FX Compass: Back to Our Regularly Scheduled Programing
Back to Our Regularly Scheduled Programing
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Andrew Kositkun Senior FX Advisor
Following the Democratic sweep of the Georgia Senate runoff elections, markets started to position for higher rates and early Federal Reserve tapering. Subsequently, the Fed has come out against early QE tapering, hitting the brakes on higher U.S. yields and the U.S. dollar’s rally. In essence, we are back to the risk-on, U.S.-dollar-negative market narrative that characterized the end of 2020.
While optimism around additional fiscal stimulus is understandable, the U.S., and most of the world, remains in the middle of a severe COVID-19 wave with vaccinations rolling out slower than expected. Even if one were to take into account President Joe Biden’s ambitious vaccination plans, less than 33% of the U.S. population will be vaccinated in the next three months. This likely means lockdown restrictions will remain in place for all of the first quarter and most of the second quarter.
Unfortunately for the Fed, the policy normalization genie is out of the bottle and can’t be put back in. The current COVID-19 wave is more severe than the first, but targeted lockdowns, better treatment methods and adaptation to lockdown life make it likely that the economic downturn will be milder. Furthermore, the amount of fiscal stimulus being discussed is massive, and more is likely to follow in the form of infrastructure spending. As such, the economic rebound after the pandemic has passed is expected to be very strong leading markets to continue debating the timing of Fed policy normalization. In turn, this will require the Fed to keep pushing back against early policy normalization pricing.
As long as the Fed remains dovish, it should be hard for the U.S. dollar to strengthen in the near term. But eventually policy normalization will come, and that provides upside medium-term U.S. dollar risk. But again, the markets will have to wait for the Fed’s “signal” before this can sustainably happen.
Until then, expect central banks around the world to affirm their commitments to accommodation, as we saw this past week. Case in point, the European Central Bank’s ongoing Strategy Review should result in new ways to keep policies supportive after the Pandemic Emergency Purchase Program ends early next year. Of course there is also the Fed meeting this week, at which Chair Jerome Powell will undoubtedly underscore the central bank’s commitment to maintaining an accommodative stance for the foreseeable future.
Global Perspectives is now available as a podcast.
Presented by David Atkinson, FX Sales and Trading Manager, this week’s podcast touches on three major central banks outside the US that had policy meetings this week. While they were obviously overshadowed by the inauguration of President Joe Biden, these central banks enter 2021 with the same easy monetary stance they had in 2020. The hoped-for recovery in the last half of the year is welcome, but it presents a more nuanced policy environment for central bankers.
One- to two-week view: As expected, the European Central Bank (ECB) meeting this past week was a nonevent, as the bank already took action in December. After a period of rising U.S. rates due to fiscal expectations, curve steepening has stabilized, and the focus appears to be shifting back to the previous risk-on trend. The euro continues to hold on to much of the gains made since November as global reflation expectations provide support. Clearly, as the global economy recovers, policy support will have to be removed, but central bankers (see Fed officials) have notably pushed back on near-term tapering talk, which should keep pressure on the dollar/euro supported. Countering this are the increased lockdowns in Europe that imply downside first-quarter risk, as confirmed by recent weak PMI numbers, leading to expectations for choppy trading.
Three- to six-month view: 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. Moreover, the prospect of more U.S. fiscal stimulus has helped U.S. yields move higher, challenging the view that the rest of the world’s growth could outpace U.S. growth. Near-term optimism on a recovery in global growth should help the euro move higher, but the single currency should dip into year-end as U.S. yields rise, the 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: Further details on services negotiations between the U.K. and the EU will ultimately be an important driver for sterling’s post-Brexit trajectory, but near-term price action should revolve around the race between the vaccine and increased infections. On this front, the U.K. is receiving some good news, as infection rates are starting to fall despite an increase in testing and with COVID-19 headlines poised to improve, as the U.K. is the clear leader among major countries in getting its population vaccinated. Nevertheless, the economy still needs help, as a third national lockdown led to poor PMI numbers and increases the likelihood of negative first-quarter GDP. As such, expect additional fiscal and monetary stimulus in some form.
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 U.K. economy can recover from the pandemic. On the pandemic, the U.K. is in its third lockdown, which puts first-quarter GDP in danger of contracting. However, the country is leading most other countries in the pace of its vaccination program, putting the economy in a relatively strong position to recover sooner than its peers. But the prospect of economic outperformance is hindered by persistent headwinds from what is a relatively unfavorable trade deal that largely ignores the U.K.’s important services sector. Certainly, the pound is a weak currency compared to historical standards, but weak doesn’t always mean cheap, as the negative consequences of Brexit warrant a discount. This is why the pound is expected to drift lower as markets refocus on the fact that a skinny deal is still a fundamentally bad development.
One- to two-week view: USD/JPY has moved higher in tandem with rising U.S. yields, although this move has been tempered through Fed jawboning and a strong treasury auction. While the backup in U.S. rates could dampen near-term yen gains, the core view remains to add on rallies, as USD/JPY should continue to move lower due to Japan’s real interest rate advantage and a relatively cheap yen versus the current level of yields. Overall, USD/JPY appears to be stuck between a rock and a hard place, as U.S. 10-year yields remain above 1%, but arguments for a weak dollar continue to swirl.
Three- to six-month view: The move higher in U.S. yields has interrupted what was a fairly linear decline in USD/JPY. Nevertheless, the medium-term view on the yen remains informed by inflation-adjusted rate differentials that support continued yen strength. Japan’s second state of emergency should result in increased headwinds for growth and inflation. As a result, real yield spreads and relative U.S.–Japan inflation expectations continue to support yen strength.
One- to two-week view: The Bank of Canada kept its policy rate and QE pace unchanged at its meeting last week. Additionally, the bank issued guidance that was stronger and more secure than in previous projections, as the global economy continues to recover. In response, the currency moved to around a two-year high. Looking forward, the near-term outlook remains choppy and capped by the course of the virus. However, extended fiscal support, accommodative monetary policy and encouraging news on the vaccine front should keep the economy supported and prevent a collapse in sentiment. The expectation for additional fiscal stimulus in the U.S. also bodes well for Canada given its integrated supply chains. Bias remains for further loonie appreciation, with rising U.S. yield providing the counterargument.
Three- to six-month view: The loonie should remain driven by market sentiment and is expected to continue to strengthen through the year as domestic factors continue to improve. Specifically, Canada’s domestic outlook has improved due to improved odds for U.S. fiscal stimulus and its spillover effects. In essence, Canada’s proximity to the U.S. and correlation between longer-end U.S. and Canadian yields should see Canada benefit more than its DM peers. While the Canadian energy sector will feel some pain from the elimination of the Keystone pipeline, the improved global outlook and actions from OPEC+ give support for the outlook on oil and should allow the Canadian energy sector to benefit without being tethered to OPEC+ production constraints.
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. Recently, Chinese officials took several steps to limit capital inflows and promote capital outflows, signaling their concern over yuan strength. Nevertheless, these steps should only slow, not reverse, the current trend.
Three- to six-month view: Yuan strength has extended into 2021 largely as expected and should continue, with appreciation driven by supportive fundamentals and solid fund inflows. China’s export sector has outperformed, and an imminent reversal of this is unlikely given the global COVID-19 situation and slower-than-expected vaccine rollout. On the flows front, bond inflows remain solid and should continue given China’s relative yield advantage. Recent weaker-than-modeled yuan fixings have garnered some attention, but it’s too early to extrapolate this into a shift in policy stance as the PBoC is expected to remain accommodative to support growth for the foreseeable future.
One- to two-week view: Consolidation appears to be the name of the game, as the move higher in U.S. rates has stabilized. With idiosyncratic factors taking on a larger role, expect volatility to remain elevated. Nevertheless, expectations remain for markets to look to buy dips. As long as markets continue to look through near-term risks and toward medium-term optimism, the U.S. dollar should weaken and the Australian dollar should remain supported. This is especially true given the steady grind higher in equities; however, economic data has been mixed, with good labor market numbers offset by weak retail sales and PMI prints.
Three- to six-month view: Recent price action has been driven by strength in key commodity prices, with iron ore being a particularly important catalyst. However, the bias remains to see the currency move lower, as the real yield compression story runs out of steam and the U.S. dollar gains support from additional fiscal spending. Regarding trade, Australia–China trade tensions should continue to linger, but critically, China is not expected to put restrictions on iron ore due to the lack of alternative supplies. Finally, the Reserve Bank of Australia has historically been more concerned with relative performance than absolute levels. Therefore, while the currency level is not optimal, it is unlikely to be a major monetary policy consideration in the near term.
MAJOR CENTRAL BANK ACTIVITY THIS WEEK
Expectations for rates to remain unchanged at 0.25%
KEY MARKET MOVING ECONOMIC RELEASES
United States and Canada
U.S. Consumer Confidence
Expectations for an 89.1 print
U.S. Durable Goods Orders
Expectations for a 1.0% increase
U.S. Q4 Annualized GDP
Expectations for a 4.4% print
U.S. Initial Jobless Claims
Expectations for an 875,000 print
Canadian November GDP
Expectations for a 0.2% month-over-month gain
U.K. Labor Market Report
Expectations for the unemployment rate to rise from 4.9% to 5.1%
German IFO Business Climate, Expectations and Current Assessment Survey
Expectations for a 91.3, 93.5 and 90.5 print, respectively
German Q4 GDP
Expectations for a 3.2% year-over-year decline
German Labor Market Report
Expectations for the unemployment rate to remain unchanged at 6.1%
Asia/Japan, and New Zealand
Australian Q4 CPI
Expectations for a 0.7% quarter-over-quarter increase
Japanese January CPI
Expectations for a 0.9% year-over-year decline in Tokyo consumer prices
Japanese Labor Market Report
Expectations for the unemployment rate to rise from 2.9% to 3.0%
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