Still Bearish on USD Longer Term
- The recent rally in USD since mid-April may be losing momentum. Citi analysts expect USD weakness to resume as focus shifts back to the worsening twin deficits in the US. The main beneficiaries are likely to be EUR and JPY as real growth rates in the Euro zone and Japan begin to converge with the US.
- Commodity currencies such as AUD and NZD are likely to be better supported on improving fundamentals against a weaker USD but likely less so than EUR as their central banks retain a neutral stance for longer – until early to mid-2019.
- Asia EM may remain broadly stable, anchored by a range bound RMB and weighed down by the risk of capital outflows due to rising interest rates in the US. Citi analysts expect THB and KRW to outperform given the robust current account balances in Thailand and Korea which provides cushions against higher US rates.
The sudden and rather unexpected strong rally in USD since mid-April may to be due to 2 reasons:
- A number of central banks (ECB, BoE, BoC, BoJ etc) which seemed to be leaning more hawkish earlier in the year, changed their stance to more cautious as their economic recovery faded. This resulted in lower rates and weaker currencies (EUR, JPY & GBP) versus USD.
- An unusually high demand for USD from offshore to participate in the large US Treasury debt auctions. This demand stemmed from attractive yields on offer in US Treasuries relative to their home currencies that fell when central banks reverted to a more cautious stance.
Citi Analysts forecast the structural elements driving USD weaker remain:
- The US late cycle fiscal stimulus could lead to a deterioration of its twin deficits and may likely require the US to offer investors a discount on its assets via higher yields, a weaker currency or both.
- The combination of a flatter (or inverted) US yield curve / higher yields / higher oil prices may slow US growth. This could lead the Fed to weigh its current policy tightening stance and negatively impact USD.
- Rising political headwinds in the US as tensions grow between the White House and Congress ahead of mid-term elections in early November.
Escalating US-China/Europe trade tensions where the risk is for either side to weaken its currency as a reaction to further escalation.
JPY: Benefiting from reduced capital outflows and heightened geopolitical tensions
The yen typically benefits from:
- Investors seeking a safe haven asset in times of heightened risk aversion including US-China trade tensions or if political tensions within the US escalate.
- Taking a longer term view into 2019, the underlying broad balance of payments deterioration in the US as a result of worsening twin deficits is in contrast to an improvement in Japan’s current account surplus.
Euro Bloc: EUR likely to strengthen; GBP faces Brexit test
The Q1 2018 slowdown in the euro zone economy that has been largely weather related is now showing signs of rebounding. More importantly, the ECB announced the end of its Quantitative Easing (QE) program, leaving markets to re-price a less accommodative ECB stance via higher euro zone rates and a stronger EUR.
Pounds (GBP) faces heightened Brexit uncertainty as negotiations with the EU on the Irish border and customs union enter a critical phase at the EU-UK summit. With no solution in sight, time is running out for a Brexit deal.
Commodity Bloc: Better supported on improving fundamentals
AUD has been the worst-performing G10 currency versus USD in the first half of 2018. The RBA is unlikely to commence raising rates until Q1 2019, given the underwhelming inflation and consumer spending outlook in Australia. Other indicators including business investment, employment and retail sales activity are gathering momentum and together with an improving external picture due to higher commodity prices, AUD is now starting to resist further downside pressure and is poised to gain against USD.
NZD has suffered a similar fate to AUD as new RBNZ Governor Adrian Orr surprised markets with his more dovish first official cash rate (OCR) statement. Citi economists do not expect RBNZ to cut rates given the backdrop of a positive NZ output gap and accelerating GDP forecast though rate hikes are equally unlikely until Q1 – Q2 2019.
CAD was the outperformer within the commodity bloc until the Bank of Canada raised rates earlier in 2018. While BoC is poised to hike twice more this year, delays on a new NAFTA deal have undermined current sentiment. CAD remains significantly below levels implied by its medium- to longer-term fundamental drivers but NAFTA negotiations hold the key to its near-term direction.
Asia EM: Selectively stronger
EM FX also sold-off against USD in the first half of 2018 but the outlook is relatively neutral based on prospects for a stronger EUR, range bound RMB, higher equities and broadly stable oil prices which are offset by rising US interest rates.
THB and KRW are potential outperformers given the robust current account balances in Thailand and Korea which could provide a cushion against higher US rates.
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