Global FX Monthly Treasury Research Group

Transcription

1 Treasury Research Group For private circulation only April 26, 2018 Treasury Research Group Central themes in the currency market Volatility is unlikely to abate: The trading environment in 2017 was relatively linear as investors used the USD to fund positions in European/EM assets on the back of evidence that growth in the non-us world was converging towards growth in the US economy. The USD weakened across the board as a result. However, 2018 is proving to be just the opposite with volatility spiking higher. We expect this volatility to persist until there is clarity on: (a) the full-extent of the US protectionism stance, (b) geo-political tensions in the Middle-East and (c) global growth prospects. In a still uncertain trading environment, price action is likely to be driven more by news flow and political developments in the near-term than by developments in the real economy. Commodity prices: Changing the FX game? While sentiment was disrupted by US trade policy, the uptrend in global commodity prices has had a more pronounced impact. For one, it has raised long-term US inflation expectations pushing the longer end of the nominal US yield curve higher in the process creating renewed demand for the USD. The global FX universe was yet again divided into currencies of commodity exporting nations that received a favourable terms of trade shock and currencies of commodity importing nations that fell across the board. Our view on the global crude oil market remains unchanged. We do not expect the sustained uptrend in prices to persist as an increase in the supply from US Shale is likely to ensure that there is no substantial widening in the gap between demand for and supply of oil over the medium term. Hence, we expect global crude oil prices to correct lower in the medium term. Nevertheless, uncertainty in the near-term is likely to persist weighing on sentiment and currencies of commodity importing nations on balance. US Protectionism: More noise than definitive action?: Over the last fortnight, market response to protectionist rhetoric from the US government has softened as actions have been more subdued in nature than the headline announcements made so far. However, there does not appear to be any letting up from the US administration as the US President has warned that if the new round of negotiations between US officials and Chinese officials do not end favourably, the US government could impose tariffs on 15-May-2018 after a public hearing. While we are not anticipating a full-scale trade war, we do not rule out further hostility from the US government that could keep markets on the edge. USD rebound: Temporary or permanent? A substantial change witnessed over the last month has been a renewed uptrend in the USD. The rally in the USD is not totally unexpected given that the FOMC has been sending hawkish signals and US economy has outperformed its G-4 peers so far in However, the real game changer in the last week has been some degree of steepening in the US yield curve as the longer-end has moved higher creating renewed demand for the USD. We do not rule out further upside potential in the USD over Q22018 given that the first round effects of the fiscal stimulus package are likely to ensure that US growth remains firm. However, we maintain our view that the twin deficit problem is likely to weigh on the USD over the medium term. We are, therefore, not altering our longer-term FX projections but adjusting our near-term forecasts to take into account a short-term rally in the USD. The DXY index could in the near-term move towards the range before correcting lower towards the level by end Our medium term bearish view on the USD is also validated by the release of the IMF s COFER data Q42017 that shows that global central banks demand for the USD has dwindled probably in anticipation of a long-term deterioration in the US fiscal position. One point to keep in mind, however, is that the more aggressive the US government gets in its protectionist stance by announcing possible additional tariffs on its partner nations the lesser is the upside potential of the USD. Investors view tariffs and unilateral protectionism as having negative consequences for the US economy over the longer-term. It is also no coincidence that the USD has risen (over the last fortnight) at same time as investor concerns about protectionism appears to have subsided. Hence, we watch the outcome of the US- China trade negotiations very closely. Global growth outlook: remains constructive: Even as economic surprise indices have disappointed to the downside in Q12018, we do not think that the global economy is on the cusp of another downturn as the fundamentals remain strong. Robust labour markets, a still accommodative global monetary environment and a looser fiscal policy framework on aggregate are likely to act as the main catalysts ensuring that there is more steam left in the global growth cycle. We view the moderation in Q12018 as a temporary blip.

2 23-Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr-18 Currency Macroeconomic snapshot Currency view US Dollar (USD) Euro (EUR) US unemployment rate ticked lower, consumer confidence as measured by the conference board improved and retail sales picked up in March highlighting that the growth momentum is still strong However, CPI inflation fell on a sequential basis by 0.1% in March highlighting that inflation pressures are not accelerating. The Fed is likely to continue with gradually normalizing policy but focus is likely to be more on oil price developments, US sovereign yield movements and statements coming from the White House than on data flow. After a strong 2017, both hard and soft indicators have moderated in 1Q218 visible in industrial production releases and confidence surveys both investor and consumer confidence. Even though the ECB removed its dovish forward guidance on QE, it maintained a neutral tone citing still subdued inflation pressures. We expect the ECB to maintain a neutral tone in the near-term. Focus will be on whether the softer growth in Q12018 is temporary or not. The improvement in PMI composite and PMI services survey s respectively for April highlights that the region is unlikely to enter a softpatch. Possibility of further rise in US yields driven by inflation concerns and nearterm oil price movements could mean further USD upside. But we remain bearish on the USD in the longer-term. Expect EUR/USD to possibly move lower in the near-term in response to the pro- USD trade and neutral ECB tone with a downside possibility of 1.20 But year-end target of 1.28 remains in place. British Pound (GBP) Japanese Yen (JPY) Both growth indicators and inflation has moderated in Q12018 reducing the chances of the BoE hiking rates in its policy meet in May-2018 After favourable news on a transition deal, there was an adverse political outcome with House of Lords voting against PM May s decision to leave the European Customs Union. We watch for these developments as that will have a more pronounced effect on the GBP. The BoE Governor provided a dovish signal implying that a rate hike in May-2018 could be a close call. We expect the BoE to provide a dovish to neutral guidance at least until there is some clarity on the UK growth cycle. The fundamentals of the Japanese economy has improved as there is strong evidence that the economy has moved out of deflation. Other indicators such as the Tankan Sentiment Index have also moved higher. The USD/JPY pair has moved higher responding primarily to a hardening in US yields and steepening in the US yield curve. The BoJ is likely to maintain a neutral tone in its upcoming policy meet in April GBP could soften marginally in the nearterm to possible dovish statements from the BoE and the pro-usd trade. See near-term downside possibility of with a move to 1.44 by end Yen could move towards range if risk sentiment improves but head lower in the medium term because of the US s twin deficit problem towards the 105 mark by end US economy: Outperforming its peer group DXY: A rally at last? DXY Source: Bloomberg & ICICI Bank Research Source: Bloomberg & ICICI Bank Research 2

3 F 25-Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr-18 USD: Further upside potential in the near-term The USD is being driven primarily by statements from the White House The economy should recover after a weak 1Q as labour markets remain robust and consumption demand strong The Fed is likely to maintain its gradual rate hiking cycle as inflation could pick-up The twin deficit problem and a flatter yield curve could mean further medium-term downside for the USD The USD that has received renewed support in the last fortnight is likely to be driven by: (a) crude oil price movements that are influencing US yields at the longer-end via the inflation expectations channel, (b) protectionist statements from the White-House and (c) comments from the Fed officials. On balance, we think that there is further near-term upside potential in the USD on the back of risk aversion and prospect of a further uptrend in US yields as oil prices remain firm. Macroeconomic snapshot Although the US economy is likely to slow in 1Q, it is in keeping with the trend witnessed since 2009 in which growth slows in the 1Q due to adverse weather conditions that is followed by a rebound over the remainder of the year. The continued evidence of a robust labour market, retail sales increases, high levels of consumer confidence and the boost from fiscal stimulus are likely to ensure that growth remains robust. However, inflation still remains fairly subdued. The latest CPI inflation print fell on a sequential basis by 0.1% in March-2018 and the growth in average hourly wages remains fairly moderate. Monetary policy A key change over 2018 has been the more hawkish rhetoric from the Fed, in particular from the new Fed Chair Powell that was also reinforced in the FOMC minutes. In the minutes, there was some talk about the possibility of the Fed adopting a steeper rate hike path and a discussion on changing the future policy statements from accommodative stance to neutral/hawkish. We remain of the view that inflation is likely to move higher as: (a) USD depreciation over 2017 results in increase in import prices, (b) fiscal stimulus results in substantial positive output gaps and (c) evidence that unit labour costs are picking up. Hence, we think that the Fed will hike policy rates by another 50 bps over 2018 and another 75 bps over Drivers of the USD The USD is likely to respond more to relative changes in the yield curve than yield differentials itself. A main contributing factor to USD weakness in 2017 was the flattening in the US yield curve. However, that trend reversed over the last month in response to a steepening in the US yield curve relative to its peer group. The shape of the yield curve is in a sense a function of investor expectations of long-term outlook on the real economy. The US yield curve had flattened in 2017 as the shorter-end moved higher pricing in the Fed s rate hiking path while the longer-end remained anchored as long-term inflation expectations remained low. However, the rise in oil prices has pushed long-term inflation expectations and nominal yields higher in the process steepening the curve. Given our expectations that oil prices could moderate in the medium term, we would expect the yield curve to flatten again with the shorter-end rising faster than the longer-end. Hence, the USD could come back under renewed pressure in the medium term especially as focus could shift to the twin deficit problem. US fiscal stimulus is pro-cyclical that could drive inflation higher over the medium term Output gap Budget balance/gdp (RHS) (% of potential GDP) (% ) The USD is being influenced by the shape of the yield curve DXY (LHS) UST 10 yr- 2 yr (bps) Source: IMF & ICICI Bank Research Source: Bloomberg & ICICI Bank Research 3

4 1/6/2017 2/6/2017 3/6/2017 4/6/2017 5/6/2017 6/6/2017 7/6/2017 8/6/2017 9/6/ /6/ /6/ /6/2017 1/6/2018 2/6/2018 3/6/2018 4/6/2018 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar-18 Re-based to 100 EUR: Neutral ECB + stronger dollar = some weakness in the near-term The EUR has been driven by opposing forces anti-usd trade and weaker domestic data flow keeping it range bound We expect the growth to rebound after a weak Q1 The EUR has been driven by opposing forces in On the one hand, concerns about the US economy translating into the anti-usd trade is working as an upside driver for the EUR/USD pair. However, weakness in Euro-zone data flow is knocking it lower and capping the upside potential in the pair. Macroeconomic snapshot After a much sharper than expected rebound over 2017, the Euro-zone growth cycle has shown signs of softening in Q This is visible in both hard indicators such as industrial production data releases and soft indicators such as various business confidence surveys. However, these surveys still remain at a relatively high level from a historical perspective. Besides, we are not of the opinion that the Euro-zone growth cycle is poised to collapse or move into reverse gear. Instead, we think that temporary factors are responsible for the weakness such as adverse weather conditions and the protectionist rhetoric that is weighing on confidence. We expect the following factors to ensure that growth rebounds over 2018: (a) an accommodative monetary environment is likely to keep private demand consumption and investment supported, (b) strong global demand that could keep exports strength intact and (c) incrementally looser fiscal policy at the aggregate level. We also assume that the US government does not adopt a very restrictive protectionist stance. The ECB is likely to end QE by September- December-2018 followed by possible rate hikes in 2019 Improving growth and normalization in monetary policy likely to emerge as main supports for the EUR in the medium term Monetary policy Although the ECB has removed its guidance on QE, it continued to emphasize that inflationary pressures are still very subdued in its last policy meet. We expect inflation to pick-up gradually over 2018 driven by closing output gaps that is likely to in turn allow the ECB to move ahead with its plans to end QE by September-December. However, in the upcoming policy meet due next week on 26-April-2018 we expect the ECB to maintain a broadly neutral tone with some acknowledgement of recent softness in data flow. It is likely to only slowly prepare markets from a move away from an extremely accommodative stance to a neutral stance. From a market perspective, the next important policy meet will likely be on 14-June-2018 in which the ECB will provide guidance of when and how it plans to end its QE program. Drivers of the EUR We think that there is further downside potential in the EUR/USD pair in the near-term with the EUR/USD pair responding primarily to sentiment on the USD and a neutral tone from the ECB. However, the next uptrend in the EUR/USD pair is likely to come in H22018 as Eurozone growth cycle picks up that is accompanied by the ECB reducing quantum of stimulus. The USD s twin deficit problem is likely to emerge as an important catalyst working to driver the EUR/USD pair higher in the medium term. The EUR has rallied against the USD but the rally has not been broad-based Euro-zone confidence surveys have deteriorated but still remain at elevated levels EUR/USD EUR TWI EC economic sentiment index ZEW sentiment index(rhs) Source: Bloomberg & ICICI Bank Research 4

5 Jan-16 Mar-16 May-16 Jul-16 Sep-16 Nov-16 Jan-17 Mar-17 May-17 Jul-17 Sep-17 Nov-17 Jan-18 Mar Sep Oct Oct-17 7-Nov Nov-17 5-Dec Dec-17 2-Jan Jan Jan Feb Feb Mar Mar Apr Apr-18 GBP: Rate hike chances falter on weaker data Sterling has recouped most of its post Brexit losses The GBP has to a large extent reversed most of the losses suffered since Brexit. Over the medium to long term developments on the Brexit front would intermittently move markets but for now the focus has shifted back to economic data and the Bank of England s (BoE) monetary policy meeting that is due on 10-May Recent CPI data to weigh on May rate hike chances Brexit difficulty for Theresa May Hike probability lower but not off the table as yet March CPI casts a pall on rate hike chances The recently released March CPI print reduced the probability of a May hike by the BoE. CPI printed 2.5% YoY in March, down from 2.7% in February and sharply lower than expectations. Core inflation showed a downtick while energy inflation declined as well. Weakness in core inflation could also have stemmed from bad weather conditions as well. Recent high frequency activity such as construction PMI has softened of late and Q4 GDP was also weaker. However, over the medium term as Brexit concerns recede growth should be on a firmer footing. House of Lords delivers a facer to May s Brexit stance Brexit related negotiations have suffered a road block recently as the House of Lords has recently voted against Theresa May s decision to leave the European Customs Union. May s stance would have allowed UK to forge independent trade deals. There is no clarity yet about how this development will pan out medium term but will be watched closely. Rate hike chances recede but not off the table yet The Bank of England was widely expected to raise rates in the May policy meeting amid assessment that labour markets were tightening that would lead to upward pressure on wages and that currency depreciation would also feed into CPI. As it now stands the Q1 CPI outturn is lower than the BoE s expectation and has subsequently weighed on the market pricing in a possible rate hike in May However, BoE Governor Mark Carney, in an unexpected flip flop in Central Bank communication, also opined after the CPI data that the May hike was not a done deal However, it could well be that CPI resumes its up move going ahead as idiosyncratic factors get smoothed out and on account of very high crude prices. In this context, the probability of a hike in May has receded somewhat although it could well translate into a dovish hike. The GBP/USD pair could soften at the margin in the near-term in response to a dovish rate hike by the BoE and a stronger USD. Over the medium term, we maintain a mildly bullish outlook on the GBP on the back of a positive economic outlook, softer than expected Brexit outcome and a weak bias on the USD. UK Inflationary pressures have moderated (% YoY) Average weekly earnings CPI (RHS) (% YoY) GBP has fallen responding to Carney s statements and the pro-usd trade GBP TWI 5

6 Feb-15 May-15 Aug-15 Nov-15 Feb-16 May-16 Aug-16 Nov-16 Feb-17 May-17 Aug-17 Nov-17 Feb-18 Apr-17 Jun-17 Aug-17 Oct-17 Dec-17 Feb-18 Apr-18 Safe haven status keeps the currency from weakening Despite recent weakness in high frequency data economic outlook remains positive Scandal ridden government and concerns about the trade wars especially around Trump-Abe summit affecting Yen JPY: Safe haven status in focus The Japanese Yen has repeatedly frustrated all attempts to effectively forecast it over even a near term horizon let alone in the medium term. The Yen has strengthened sharply over the past year and has seen highs of 104 against the Dollar earlier this year. Just when you thought it could not weaken significantly for a sustained period of time, we have seen it trade at ~ against the Dollar recently over the past few days. It also seems that the long standing correlation of USDJPY with the US and Japan rate differential seems to have made a comeback. It had broken significantly over the past few months. This has also broadly been triggered by the US 10Y yield spiking to the key psychological level of 3% on an increase in inflationary expectations. We will watch for the sustainability of this move. Economic backdrop improving for Japan The Yen is different from other currencies in as much as it is most often driven by global risk sentiment and cross border fund flows given that it used as a funding currency. That said, the fundamentals for the currency have improved substantially over the past few quarters. GDP growth in annual terms has been strong till the December quarter and the Tankan sentiment index for large businesses is at a decade high. More importantly, Japan has now firmly left deflationary climes and has witnessed a sharp uptick in CPI (latest print 1.5% YoY). There has been some near term softness in high frequency data such as industrial production but nonetheless the outlook for the economy remains robust. Political developments reinforcing safe haven quality Other factors that have also been affecting the Yen have been mostly political in nature. Investors have been grappling with a scandal ridden Abe government whose popularity ratings has taken a strong beating. Added to this is the concern about the potential fallout from the ongoing trade war related rhetoric. In this context, the Trump-Abe summit was a key development but failed to address Japan s trade related issues as exemptions on steel and aluminium were not forthcoming. Incremental developments on North Korea, trade and geo-politics could keep the Yen support against the USD. Cross border flows have increased; monetary policy need not tighten quickly Government data also shows that there has been significant increase in foreign bond buying by large Japanese investors especially lifers. Markets were also factoring in early tightening by the BoJ (some move on the yield curve control given rising global yields) but despite the stealth tapering no such signals have yet crystallised. Mild depreciation bias near term but global risk aversion could queer the pitch We maintain a medium term USD bearish view and that in itself would not allow the JPY to weaken meaningfully anymore contrary to what we were expecting about a year ago. If global risk perception improves in the near term the Yen is likely to weaken to ~ levels. Risks to the view stem from key geopolitical events in the near term that bear watching including Iran s nuclear deal and any escalation in the already ongoing trade tensions. CPI has seen sharp uptick over past few months Yen and rate differentials seems correlated again (% YoY) Japan CPI (bps) US-Japan 10Y spread USDJPY (RHS) Break in correlation

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