Foreign Exchange

Dollar Reaches New Lows

Continued soft inflation leaves the timing around the Fed’s actions in doubt; meanwhile, foreign central banks give clear indications of their actions moving forward.
J.P. Morgan Global FX Strategy & Global EM Research
September 27, 2017

Executive Summary

  • USD: Soft inflation persists in the US and the dollar continues to fall. The timing of the Fed’s next interest rate hike remains uncertain, and legislation on tax reform and infrastructure spending looks like it will be delayed again.
  • JPY: The Japanese yen has yet to feel significant effects from the tensions on the Korean Peninsula. It has actually seen gains against the dollar due to Fed inactions, but rising geopolitical tensions could result in increased volatility for the yen.
  • EUR: The euro is soaring as Europe’s central bank is expected to begin tapering its asset-purchasing program. Political risks have also subsided in the region, and upcoming elections in Italy and Spain don’t appear to pose significant threats.
  • GBP: The British government has signaled it will pursue a more gradual process of withdrawing from the EU, helping the pound recently. But as exit negotiations continue, risks to the pound are likely to remain high in the long term.
  • CAD: As Canada has sustained its recent economic growth, the country’s central bank has responded by again raising rates, leading to further gains for the Canadian dollar. Forecasts for GDP growth in Canada remain positive.

USD: Federal Reserve Action Remains Uncertain

The broad US dollar index shed an additional 2 percent over the past month, setting a new 26-month low. Since January, the USD has dropped 9.5 percent against major foreign currencies, and as fiscal drags persist and the policy outlook deteriorates, the dollar is unlikely to make a quick recovery.

The dollar’s slide is primarily due to the US economy’s sluggish performance. Although consumer prices rose in August, inflation fell short of expectations for the five months prior, casting doubt on the timing of the Federal Reserve’s next interest rate hike. A weak August payrolls report showed wages growing more slowly than expected, a trend that could further dampen inflationary pressure.

As the Fed remains inactive, US policy rates are converging with Europe and Canada. The European Central Bank (ECB) is widely expected to begin tapering its asset-purchasing program in October, and the Bank of Canada (BoC) has surprised markets by aggressively hiking rates. Narrowing rate spreads and faster growth abroad may work together to prolong the dollar’s slide.

Until recently, investors may have hoped that October would bring a conclusion to Congressional budgetary negotiations, clearing the way for tax reform and infrastructure spending bills. However, the devastation caused by Hurricanes Harvey and Irma compelled a temporary bipartisan agreement that will postpone the showdown over the debt ceiling and 2018 federal budget until December. The deal will keep the government operating, but it also diminishes prospects for any action on tax reform prior to the 2018 midterm elections.

Markets are no longer fully pricing in another rate hike from the Fed before the end of 2018. While the Fed announced that it will begin balance sheet normalization in October, its gradual withdrawal from the Treasury market isn’t expected to support a sustained rebound for the dollar. Without a potential catalyst to stop the dollar’s slide, the currency is unlikely to rebound in the near future.

JPY: Yen Feeling Limited Effects From Tensions for Now

On September 14, a North Korean ballistic missile passed directly over Japan’s Hokkaido Island, marking the second missile to breach Japanese airspace in 17 days. The test provided a stark illustration of the region’s rising geopolitical risks, coming on the heels of North Korea’s most powerful nuclear detonation to date. Tensions on the Korean Peninsula have had a relatively limited impact on the yen so far, but if they escalate, the currency could see increased volatility.

The yen has recently declined 0.8 percent, holding near a one-year low against the US dollar. Relative weakness in the US economy is likely keeping the yen from slipping further. The currency rose slightly against the dollar recently as prospects for an additional 2017 rate hike from the Fed diminished. The Bank of Japan kept monetary policy steady coming out of its September 21 meeting, leaving the currency pair sensitive to geopolitical developments and the deteriorating outlook for tightening in the US.

EUR: Recovering Losses From Quantitative Easing

The euro has set a three-year high as the ECB prepares to taper its asset-purchasing program. This marks a complete reversal of the currency’s quantitative easing-driven decline, which has kept the euro relatively weak since the program’s inception in 2014.

While political risks in Europe appear to be fading, two important elections remain. Voters in Italy will head to the polls in early 2018, bringing the possibility that euroskeptic parties will join the country’s next ruling coalition. And on October 1, residents of Catalonia will have the opportunity to weigh in on a referendum in favor of seeking independence from Spain.

Projections indicate that Italy’s euroskeptic parties stand to gain seats in parliament, but don’t have a viable route to create a governing coalition. The election’s most likely outcome is an unwieldy alliance with mainstream conservative parties, leaving the chances of an Italian exit referendum quite low.

Catalonia’s referendum has been motivated by the region’s concerns with Madrid, rather than Brussels, and so doesn’t appear to be primarily concerned with the EU. The implications of a “yes” vote are unclear. The Spanish government has called the referendum illegal, pledging to keep the nation unified regardless of the outcome. Meanwhile, independence movement leaders insist Catalonia would retain its EU membership after partition, but all 28 current member nations—including Spain—would have to approve the new nation’s accession to the union.

GBP: Brexit Turns Chronic

The pound was buoyed last month as the British government has acknowledged that its exit from the EU must be a gradual process, with the economic separation from the common market extending several years beyond the March 2019 deadline. But as negotiations continue, markets are realizing that even a “soft” Brexit will prove disruptive to the nation’s economy.

The UK remains intent on controlling the free movement of labor, but restrictions on immigration are likely to be met with trade barriers from the EU. An early-October Conservative party conference may harden the British leadership’s stance, as officials will be pressed to demonstrate their commitment to a complete exit. The pound is likely to suffer throughout the exit negotiations. Until a new free trade agreement with Europe is finalized, markets are expected to continue pricing in a hefty risk premium for the currency.

CAD: Continued Growth in Canada

Canada is sustaining its recent accelerated growth, reflected in the economy’s 4.5 percent growth in the second quarter. As a result, the BoC hiked rates again, and the trade-weighted Canadian dollar has now gained 8 percent since June.

Rate spreads against the US are narrowing. Policy rates may soon reach parity if the Canadian economy continues to gain momentum while interest rate normalization in the US remains on hold. Recent Canadian growth has been based on a solid foundation; strong second-quarter growth wasn’t reliant on rising real estate prices. Forecasts call for GDP to expand at a 3 percent pace in the third quarter, which would open the door to a further decoupling between the Canadian and US currencies.

Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views; published September 8, 2017.

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