May. With stimulus measures fading, it is expected that unemployment numbers will creep up but remains to be seen if this peak will be lower than previously thought, as some analysts are predicting.
The continued economic recovery in China has also helped support the Aussie. However, China also represents a risk factor to the Aussie due to 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. This uncertainty should weigh on the economy and could prevent investments such as mining companies pursuing capex to take advantage of high iron ore prices.
Finally, on bond yields, the Australian-U.S. 10-year bond spread has compressed, with bond yields pricing in more RBA easing than the FX markets. Ultimately, both sides will need to adjust but the bias remains for AUD to move lower.
This past month, Chinese officials finally signaled their concern about the yuan's (CNY's) advance by removing the requirement for financial institutions to hold 20% reserves against forward positions as well as the counter-cyclical factor. The 20% reserve requirement and the counter-cyclical factor were put in place at a time when the yuan was under pressure. While an argument can be made that Chinese policymakers removed these requirements because they felt current market conditions allowed for such a change without hurting market liquidity, the fact that the 20% requirement change came one day after sharp CNY appreciation was not lost on the markets.
Given this, the outlook for the yuan remains bullish. The foundation of this view comes from China's solid balance of payment backdrop. The Chinese economy continues to perform, with COVID-19 numbers a greater concern outside of Asia, and China's interest rates remain relatively high. In fact, U.S.-China interest rate differentials are roughly around their all-time highs. This should continue to attract inflows as market participants search for yield in a global lower for longer environment. On a YTD basis, flows into Chinese bonds have run at a monthly rate that is 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.
Politically, the extent to which the U.S. election will be a market-moving event for the yuan is tied to concrete proposals around the re-imposition/increase in tariffs. The markets understand that both presidential candidates need to sound hawkish on China, so talk alone has not triggered a material FX response. Clearly, if talk turns into action — e.g., a new round of tariffs — then yuan weakness is expected. Conversely, should the U.S. adopt a policy mix after the election that both stimulates the economy and isn't specially anti-China on trade, you could see the yuan revisit recent highs.
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