The broad USD index has now reversed the entirety of its post-election gains, even as the Federal Open Market Committee (FOMC) continues normalizing interest rates. The trade-weighted dollar index dropped 2.4 percent over the past month and is now approaching a seven-month low, driven down by relatively weak growth and two consecutive months of faltering inflation.
The Fed’s rate hike earlier this month failed to rally the dollar, as markets had already priced in the decision. In addition to lifting the target range for short-term interest rates by 25 basis points, the FOMC also clarified plans for normalizing its balance sheet. It still holds approximately $4.5 trillion in excess assets purchased as part of its quantitative easing program, and the committee announced its intention to begin tapering the reinvestment of principal from maturing Treasurys and mortgage-backed securities later this year. The Fed indicated its balance sheet will initially be unwound by $10 billion monthly, before gradually accelerating to as much as $50 billion in monthly reductions by late 2018.
Eventually, balance sheet normalization could push long-term Treasury yields higher, widening the rate spread and putting upward pressure on the dollar. But any material move for exchange rates will likely appear after the Fed launches its normalization program later this year.
President Donald Trump’s victory generated a wave of optimism among investors last fall, but the administration’s agenda of tax cuts, regulatory reform and fiscal stimulus has since stalled in Congress. Investors have adjusted their expectations for legislative progress, and 81 percent of the long dollar positions that had accumulated by the end of 2016 have now been unwound. An upcoming showdown over the debt ceiling may only increase the political drag on the dollar.
Weak inflation and underwhelming growth may limit the dollar’s potential to rebound in the near term, but the currency’s slide appears to be nearing its rational limit. The dollar is once again screening weak against rate spreads. While the ongoing political turmoil facing the Trump administration may continue to dominate headlines, currency markets have not historically been driven by similar circumstances.
The European Central Bank’s (ECB) gradual tightening is expected to put upward pressure on the euro, but political risks may periodically reintroduce volatility. With European growth exceeding expectations, markets are widely anticipating the ECB will begin tapering its quantitative easing program this fall. This could place the ECB on a path to begin normalizing interest rates, with the first rate hike possibly coming in early 2018.
The euro’s upside will likely be limited by the slow pace of monetary tightening. For example, to strengthen to USD 1.20 against the euro, models call for rate spreads tightening by more than 50 basis points from current levels. This is a high hurdle, as it would require the US Fed taking a surprisingly dovish turn, combined with the ECB accelerating its tightening timeline.
Italy appears poised to be the next source of political risk in Europe. Following the breakdown of an agreement to hold parliamentary elections in October, odds are even that elections will be called early, which could allow euroskeptic parties to capitalize on their present momentum. Parties supporting an EU exit are now polling near 50 percent, but the actual threat to the monetary union still appears distant. A popular referendum on leaving the EU would likely require amending the Italian constitution, which may strain the political will of any euroskeptic coalition. An early Italian election would likely produce volatility without fundamentally changing the euro’s rising trajectory.
British parliamentary elections were expected to deliver a strong majority for Prime Minister Theresa May’s Conservative Party, solidifying her power as Brexit negotiations get underway. Instead, the Labour Party’s surprise gains prevented the Tories from reaching an outright majority, and they’ve now turned to an unplanned coalition with Northern Ireland’s Democratic Unionist Party.
The new political landscape’s implications for the pound are unclear. The new governing coalition may prove fragile, and political volatility could exacerbate slowing economic momentum, leading the Bank of England to take a dovish turn.
However, Prime Minister May’s weakening position could also encourage a more conciliatory posture during Brexit negotiations, possibly allowing the country to retain tighter bonds with the common market. The election also brought the defeat of the right-wing UK Independence Party, which has been pushed out of Parliament entirely, and the separatist Scottish National Party lost 21 of its seats, diminishing the chances of a UK breakup.
The yen outperformed all G10 currencies except the New Zealand dollar last month, gaining 2 percent in trade-weighted terms and rising against the US dollar despite low volatility in financial markets. The yen’s climb was amplified by deleveraging—over the past four years of Prime Minister Shinzo Abe’s economic policy, investors and corporations have sold off approximately 70 trillion in yen-denominated assets, and the dollar’s slump may have forced some investors to repurchase yen in order to cover short positions.
The yen appears to have been buoyed by political turmoil in the US, with yield spreads narrowing to 210 basis points and losing 60 percent of spreads that had widened after the post-election peak last November. However, Abe is facing turmoil of his own, as public opinion has appeared to turn against him following allegations of inappropriate meddling in the permitting of a new veterinary college run by a close friend.
Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views; published June 9, 2017.
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