Forex: Bracing for a New Period of Monetary Easing
Daily FX Market Roundup 07.01.16
What a difference a week makes. The market went from preparing for another financial Armageddon post Brexit to wondering if the worst is over. Relief rallies were seen in currencies and equities with sterling rising 4 cents off its lows. Markets rarely move in a straight line and these rebounds can be largely attributed to short covering and quarter end flows. Now that Q2 has drawn to a close and Q3 has begun, it is important to realize that the economic and political outlook for the U.K. and the global economy did not improve over the past week. In fact, we remained mired in uncertainty with both parties of the U.K. government headed for leadership votes and no one is willing to invoke article 50 and begin negotiations for leaving the European Union. Britain’s problems affect the world because they directly impact market uncertainty and can translate into greater volatility. S&P and Fitch stripped the U.K. of its AAA rating and the Bank of England warned that rates will fall in the summer. So even though U.K. data beat expectations including this morning’s manufacturing PMI report, none of this matters when business, investor and consumer confidence is at stake. It may be another month before we see the impact of Brexit on data so for this reason investors will discount every positive report including next week’s PMI services, industrial production and trade numbers. With the BoE talking about easing, we are looking for GBP/USD to move back below 1.32.
Monday is a holiday in the U.S. but investors will be watching the dollar closely in the coming week with the FOMC minutes and June non-farm payrolls report scheduled for release. Even if there is a strong rebound, the Federal Reserve is in no position to raise interest rates this year. Fed fund futures are now pricing only a 9% chance of a rate hike in 2016 and less than 50% chance of tightening in 2017. A lot can change between now and the end of next year so we believe there’s leeway for a second half 2017 hike but for the next 12 months, rates are likely to remain unchanged which should be positive for equities and risk appetite. With that in mind, stronger job growth will highlight the relative strength of the U.S. economy compared to Europe, which could help the dollar hold onto its gains.
We’ve spent a lot of time talking about sterling over the past week and another currency pair also deserves our attention. Since Friday’s aggressive move lower, USD/JPY has been consolidating within a tight 190-pip range. The pair’s recovery was largely driven by the improvement in risk appetite but investors are also growing worried that the Bank of Japan could strike soon. According to the Ministry of Finance, there was no foreign exchange intervention last week even so the 200-pip rally over the course of 2 minutes the evening after Brexit was not official action. Instead it is now obvious that the quick reversal was triggered by automatic buy orders below 100 and short covering or profit taking around that key level. The market clearly thinks that 100 USD/JPY is the line in the sand for the Bank of Japan but even at 102, we see policymakers growing very concerned about exchange rate volatility.
The strong Yen is a big problem for Japan. As an export dependent nation Japan relies heavily on a weak currency for long-term economic viability and the 7% appreciation of the Yen versus the U.S. dollar this month and 14% rise year to date is quickly becoming a serious problem. Adding to the pain is China’s active efforts in devaluing its currency. Year to date the Yen is up more than 20% against the Yuan. China and the U.S. are Japan’s most important trading partners but China imports a lot more to Japan than its American counterpart, which means Chinese demand could shrink significantly. More importantly though Japan and China are major competitors for foreign direct investment, technology and automotive production activity so a stronger Yen versus Yuan makes Japanese products less attractive.
Chinese Yuan devaluation puts pressure on the Japanese to do the same but currency intervention rarely works for the central bank. The PBoC is different in that it can keep CNY in its new range but a freely traded currency such as the Yen can and is oftentimes quickly driven back to pre-intervention levels. So what’s the BoJ left to do? Cut interest rates and/or rollout another round of Quantitative Easing. Japan has struggled with low inflation for two decades and now with the Yen rising, deflation could return. Recent economic reports have also been very weak with the trade balance returning to deficit in May, retail trade growth falling by the largest amount in 15 months year over year and industrial production contracting -2.3%. The next Bank of Japan meeting is at the end of July but if data continues to deteriorate and the Yen resumes its rise, an emergency meeting mid month could be held. The BoJ could be thinking why wait when we know stimulus is needed and a surprise move would have a more durable impact on the market. If the Japanese government really wanted to take a stand they would combine tax cuts and more spending (fiscal stimulus) with monetary easing. That probably won’t happen until after the Upper House Election on July 10th because negative interest rates have been extremely unpopular in Japan and another cut before the election could affect the results. The LDP is expected to remain in control thanks in large part to Abe’s decision to postpone the sales tax increase. So we believe that USD/JPY could hit 104 and possibly even 105 in the coming weeks as the prospect of BoJ easing grows.
It was a good week for the euro, which like many other major currencies bounced off its Brexit lows. However now that the Bank of England opened the conversation about more easing the European Central Bank could be next. On Thursday, Bloomberg reported that the ECB is considering loosening its QE rules. This sent EUR/USD sharply lower all of the losses were recovered after an ECB press officer denied the report. But we can’t help but point out that there’s merit to this argument as the pool of debt that the ECB is eligible to buy shrinks by the day. It also puts the thought of easing into everyone’s minds and going forward, market participants will be looking for dovish comments from the ECB to validate a short trade. Any denials will be viewed with skepticism. Data has been mostly better than expected but that matters little when they have yet to capture Brexit risks.
The New Zealand, Canadian and Australian dollars were the best performing currencies this week. Economic data from the region was better than expected with Chinese manufacturing activity remaining steady, Canadian GDP growth turning positive and Australian manufacturing activity accelerating. However yield continues to be the main reason why the comm dollars are attracting demand. With the Bank of England talking about cutting interest rates and the BoJ/ECB thinking about doing the same, the yield premium offered in Australia and New Zealand along with the healthier economic outlook have made these currencies particularly attractive to foreign investors. While the U.S. and China can’t avoid the impact of Brexit, compared to Europe and Japan, the consequences could be less painful especially for China who has been exercising greater control on its currency and economy. The Reserve Bank of Australia meets next week and we are not looking for an interest rate cut but the RBA could talk down AUD by sharing their concerns about Brexit and the recent strength of the currency. It will also be an important week in Canada with the trade balance, IVEY PMI and employment reports scheduled for release. USD/CAD spent the better part of last week rejecting the 100-day SMA with lower highs and lower lows and we are still looking for additional weakness in the currency.