The US dollar is emerging from a directionless month, with movement in the trade-weighted index holding near a two-decade low. The forces behind the currency’s decline have momentarily subsided. Global expansion softened considerably over the past month, and with the American economy no longer lagging behind the rest of the world, the dollar’s downward momentum has stalled.
There seems to be little enthusiasm for a dollar rebound. The currency failed to rally following the stock market’s stumble, and a hawkish report from the Federal Reserve did little to shift expectations for the pace of interest rate normalization. The US economy outperformed in economic surprise indices, but reaction was muted in the currency markets. It’s possible that investors dismissed these positive developments, looking instead at the accelerating growth abroad and slowly converging rate spreads.
Numerous political risks may also have contributed to the dollar’s sideways move. A trade conflict with China has simmered, but the heated rhetoric has accompanied minor tariffs, which are projected to have only a marginal economic impact. Yet until negotiations with China, Canada and Mexico conclude, the threat of a trade war will hang over the currency.
Ultimately, the dollar should regain its direction as political risks subside, allowing broader structural forces to take over. The eventual resumption of above-trend global growth would be expected to push the dollar lower, and the nation’s growing twin deficits also promise to exert long-term downward pressure. As the US trade deficit widens and its national debt grows, investors may increasingly look to alternative reserve currencies that face fewer long-term challenges.
The dollar’s breakout from this period of stagnation will likely be triggered by stronger economic data from Europe and the developing world. Firming commodity prices and a pickup in foreign manufacturing indices over the coming months could contribute to the dollar’s gradual decline.
The yen lost 1 percent against the US dollar over the past month, making it the weakest performer among major currencies. The yen is currently trading at 25 percent below its 20-year real effective exchange rate average, and hurdles to further depreciation seem to be falling away. Notably, last week’s amicable summit between Prime Minister Shinzo Abe and President Donald Trump may indicate the easing of trade tensions between the nations.
The prime minister’s political scandal has only deepened, but currency markets are taking the developments in stride. Abe’s approval rating recently slipped below the crucial 30 percent mark, amid new allegations that the prime minister lied to the Diet, but his administration’s ouster would not be expected to spark a long-term appreciation for the yen. Abe’s departure would mean only a brief pause in the currency’s depreciation.
As political risks lose their potency, the yen has grown sensitive to rate spread differentials. In April, the currency showed a positive correlation to both rising US Treasury yields and expectations for further US rate hikes in futures markets.
The European Union lost its economic footing in the first quarter, but the euro proved resilient in the face of slowing growth. New data shows the EU’s economy grew only 1.5 percent in the first quarter, far short of the forecast 3 percent expansion. Capital flows have reversed in early 2018; net equities and foreign direct investment (FDI) outflows totaled €62 billion in January and February, partially erasing the €249 billion in cumulative inflows of 2017.
The EU’s downturn may prove transitory, however. Most economists attribute the slump to an unusually harsh winter, with storms delaying shipping and construction, as well as dampening consumer activity. This week’s PMI report will provide a hint as to the EU’s momentum—forecasts still call for growth to accelerate in the second quarter, returning to an above-trend 2.5 percent pace. Despite the outflows from capital markets, the EU still has a strong balance of trade, posting a near-record €36 billion monthly surplus.
The euro’s resilience over the past month is a testament to its strong fundamentals. The currency’s long-term upward trend is likely not dependent on stronger GDP growth or rapid interest rate normalization. The EU’s balance of trade will be supportive of a strong euro, even when growth stalls.
Confidence in a successful Brexit is growing, strengthening the pound. At a late-March summit, negotiators agreed in principle to a two-year standstill transition period during which the UK would retain access to the common market. The question of customs controls at the Irish border remains unresolved, but with parliament taking a conciliatory tack, the prospect of an unnegotiated “hard” Brexit seems to be fading.
The greater downside risk for the pound seems to come from domestic developments. Britain’s growth has underperformed expectations, and inflation has dropped to 2.3 percent, its lowest in a year. This backdrop led Bank of England Governor Mark Carney to make equivocating statements regarding the next interest rate hike, previously anticipated in May. Futures markets reacted to Carney’s tone by lowering expectations for a May hike from a near-certainty to a coin flip.
Despite running the strongest trade surplus in the G10, the Swiss franc’s decline accelerated over the past two weeks, bringing the currency back into alignment with its real effective exchange rate (REER) projected fair market value. The currency’s fall has likely been driven by widening rate spreads against the US dollar, and its decline was possibly aided by the repatriation of Russian capital following a new round of sanctions.
A natural floor may be approaching for the franc, however. Switzerland still runs a balance of payments surplus equal to 12 percent of GDP, and the Swiss National Bank is expected to begin tightening in the second half of 2019, roughly in tandem with the European Central Bank.
Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views, published April 20, 2018.
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