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Foreign Exchange

Tightening Abroad Shifts Currency Movements

Announcements from Europe and Canada reveal their central banks’ policy tightening plans, while Japan remains engaged in quantitative easing and the UK experiences an unexpected drop in inflation. Meanwhile, the Federal Reserve appears on track to normalize its balance sheet in the fall.
J.P. Morgan Global FX Strategy & Global EM Research
July 26, 2017

Executive Summary

  • USD: The Federal Reserve has indicated it will begin normalizing its balance sheet before raising rates again, but has not provided a specific timeline. And while markets expect the Fed to hike rates in December, weak inflation could test the Fed’s resolve.
  • EUR: The European Central Bank has provided clear direction that it intends to begin tapering quantitative easing in September, which has prompted a rally in government bonds across Europe. The surprisingly hawkish statements have also led to upward pressure on the euro.
  • JPY: The yen has recently lost ground against G10 currencies due to interest rate differentials. But for now, the Bank of Japan appears intent on maintaining its quantitative easing policies. Political developments within the country and surrounding region could affect its policy decisions moving forward.
  • CAD: The Bank of Canada surprised markets by announcing a rate hike, helping the Canadian dollar outperform other G10 currencies and gain against the US dollar. Markets now anticipate more hikes before the end of 2018.
  • GBP: The UK has seen relatively weak growth; while inflation had been rising, it dropped in June to 2.6 percent from a nearly four-year high of 2.9 percent in May. Markets now expect the Bank of England to maintain low interest rates at its August meeting.

USD: Fed Waits While Europe Tapers

A series of offsetting moves is expected to leave the US dollar without a clear direction through the remainder of the summer, with a stable broad dollar index likely the best case scenario. The Federal Reserve has signaled its intention to normalize its balance sheet before raising rates again, which may leave the Fed idle when the European Central Bank (ECB) begins tapering quantitative easing in the fall. The dollar is likely to experience downward pressure as a result. Currently, non-US bond yields are sitting further below their natural equilibrium level than US Treasury yields, giving European rates greater room to rally as the era of easy money comes to an end.

Markets still anticipate the Fed will next hike rates in December, despite a series of soft inflation reports. The Federal Open Market Committee’s June meeting minutes show that members believe the current weakness in inflation is “transitory,” but this view could be tested if prices don’t begin to rise in the coming months.

Meanwhile, political risks don’t seem to be driving the dollar’s present outlook. The ongoing Russia investigation appears to have few potential implications for US fiscal policy. As long as Congress is dominated by deficit hawks, there’s little chance of fiscal stimulus emerging from Washington.

EUR: Europe Sends Strong Tapering Signals

The ECB clarified its intention to start tapering its bond-buying program in September, and yields on German bunds have led a rally in government debt across the eurozone in response. With the Fed’s noncommittal approach to the timing of balance sheet normalization, the ECB’s surprisingly concrete statements are generating upward pressure on the euro. Given the recent weakness in US inflation readings, the ECB is likely to maintain its more activist approach than the Fed in the near-term, which should continue to support the euro’s strength heading into the fall.

Political risks are also fading in the EU. In Italy, recent polls show euroskeptic parties losing ground in the run-up to the general election, and the far-right Five Star Movement party has begun downplaying calls for an Italian exit referendum. If Italy’s mainstream parties continue to solidify their lead, the euro may see relatively little political turbulence heading into 2018.

JPY: Will Japan Be the Last Nation Easing?

The Japanese yen lost ground against other G10 currencies in June, falling 2.5 percent against the US dollar—the G10’s second-weakest currency—and 8.3 percent against the surging Canadian dollar. The yen’s losses are being driven by growing interest rate differentials as Japan is poised to become the last major economy engaged in quantitative easing. The Bank of Japan (BoJ) has reiterated its desire to peg the yield on 10-year government bonds at zero, and it launched another round of asset purchasing on July 7, widening yield spreads against the rest of the developed world.

A rising volume of investment outflows in recent months has put further downward pressure on the yen. Japanese investors were net buyers of foreign stocks for seven consecutive weeks in June and July, with outflows totaling 2.3 trillion ($20.7 billion). Bond markets have also seen net outflows in recent weeks, and foreign direct investment outflows for the first five months of 2017 grew 58 percent versus the same period last year.

Materializing political risks may soon contain downward pressure on the yen. The potential for US-Japan trade friction hasn’t entirely dissipated, and mounting geopolitical uncertainty regarding North Korea hasn’t had much impact on investors’ risk aversion. Prime Minister Shinzo Abe’s administration has seen its approval rating drop, and the ruling Liberal Democratic Party suffered a loss in the Tokyo Metropolitan Assembly election on July 3. Declining support for Abe’s economic policies could result in the BoJ eventually moving into alignment with Europe and the US. While these political developments have yet to significantly impact the yen, a surprise move on any front could stop the currency’s decline.

CAD: Canada’s Surprising New Stance

The Canadian dollar outperformed other G10 currencies in June following a dramatic policy shift from the Bank of Canada (BoC), which surprised markets by abruptly delivering the first interest rate hike in a tightening cycle. Yield spreads tightened by 45 basis points against US Treasurys and the Canadian dollar gained 5.7 percent against the US dollar. Markets now anticipate two additional rate hikes by the end of 2018.

Whether Canada’s economic fundamentals will support an ambitious tightening schedule remains to be seen. Inflation is currently running 70 basis points below target—slightly weaker than in the US—and considerable slack remains in the Canadian labor market. The Canadian dollar may have a limited opportunity to outperform the US, as similar cyclical forces are affecting both nations’ economies. If the BoC’s assumptions about the return of inflationary pressure prove correct, price pressures are likely to emerge in the US as well, hastening action from the Fed.

GBP: Uncertain Outlook for the Pound

The outlook for the pound remains uncertain as growth in the UK has been relatively weak, with GDP expanding at an annualized pace of only 1 percent. Inflation had reached a nearly four-year high of 2.9 percent in May, but fell to 2.6 percent in June, increasing the likelihood the Bank of England may maintain current interest rates at its August meeting. Meanwhile, questions surrounding the government’s authority remain following the June 8 election, leaving the possibility of a more orderly and less disruptive Brexit.

Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views; published July 14, 2017.

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