Hello, and welcome to the EncoreFX Mid-Year Market Update. As markets face increasing uncertainty, we break down the key themes that will affect currency markets for the rest of 2018. Our commentary kicks off on the hottest topic of 2018: the US Federal Reserve.
Comments on the USD and CAD are from Leo Ramos, CFA – Director of FX Dealing, Canada
The first half of 2018 marked the beginning of the Jerome Powell era at the US Federal Reserve. Taking over from Janet Yellen in February of this year, markets initially sold off on the anticipation that the new boss would take a more hawkish approach to normalising interest rate policy. So far, he has not disappointed, increasing interest rates twice since taking the reins. Perhaps of more significance has been his steadfast tone on future rate hikes, maintaining market expectations for 2 more increases in 2018.
The Fed continues to act with quite a bit of faith in the growth trajectory of the US economy and it’s not clear if the markets agree with their forecasts. The hawkish approach of policy makers has translated into higher short-term yields, however, longer-term yields have not reflected this same optimism. We have seen a significant flattening of the yield curve which, above all else, signals that the market does not believe future growth will be as strong as policy makers are projecting. Should the yield curve invert, a recession may very well be in the cards.
Not to be outshined by the Fed, President Trump continues to provide us with a slew of headlines each week. Investigations regarding any Russian involvement in the US elections remain ongoing, however, the markets seem rather exhausted by the headlines and reactions to recent news have been fairly muted. Additionally, the fear of a nuclear war with North Korea has largely diminished after the historic meeting between Trump and Kim last month which some believe may actually lead to the denuclearization of North Korea (although this remains to be seen).
There is one agenda of the Trump Administration that is weighing heavily on global markets and risk sentiment in 2018, and that is his trade policy. Or, put differently, his dismantling of current trade agreements and relationships in an attempt to negotiate more favourable arrangements for the USA. While his intentions of putting America first may have some merit amongst his constituents, the path there may be a painful one.
Last year, the US began the process of renegotiating NAFTA with Mexico and Canada, which included threats to scrap the agreement entirely. Now, in the first half of this year, Trump has imposed steel (25%) and aluminium (10%) tariffs on the EU, Canada and Mexico, is currently discussing similar tariffs on India, has imposed tariffs on $50 billion of Chinese imports (to take effect July 6), and has contemplated pulling the US out of the World Trade Organization. All countries targeted have retaliated with similar tariffs or plan to do so in the very near future.
The trade tactics taken by this Administration are amounting to nothing short of trade wars. The majority of economists believe these policies will have an adverse effect on the US economy and the markets have tended to agree. Since these new policies took effect, major US stock indices have fallen from their highs – at time of writing, the Dow Jones is down 2.2% YTD and the S&P 500 is up 1.5% YTD.
That said, economic data in the US has been quite strong this year. With an official unemployment rate of 3.8%, many are arguing the US is at or near full employment. This, in turn, is initiating an increase in wage growth for employees and signals that inflation in the economy is picking up. The Fed’s dual mandate of full employment and stable prices appears close to being satisfied, further bolstering the case for gradual increases in lending rates. One thing we can be sure of is that the Trump Administration is full of surprises; trying to predict how this story plays out is certainly a tall task.
For the Canadian economy and the Canadian Dollar, one theme stole the show in the first half of 2018: trade. The Trudeau Government is really being put to the test in 2018, spurred on by their neighbours to the South. Negotiations for a new NAFTA have continued to drag on longer than expected, with no clear end in sight, and more recently, a tit-for-tat series of tariffs on steel and other goods between Canada and the US have gone into effect. Add to that the uncertainty in the Canadian oil industry; protests over building new pipelines have led the Canadian government to purchase the Trans Mountain Pipeline from Texas based Kinder Morgan, in an attempt to ensure its completion.
Add it all up and you’re left with a world of uncertainty for Canadian businesses and those invested or considering investing in the Canadian economy. Mr Trudeau and his government have their work cut out for them – how they stick-handle these issues in the second half of 2018 will massively impact the Canadian economy for years to come.
Increased political uncertainty certainly doesn’t make the Bank of Canada’s job any easier. Despite the BOC being one of two major central banks to have increased interest rates in 2018, the loonie has steadily depreciated against the US dollar for the first half of the year, and the yields stateside continue to climb at a faster pace. There’s no doubt that the BOC would like to continue to normalize policy, however, they also recognize the potential risks of moving too quickly. Canadian households remain amongst the most indebted of any G20 nation, and while the red-hot housing markets around Vancouver and Toronto may have shown signs of stabilizing, Governor Poloz is certainly conscious of the adverse effects that tightening monetary could have on these sectors.
The BOC wishes to maintain maximum flexibility in their future policy decisions. Policy makers continue to stress the fact that they are data dependent and will refrain from providing the market with forward guidance. So, what has the data told us in 2018?
Economic growth has recently surprised to the upside while inflation has missed the mark. Canadian stocks had a small conniption to start 2018 with the TSX falling almost 10% from its opening levels. Since then, the Index has steadily ground higher and is virtually unchanged from where it opened the year. Another X-factor to consider is the wild ride in oil prices. Kicking off 2018 at $60.20, WTI has rallied over 23% and now sits at $74.20. As such an important commodity to the health of the Canadian economy, it will be worth keeping an eye on price developments in this market.
The big challenge for Governor Poloz in the back half this year will be the delicate balancing act of continuing to normalize interest rate policy without shocking the Canadian economy by moving too quickly. Markets expect the BOC to hike rates one or two more times this year, but whether it is one or two will continue to be guided by the developments we see in the Canadian economy and political environment.
Upcoming Australian Contribution from Roy Agostino, Senior Relationship Manager – Sydney
After a strong start to 2018, the AUD/USD finds itself closing mid-year some 9% lower than its January 26 high (at 0.8135).
The factors that have conspired to undermine the AUD/USD have come to the forefront more so in Q2 than Q1. They are:
Australia’s domestic backdrop has not helped, with consumers seeing the value of their homes fall while wage growth stagnates. This combination of lower house prices and zero wage growth continues to crimp household spending and holds back inflation, making it difficult for the RBA to raise rates anytime soon.
All this against a backdrop of a US Fed committed to normalising rates by the end of this year.
Trade-wise, the tariffs imposed by President Trump on China, the EU and Canada create uncertainty that hurts trade-sensitive currencies such as the AUD.
In a world moving towards the normalisation of interest rates, Australia’s own lack of urgency will continue to weigh on the currency. This is illustrated in the following chart which shows the direction and spread between US and Australian 2-year rates:
Trade tensions are likely to keep commodities from rallying significantly, further stifling the potential for a sustained AUD/USD rally.
As such, expect 0.7150 – 0.7750 to be the predominate trading range in H2 2018, with a bearish bias unless we see a shift in the RBA’s rhetoric on monetary policy.
Upcoming commentary on New Zealand, Europe, and the UK from Phil Lynch – Corporate Hedging Director, Asia Pacific
So far in 2018, the New Zealand dollar has lost 4.6% against the greenback (0.7086 to 0.6757). However, it feels like our flightless bird has fallen further – perhaps even stumbled off a cliff – given the currency spent more than half of the year above 0.7200. The first six months saw the kiwi achieve an average rate of 0.7168, so we are now 5.8% lower than this average. The NZDUSD is under pressure for two key reasons:
On a trade weighted basis, the kiwi is also struggling, down just 2.2% (73.88 – 72.26). This is not an entirely bad performance given that the significantly lower NZDUSD makes up a good part of the TWI.
As per usual, most New Zealand dollar movements are being driven by offshore developments, though we still like to dig a little deeper into the local environment to see what lies ahead.
The Reserve Bank of New Zealand is set to continue with its staggeringly boring and neutral course in 2018 (if you’ve heard that line before, I copied it word for word from our January update). The RBNZ is not projecting any rate hikes until the end of 2019.
The RBNZ’s new governor (Adrian Orr) has settled in well and is continuing with a stable outlook for monetary policy. Orr outlined the bank’s priorities in the Statement of Intent, which included comments around implementing the government’s changes to the RBNZ Act (the employment mandate and the introduction of a committee for policy decisions). The RBNZ will also be reviewing the adequacy of the local banks and assessing infrastructure, but it is still too soon for the bank to roll out a digital currency.
According to Thomson Reuters (who surveys the world’s leading economists), the median expectation is for the RBNZ to raise rates in Q3 2019. Some expect several hikes by the end of next year, with ANZ expecting the OCR to be at 2.25%, BNZ at 2.75%, and Goldman Sachs and UBS at 2.50%. These picks are all at odds with the RBNZ’s own projections of a possible rate hike by the end of 2019.
Business confidence is a key theme as we enter the second half of 2018. Typically, markets don’t react to business confidence but the ANZ ‘June Gloom’ confidence reading has kicked the kiwi whilst it’s down.
The confidence survey appears more pessimistic than most economists, but our economy should expect a minor slowdown with GDP somewhere between 2.5-3.0% by this time next year. Our unemployment rate should stay steady around the current level of 4.4%. Inflation might be revised with the lower NZ dollar, with our next round of inflation data released on the 17th of July. Overall, it’s a neutral outlook for the kiwi, with a touch of bearishness thrown in.
The fragmented European economy is continuing its long and tired road out of the doldrums. The story in Europe centres around two key stories:
The ECB has long signalled desire to move away from its own bond-buying program which has kept the Eurozone bubbling along on life-support for the last several years. It looks likely to end in December – a good visualisation of the purchases can be viewed on the ECB’s website, here.
Focus is now shifting to when the ECB will move towards policy normalisation (raising their interest rates from below zero). It’s clear that this won’t be happening anytime this year, but what we might get later this year is a signal from ECB boss Mario Draghi as to the timing and pace of policy normalisation. This poses the greatest opportunity for the euro, as markets like to get ahead of any monetary policy moves.
Whilst the ECB is moving towards normalisation, politics in the European Union bring about a never-ending melting pot of headlines. This year we have seen major developments with two of the top economies in Europe. Germany’s Chancellor Merkel scraped together a coalition, however, the coalition is already at risk of strife with the leader of the coalition partner CSU party not satisfied over EU deals. In Italy, we have seen on-again-off-again developments with the new government being forced to deny they want to leave the EU.
Amidst the backdrop of a nationalistic movement in the Eurozone, the current administration is also faced with the threat of a trade war with the world’s largest economy. Uncertainty remains as to how this story will unfold.
Despite the fragmented market, the European economy is showing signs of strength. GDP growth has risen to 2.5% year on year from -1.2% in March 2013. The unemployment rate has fallen steadily from its May 2013 high of 12.1%, and is now at 8.4%. Inflation is patchy, having spiked to 1.9% at the last reading. However, whilst there are pockets of hope that are allowing the ECB to return to policy normalisation, there are still serious concerns about major economies with the union. Two glaring examples include unemployment in Spain (16.7%) and the debt to GDP ratio in Greece (179%).
One thing is for certain: there are more curveballs to come in Europe’s unfolding recovery story. One of the major questions is how they will handle Britain’s exit…
In the second half of 2018, London and Brussels are aiming to finalise a Brexit deal. The goal is for a deal to be struck by October, to provide authorities enough time to ratify it before Brexit Day in March 2019. With just nine-months left, it really is crunch time.
However, few diplomats believe a deal will be struck in October. Concern is growing that Britain could crash out of the EU without a deal, or with a deal that would silt up the arteries of trade. Major manufacturers are calling for decisions to be made and clarity to be achieved. BMW, for example, runs a plant in Oxford which imports about 5 million components each day. The lack of clarity has led executives to quietly increase capacity in the Netherlands where staff numbers have quadrupled – a worrying sign for British business.
Brexit negotiations will be crucial for the sterling, and Brexit headlines will continue to cause significant movements in the exchange rate. The status quo would be to assume a reasonable deal will eventually be struck, and this should be mildly positive for sterling. However, the risk of a poor deal or no deal could be very damaging for sterling and even have a broader impact on the European economy.
Despite Brexit uncertainties, the Bank of England is expected to continue with its excruciatingly slow pace of rate normalisation. Current rates sit at 0.50%, having been raised from their record lows in November 2017. One more 0.25% hike is almost fully priced in by the end of 2018 with a 57% chance of that hike coming in August.
However, the bank will inevitably be cautious as the economy reacts to Brexit uncertainties. GDP growth remains subdued at 1.2% year on year, but unemployment and inflation are reasonable at 4.2% and 2.4% respectively. Further moves towards normalisation will be data dependent, and this will in turn depend on the economies reaction to Brexit negotiations.
China will continue to grow at 6.5% or more, especially with the Chinese authorities ‘smoothing’ the numbers. Manufacturing costs in China will also continue to rise. A trade war with the US is now underway and poses the greatest catalyst for volatility.
The Bank of Japan will continue with its ultra-loose monetary policy. It is highly unlikely they will move rates in 2018, however, by the end of 2018, they may indicate their intentions to tighten their current stance and this would benefit the yen – the adage of ‘buy the rumour, sell the fact’ could come into play.
Six months ago, the threat of nuclear war was upon us with Chairman Kim of North Korea regularly testing intercontinental ballistic missiles that had the capacity to reach the USA. Meanwhile, Trump responded with threats to wipe out North Korea.
Just six-months later, these threats feel like a distant memory. The Trump-Kim summit in Singapore has ushered in an era of supposed denuclearisation. This story undoubtedly has twists and turns to come, but will likely take a back seat for the rest of 2018.
Equity markets, including both the Dow Jones and S&P 500, are continuing their strength mid-way through 2018. Whilst some believe an equity bubble is forming, others argue that stimulative policy will continue to support record growth in equities. Liquidity remains high to protect against shocks, but there is a sense of caution after equity markets went through 2017 unscathed (unlike in 2007 – GFC; 1997 – Asian Crises; 1987 – Market Crash).
The Fed is projecting to raise rates dramatically in 2018 and will continue with unwinding QE. Treasury yields have lagged so far, but the all-important 10-year treasury yield did spike above 3.0% in early 2018. This kicked off a big run on US dollars. Should the yield once again tip-over 3.0%, we can expect the US dollar to react accordingly. At the time of writing, 10-year yields have dipped to 2.84% with 2-year yields holding firm at 2.53%.
The oil market has suffered quite a few disruptions in 2018. Political chaos in Venezuela, new OPEC production limits (and subsequent removal of those limits), uncertainty around Canadian pipeline projects, and recent pressures by the US to boycott Iranian oil have all raised serious questions about global oil supply. Brent Crude is up 17% YTD while West Texas Intermediate is up 23% YTD. Will these tensions around supply subside and bring oil back down to earth? Or will these disruptions continue in the latter half of the year and bring the price at the pump to new highs?
Picking currency can be a bit like picking the winner of the Football World Cup. Before the cup began, few would’ve thought that a teabag would last longer in the cup than Germany. Or that England could win a penalty shootout. I know, I know – rich commentary coming from a kiwi whose team didn’t qualify! But in this World Cup, it has been safe to expect the unexpected.
Even once the grand finalists of this cup are known, picking a winner will be down to a coin toss with 50/50 odds. Many will successfully pick a winner, just like many will successfully guess which way the currency will go next. But if you want to protect your exchange rate exposure and your business from being on the wrong side of a coin toss, contact us today.
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