by Marc Chandler
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After falling against all the major currencies in June, the US dollar rebounded in July. The Dollar Index finished the month at new two-year highs with the Fed’s suggestion it was engaged in a mid-course correction rather than a sustained easing cycle. The dollar also appeared buoyed by the extent of the dovishness by the ECB and the heightened risks that the UK leaves the EU at the end of October without an agreement. Short-term interest rate differentials that had been seeing a reduced US premium since last November stabilized in July. The resumption of US-Chinese trade talks also spurred optimism in some quarters even though the multifaceted competition continued on several fronts.
Keynes famously compared the markets to a beauty contest, with the goal of picking, not who one thinks is the most beautiful but picking who everyone else thinks is the more beautiful. However, now with many of the major central banks poised to ease policy and a US administration intent on trying to verbally intervene to force a lower dollar and bully the Federal Reserve into easing policy, the foreign exchange market may be more accurately conceived of as an ugly contest.
The US happens to be the least ugly, though it has considerably more to ease policy than other major central banks. While the dollar finished July well bid and the momentum can carry it higher, we continue to believe that the third significant dollar rally since the end of Bretton Woods is over or nearly so as the convergence of monetary policies replaces divergence, the US policy mix is less supportive, and the US dollar is over-valued by various valuation models.
President Trump has threatened to take unspecific action to offset the dollar’s strength, but we think any review of his options will conclude that the risks associated with unilateral intervention are too high for the benefits that could be elusive if not counter-productive. We are struck that the US verbal intervention has been all but seemingly ignored by international policymakers and market participants. The bigger risk, we think, to the dollar’s role in the world economy than intervention, is the continued use of access to the dollar market as a weapon. This gives a sense of urgency to develop alternatives.
ECB President Draghi said at the late July meeting, roughly the on the seventh anniversary of his pledge to “do whatever it takes” to ensure the future of monetary union, that the economic outlook was getting “worse and worse.” But delivering on the policy response to this situation will wait until September 12, when the economic forecasts will be updated as well. France’s determination to go forward with its “digital tax” and a series of diverging of interests (e.g., Nord Stream II pipeline, defense spending, trade imbalance, Iran, China and Huawei, and exchange rates). Tensions within the Northern Atlantic alliance are set to increase as China and Russia stage what appears to be a joint exercise that crossed into South Korean airspace recently.
Boris Johnson won the Tory leadership contest to replace May to become the UK’s Prime Minister with less than 100 days before the October 31 deadline. Johnson demands that the backstop, which protects the Good Friday Agreement that ended the violence at the border be scrapped altogether. The EC and Ireland cannot make that concession. Johnson does not appear to have a majority of Parliament willing to support a no-deal exit, and it will seek to frustrate such a course, making an election still a likely scenario.
China’s economy is slowing independently of the trade tensions with the US. At the same time, the financial system is being stressed as the large banks appear to be growing more reluctant to lend to smaller banks, which in turn of often buyers of wealth management products. A cut in required reserves appears a likely measure in the coming weeks. The yuan has been remarkably stable in recent weeks, with the dollar mostly confined to a CNY6.85-CNY6.90 range.
Dollar: The Dollar Index rose 2.5% in July, the biggest monthly increase in nearly three years. The advance accelerated late in the month and Fed chief Powell’s characterization of the first cut in over a decade as a mid-course adjustment spurred gains through levels the previously capped it. The market has consistently been more dovish than the Federal Reserve. Still, the mid-course adjustment language harkens back to the 1990s, where Greenspan engineered two such adjustments and each was for three 25 bp moves. Although we are more sympathetic with the dissenting Fed Presidents (George and Rosengren, who wanted to stand pat) and the seven regional Federal Reserve regional banks that did not request the usual discount rate cut in the face of a reduction in the fed funds target rate, we expect another cut in Q4 and one more in Q1 20. The dollar’s appreciation in the face of the cut and the two-month early end to the balance sheet roll-off is likely to frustrate the White House, which seems to see the strength as a significant headwind. The Dollar Index finished July near 98.50. The next important target is near 100.00. The cyclical high was recorded in January 2017 near 103.80.
Euro: The ECB has left little doubt that it will ease policy in September. A 10 bp reduction in the deposit rate (to minus 50 bp) is expected to be coupled with a resumption of asset purchases, and easier terms of the targeted long-term refinance operation (TLTRO) that will be launched in October. Lagarde, Draghi’s successor, is seen continuing the current path. Tensions with the US are rising, and this coupled with heightened antagonism with the UK over Brexit, and the slowdown in China are significant sources of uncertainty. Within the EMU, Italian politics appears to have replaced bad loans as a source of risk, while Spain continues to struggle to form a government.
(previous in parenthesis, end of July indicative levels)
Spot: $1.1076 ($1.1373) Median Bloomberg Forecast $1.1228 ($1.1348) One-month forward $1.1106 ($1.1402) One-month implied vol 4.9% (5.6%)
Yen: The dollar consolidated the decline that took it from JPY112.40 in April to JPY106.80 in late June. It spent July between JPY107.20 and JPY109.00. Although the dollar strengthened against all the major currencies in July, the yen (~-0.8%) fared better than all except the Canadian dollar. The government and the BOJ revised down growth forecasts for this, and the BOJ has all but given up achieving its two percent core (excludes fresh food) until after FY21, which ends March 2022. Japan’s Government Pension Investment Fund reportedly will raise the hedge ratios of their US and European bonds. Currently, the roughly $1.5 trillion fund is believed to have hedged only 5% of such exposure. With the sales tax set to increase to 10% (from 8%) in October, both the BOJ and the Ministry of Finance could provide additional support to the economy. In the meantime, the rate cuts in the US, Europe, and several emerging market economies, also lend support to the yen.
Spot: JPY108.78 (JPY107.85) Median Bloomberg Forecast JPY108.06 (JPY107.90) One-month forward JPY108.49 (JPY107.59) One-month implied vol 5.1% (6.6%)
Sterling: The prospects of a no-deal Brexit has undermined sterling, but practically since the deadline was extended from March to the end of October, it has underperformed. The losses accelerated as Johnson replaced May threatens to leave without an agreement. Over the past month, PredictIt.Org positioning has seen the odds that the UK does leave by at the end of October have risen from about one-in-three to about one-in-two. He demands that the backstop, which is to ensure no hard border separates Northern Ireland from the Republic of Ireland, be scrapped, even though it a practical consequence of the Good Friday Agreement. Since the middle of April, sterling has only risen four weeks against the dollar, while it has fallen for a record 13 consecutive weeks against the euro. The brinkmanship game has nearly quite some time to run, and that means the downside potential has not been exhausted. The uncertainty has forced the Bank of England to give up its tightening bias and return to neutrality. A disruptive Brexit could see a rate cut and a resumption of asset purchases.
Spot: $1.2159 ($1.2696) Median Bloomberg Forecast $1.2402 ($1.2697) One-month forward $1.2180 ($1.2717) One-month implied vol 7.0% (5.9%)
Canadian Dollar: The US dollar gained about 0.5% against the Canadian dollar in July after depreciating a little more than 3% in June. However, the greenback first fell to new lows for the year (a little above CAD1.30 before consolidating in the second half of the month. The Bank of Canada is one of the few major central banks that is not considering easier policy. This leaves the Canadian dollar vulnerable to disappointing economic news. Of the three drivers we often cite (two-year rate differential with the US, the oil price, and the S&P 500 as a proxy for risk), the rate differentials seem to be dominant. Over the course of July, Prime Minister Trudeau has moved back ahead of his Conservative challenger Scheer, according to the positioning at PredictIt.Org.
Spot: CAD1.3191 (CAD1.3095) Median Bloomberg Forecast CAD1.3140 (CAD1.3199) One-month forward CAD1.3180 (CAD1.3085) One-month implied vol 4.8% (5.6%)
Australian Dollar: The Australian dollar closed June well, near $0.7025, and tried extending the gains in early July. This fizzled near $0.7050 and the Aussie retreating to almost $0.6900. It got another running start and extended its gains to around $0.7080. This was all in the first part of July. It spent the second half of the month trending lower, reaching almost $0.6830 at the end of the end. As the Australian dollar has declined the Australian discount to the US has widened more than 20 bp to over 100 bp. Except for a brief period in 1997, Australia always offered a premium over the US, until late 2017/early 2018. The Reserve Bank of Australia cut rates in June and July, and expectations for the next move had been pulled forward but after the “hawkish” cut by the Fed, it was pushed back to October.
Spot: $0.6845 ($0.7020) Median Bloomberg Forecast $0.6931 ($0.6979) One-month forward $0.6855 ($0.7028) One-month implied vol 6.5% (6.9%)
Mexican Peso: The US dollar spent most of July consolidating in the range set on July 9 when Mexico’s finance minister and ally of AMLO resigned in protest. That range is roughly MXN18.88-MXN19.35. Investors are wary after the airport construction was scuttled and AMLO is discouraging private investment in the energy sector. On the other hand, a broadly stable peso continues to reward foreign debt holders and some carry-trade strategies. Mexico’s economy contracted in Q1 and barely escaped a contraction in Q2. The year-over-year rate fell to -0.7%, the weakest since 2009, but the central bank is reluctant to cut rates. Inflation is just back into its 2-4% target range, and risks continue to emanate from the PEMEX. Few, if anyone, expect Banxico to cut rates at the August 15 meeting. However, the market is perceiving a greater chance (~30%) of a cut at the September 26 meeting (vs. less than 20% at the end of June).
Spot: MXN19.15 (MXN19.22) Median Bloomberg Forecast MXN19.26 (MXN19.28) One-month forward MXN19.25 (MXN19.32) One-month implied vol 8.9% (9.4%)
Chinese Yuan: The Chinese yuan appeared to flatline in July. It was almost as if Chinese officials had re-pegged it, which they didn’t. The dollar traded the entire month between roughly CNY6.8355 and CNY6.8960. The actual volatility in July was 2.35%. In June it was half again as high (~4.5%) and the historic volatility in April was nearly 4.6%. If this was of official doing, it might show up as a decline in reserves, though given the dollar’s broad gains, valuation shifts will also likely play a significant role. Consider that if a modest $500 bln of China’s $3.12 trillion of reserves were in German Bunds, which were nearly flat on the month, the euro’s depreciation would be reflected in a $10 bln (unrealized) loss. The Chinese economy has slowed independent of the trade conflict with the US, and this coupled with greater caution on the part of the large banks to lend to smaller banks, makes a policy response, such a reduction in reserve requirements and/or an interest rate cut more likely.
Spot: CNY6.8850 (CNY6.87) Median Bloomberg Forecast CNY6.8915 (CNY6.88) One-month forward CNY6.9050 (CNY6.86) One-month implied vol 3.1% (4.9%)
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