In the coming months, political developments could profoundly shape global currency markets:
A strengthening US economy and the potential for another round of interest rate hikes has helped the dollar regain its footing in the second quarter. This winter’s disappointing GDP growth and stock market volatility sent the dollar down 6 percent against major foreign currencies, but over the past month, the currency’s fortunes have reversed. With the American economy on a trajectory to reach full employment within a year, many analysts now believe that the Federal Reserve will announce an additional interest rate hike sooner rather than later.
However, any potential upside will likely be quite limited: Inflation has not yet reached the Fed’s official 2 percent target, and absent strong inflationary pressure, the Fed is unlikely to move aggressively to normalize interest rates ahead of schedule.
Even if the Fed does raise rates this year, the strength of the dollar may be called into question as the Trans-Pacific Partnership (TPP) trade agreement is hammered out. Currently, both the Democratic and Republican presidential candidates are campaigning on protectionist platforms and condemning the TPP. And while the actual policy implications of November's election are unpredictable—either candidate would likely face considerable resistance from Congress before revising the trade deal—historically, the US dollar has weakened during past trade negotiations, as well as during periods of fiscal dysfunction, such as the debt ceiling filibuster and federal government shutdowns.
On April 22, the yen dropped to 111 against the US dollar following media reports that the Bank of Japan (BoJ) would soon begin applying negative interest rates to private bank loans. This highly unconventional policy would likely have further eased Japan's monetary conditions in an effort to stimulate lending activity. However, the BoJ proved the media’s speculation unfounded at its April 22 meeting, when it announced that policy conditions would remain unchanged. The yen quickly rebounded to 105 against the dollar before sliding back to 109, roughly unchanged from early April.
Japan’s current account surplus hit a 20-year high in May, putting more upward pressure on the yen. However, the Japanese government appears poised to pass a supplementary budget appropriating ¥5 trillion (about 1 percent of GDP) in fiscal stimulus, including ¥800 billion in emergency funds to areas affected by the Kumamoto earthquake. If Japanese growth remains elusive, political support for an additional round of stimulus in the latter half of 2016 will likely grow.
The British government has begun campaigning against a June 23 referendum to exit the European Union. If the referendum passes, the impact on currency markets is difficult to anticipate. Most projections call for a drop in the pound’s value upon exit from the EU, and the ensuing capital flight could place significant stress on the currency. Some analysts fear that a successful Brexit would inspire similar breakaway movements in other EU nations, but the unanimous support of their own EU membership among member governments seems to indicate little political power behind continental Euroskeptic movements.
The Brazilian real has been battered by the nation’s ongoing political and fiscal crisis, but the impeachment of President Dilma Rousseff may usher in a period of stability. The new acting president, Michel Temer, will have a 180-day window to build confidence in the nation’s government. Many observers expect he will appoint an experienced, market-friendly cabinet and move quickly to reign in Brazil’s spiraling deficit and reform the nation’s labor market. While the restoration of confidence may temporarily boost the currency, the new administration is likely to ultimately pursue monetary easing and a weaker currency to lift the nation from recession.
In Canada, the devastating Fort McMurray wildfires temporarily shut down production at nearby tar sands operations, reducing the nation’s oil exports by approximately $940 million CAD in May. Fortunately, the region’s most productive mining sites were spared by the flames, and if the wildfires are brought under control, production could return to full strength in June.
Oil is not expected to fall below $30 USD per barrel in the coming months, which should limit the downside for the Canadian dollar, but weaker-than-expected employment and trade data could push the value of the Canadian dollar lower.
Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views, published June 1, 2016.
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