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Foreign Exchange

Global Crosscurrents Benefit the Dollar

The US is alone among G3 economies in tightening rates, and political risks are growing in Europe. A combination of political and economic developments buoyed dollar strength this month.

Executive Summary

  • USD: A near-perfect storm delivered surprising strength for the dollar, but forecasts still call for rate spreads eventually to narrow as synchronized global growth resumes.
  • JPY: Geopolitical and trade risks led to a turbulent month for the yen, and the downward trend is expected to continue until risk factors decline.
  • EUR: The return of inflation to the EU will lead to tapering in the fall, but a showdown with Italy is looming.
  • GBP: A Brexit breakthrough remains elusive, creating downside risks for the pound. The recent resignations of the UK’s Brexit secretary and foreign secretary have further stalled progress.
  • CAD: Trade tensions and a crude-oil bottleneck are holding the Canadian dollar down

USD: A Perfect Storm for a Strong Dollar

A near-perfect storm of economic, political and idiosyncratic factors have combined to pause the US dollar’s decline. American economic expansion continues to outpace European and Japanese growth, and trade tensions are mounting. US monetary policy normalization may be entering its later stages, but among the G3 economies, the Federal Reserve remains the only one tightening, pushing rate spreads wider. The dollar is no longer expected to print fresh-cycle lows in the near term.

Last month brought strong domestic growth and inflation data, leading futures markets to price in an even chance that rates will rise by a full percentage point over the coming year. With the European economy still stuck in neutral, widening rate spreads should strengthen the dollar over the medium term.

Trade risks continue to push the dollar modestly higher against sensitive currencies, including the Canadian dollar and Japanese yen. However, further escalation in trade negotiations may bring considerable downside risks for the currency. Investors have already priced in a steady tightening of US rates. If retaliatory tariffs cause global growth to stumble, a significant dollar repricing could result.

Developments over the past month have done little to change the dollar’s long-term trajectory. Growth abroad remains stubbornly slow, but forecasts call for expansion in Europe and Japan to accelerate in the second half of 2018.

JPY: Geopolitical Risks Drive Yen Volatility

Tensions in the Asia-Pacific region are creating volatility for the Japanese yen. Uncertainty on the Korean Peninsula and the increasingly hostile trade rhetoric between the US and China have caused the yen to gyrate. The currency climbed to 108 yen against the US dollar before falling back to a six-month low in July.

Foreign direct investment outflows are also placing downward pressure on the yen. The first quarter saw 3.6 trillion yen in net outflows. Japanese investors also purchased 2.1 trillion yen in foreign stocks and 2.9 trillion yen in foreign bonds between January and April, adding to the currency flight.

Domestic politics, however, are creating upside risks. A leadership vote in September may bring down the scandal-plagued Shinzo Abe administration. Abe’s replacement at the head of the ruling Liberal Democratic Party, however, is unlikely to signal the end of Abenomics—the leading candidates to replace him at the top of the ticket share his commitment to a monetary policy featuring negative interest rates and quantitative easing.

EUR: European Tightening Delayed

Weak growth in the European Union is now expected to delay the launch of interest rate normalization by a full quarter, with the first rate hike expected in June 2019. Forecasts call for the continent’s growth to resume in the latter half of the year. Economic expansion is projected to accelerate to a 2.5 percent pace in the third quarter. Delayed tightening and widening rate spreads against US Treasurys likely will weaken the euro against the US dollar in the near term.

Despite slow growth, mounting inflationary pressure will end the EU’s quantitative easing program by late December. At 1.9 percent, the headline inflation rate now stands near the European Central Bank’s target, leading the central bank to begin tapering. At last month’s meeting, the ECB voted to begin slowing the pace of asset purchasing in September, with the program concluding by year-end.

Potential gains from tapering likely have been curtailed by uncertainty surrounding the new Italian government. While the victorious populist coalition has not made a priority of exiting the EU, its leaders have advocated flouting the monetary union’s fiscal restrictions, setting the stage for a showdown with the common market. The antagonism is not yet serious enough to derail the euro’s positive trajectory, but the currency’s rise may be limited until the conflict’s contours are clarified.

GBP: Britain at a Standstill

With Brexit looming and the UK economy at a standstill in the first quarter, the British pound has been the worst-performing G10 currency since mid-April. The pound has failed to rally against the euro despite the antagonism between Italy and the EU, a sign that investors do not view the UK as a safe haven. British growth may resume in the third quarter, but mounting Brexit risks may limit the pound’s rally.

With just about eight months remaining before the UK is legally obligated to exit the common market, virtually no progress has been made on Brexit negotiations. In June, Parliament narrowly approved legislation granting Prime Minister Theresa May the authority to leave the EU; however, the administration released a white paper that provides crucial details regarding post-Brexit trade and customs. A lack of progress on negotiations may increase the odds of a hard Brexit, increasing downside risks for the pound.

CAD: Risks Surround Canadian Dollar

A round of retaliatory tariffs now threatens NAFTA negotiations, putting downward pressure on the Canadian dollar. After placing steep tariffs on imported steel and aluminum, President Trump is advocating a separate bilateral trade agreement with Canada, leaving little hope for an agreement before the US midterm elections in November.

Crude-oil shipping bottlenecks have also limited the rise of the Canadian dollar. The US pipeline network is operating near full saturation, and WTI spot prices rest at an $11 discount against Brent crude. Shipping bottlenecks are expected to persist through the third quarter, limiting the Canadian dollar’s potential to rise with firming global energy prices.

Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views, published June 8, 2018.

Foreign Exchange

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