Is Dollar Exceptionalism Returning?
First-quarter growth abroad was lower than expected, which pushed the trade-weighted dollar up 3 percent in May. Will overseas growth rebound in the second quarter, or will the US maintain its exceptional position?
- USD: The dollar delivered surprising strength in May, but the macro background remains bearish. US policy and political risks may contribute to a dollar discount in the long-term.
- JPY: The yen moved sideways, but the Bank of Japan has hinted normalization may be on the horizon.
- EUR: Downside growth surprises have cast the European Central Bank’s tightening timeline into doubt as the euro slips further.
- GBP: The Bank of England backed off its tightening timeline, sending the pound downward. The coming months will be pivotal as the upcoming EU summit and Brexit developments provide direction for the pound.
USD: US Seems Exceptional Again
The trade-weighted dollar gained 3 percent over the past month as disappointing growth abroad helped the US economy appear exceptional once again. Forecasts early in the year called for synchronized global growth that would set the stage for interest rate normalization in Europe and Japan, but global growth has fallen well short of expectations—leaving the US’s policy normalization singular on the world stage.
Europe and Japan may have gotten off to a slow start in 2018, but the recent downside surprises have done little to change the broader macroeconomic picture. With US short-term interest rates nearing 2 percent and inflation resting near its official target, the Federal Reserve is now entering the late stages of the normalization process. Meanwhile, the advent of tightening from the European Central Bank (ECB) and the end of negative rates in Japan promise to eventually bring an outsized boost for the euro and yen.
Political risks may also be creating a significant premium for the dollar. While NAFTA negotiations are proceeding apace, uncertainty still surrounds the US’s trade conflict with China. The recent imposition of tariffs on Chinese imports may be a tactical negotiating tool; however, the tariffs may prove to be a strategic goal unto themselves, serving the policy objective of slowing global commerce. The risk premium will only subside with the ratification of a new bilateral agreement.
JPY: Yen Steady Despite Capital Outflows
The yen held its value despite seasonal capital outflows, with the currency posting the third-strongest performance among major global economies in May. The yen is being buoyed by expectations that the Bank of Japan (BoJ) will raise its 10-year target interest rate in December, signaling the first step in the eventual tapering of its quantitative easing program. The BoJ’s most recent quarterly outlook report notably lacked a timeframe for achieving its official 2 percent inflation target, which could be a prelude to tightening monetary policy ahead of the emergence of inflationary pressure.
The yen has not been immune to political risks. Domestic political scandals continue to dog the administration of Prime Minister Shinzo Abe, now embroiling Finance Minister Taro Aso. The potential for Aso’s resignation could create upside risks for the yen, but it is unlikely that his replacement would support more hawkish monetary policies.
EUR: Is European Normalization on Hold?
Soft first-quarter growth in the eurozone caught markets by surprise. Many analysts anticipated a sharp springtime rebound for the European economy, and when no such resurgence materialized in May, the euro fell 4 percent against the US dollar. If momentum does not return this summer, the timeline for normalization from the ECB, with an initial rate hike currently expected in the first half of 2019, may be pushed back to late next year.
A delay in tightening from the ECB could lead to a further recoupling of currency values with interest rate differentials. This could drive the euro lower, as European rate spreads have widened to more than 2 percentage points against the US. Further euro depreciation could cause capital outflows to accelerate if American corporations decide to repatriate profits ahead of the currency’s decline.
But the return of European growth is still broadly anticipated. PMI reports have been consistent with a return to above-trend growth of 2.5 percent, and forecasts still call for expansion to accelerate to a 3 percent pace in the second quarter.
Italian elections have generated political risks for the EU, with the right-wing Five Star and Northern League parties taking control of the Italian government. Although the new governing coalition could see conflict with the EU over fiscal policy, markets took the election results in stride, as neither party has prioritized exiting the currency union.
GBP: Policy Reversal Leaves Pound Directionless
The Bank of England has paused its tightening timeline in response to a first-quarter economic slowdown. Growth forecasts for 2018 have been downgraded from 1.8 percent to 1.4 percent, and the Monetary Policy Committee (MPC) now believes that three rate hikes over the coming three years will be sufficient to maintain inflation at its 2 percent long-term target. The pound dropped 3 percent in response to the policy shift.
The MPC still believes a rate hike is likely for 2018, but their most recent statement downplayed the urgency for action and endorsed a data-driven approach. Futures markets still price in a 50 percent chance of an August hike, leaving the pound vulnerable should growth and inflation fail to rebound in the summer.
Brexit negotiations have reached a crossroads ahead of the June 28 summit. With the issue of the Irish border unresolved, Prime Minister Theresa May’s strategy is beset from all sides. Hard-line advocates fear the proposed customs partnership with the EU will be a back door to remaining in the union, while a cross-party, euro-friendly coalition is demanding that the House of Commons hold a vote on withdrawal.
Given the apparent support for a soft Brexit in Parliament, the chances for a negotiated settlement appear strong, with approximately even odds that Britain will maintain its de facto position within the customs union.
Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views, published May 11, 2018.