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Foreign Exchange

Despite Stimulus, Dollar Pushes Lower

The US growth forecast received a material boost, but the dollar continues to slump. Deficit spending is unlikely to propel the US currency higher, especially as Europe and the UK benefit from early-cycle tightening.
J.P. Morgan Global FX Strategy & Global EM Research
March 13, 2018

Executive Summary

  • USD: Fiscal stimulus temporarily boosted the growth outlook for the US economy, yet the dollar continues to slide as forecasts for all G10 major economies were upgraded in comparison. As the federal and trade deficits expand, there’s concern that inflation could stifle global growth.
  • EUR: The EU economy is forecast to grow more quickly than the US for the third year in a row, and the European Central Bank (ECB) is expected to move up its timeline for tightening monetary policy.
  • JPY: The yen outperformed against G10 currencies, triggered by a fall in global stocks. Yen and dollar correlations have been remarkably unstable, but the yen has remained strong even as equity markets stabilized.
  • GBP: The UK economy has seen modest growth, in part due to less immediate risks surrounding Brexit negotiations, but forecasts for a weaker pound remain until the details of a final exit deal are decided.
  • CAD: The Canadian dollar softened against G10 currencies but held its value against the US dollar. The outlook for the currency remains positive if NAFTA negotiations continue to move forward.

USD: Is Further Dollar Weakness Expected?

The dollar continued to decline despite the promise of stimulus-fueled growth. The domestic growth forecast was upgraded in early February following the passage of a federal budget that plans to stimulate the economy with deficit-financed spending. Many analysts fear that the budget will succeed only in spurring aggregate demand without meaningfully boosting the US economy’s underlying capacity for growth. Rising inflationary pressure has sparked worries that tax reform and spending legislation will hasten tightening from the Federal Reserve to keep the economy from overheating at the peak of the business cycle. Unlike the outsized gains the euro and yen are experiencing from early-cycle tightening, the dollar has seen diminishing returns from the ongoing normalization of US monetary policy.

February has also seen a widening of the US’s twin deficits. Lower tax revenues and higher spending have added to the federal deficit, while the trade deficit is growing on stronger consumer demand for imported goods. Historically, simultaneous growth of these deficits has been a bearish development for the dollar.

EUR: Eurozone Strengthens Further

The eurozone economic growth rate forecast has been further upgraded to 3.25 percent for the first half of 2018 before slowing to 2.9 percent for the full year. The EU is poised to expand more quickly than the US for the third consecutive year, and the common market’s balance of trade is strengthening—the combined surplus in trade, foreign direct investment and equity inflows now totals approximately €550 billion, or 5 percent of the EU’s GDP.

The timeline for monetary tightening in the EU has also accelerated. The ECB is expected to end its quantitative easing program in September—not December—and an initial interest rate hike is anticipated for the first quarter of 2019. In response, the euro has risen against major trading partners and is now trading above the level suggested by rate spreads alone. The currency’s real effective exchange rate is aligned with 20-year norms, which suggests that its strength against the US dollar is mostly due to risks facing the American economy rather than an overvaluation of the euro.

JPY: Yen Outperforms as Stocks Tumble

Stock volatility sparked a yen rally in late January, and the currency has remained strong even as equity markets stabilized. The yen became the strongest G10 performer in February, posting its highest value against the dollar since November 2016.

The reasons behind the yen’s outperformance are unclear. While the currency’s rise was sparked by turmoil in the stock market, its subsequent rise has been only loosely correlated with yield spreads and stock valuations. It’s possible that deleveraged investors are now buying Japanese stocks without a foreign exchange hedge. Seasonal forces may also be at play: Japanese investors have become a net seller of foreign bonds as the end of the Japanese fiscal year approaches, and many corporations are repatriating profits ahead of the year’s close.

GBP: A Brexit Decision Looms

The pound rose in January as the UK’s growth accelerated and immediate risks surrounding Brexit negotiations faded. Rate hike expectations have also firmed, and the pound is once again at the vanguard of early-cycle normalization.

Although investors have been reassured by the promise of a two-year transition period while a final Brexit deal is negotiated, Britain has yet to resolve its long-term relationship with Europe. Euroskeptics are pushing to largely divorce the British economy from the continent, whereas euro-friendly politicians would like to retain the nation’s access to the common market indefinitely. Uncertainty over the final direction of negotiations has created a risk premium of approximately 14 percent for the pound.

CAD: Near-Term Caution Due to NAFTA

The Canadian dollar held its value against the US dollar last month but softened against other G10 currencies, largely due to NAFTA uncertainty. Despite Prime Minister Justin Trudeau’s comments about “walk[ing] away from NAFTA if the United States proposes a bad deal,” near-term risks to the trade treaty seem to be fading as participants appear willing to extend renegotiations past the late-March deadline.

Pipeline disruptions have prevented Canadian oil exporters from taking full advantage of firming oil prices, which would otherwise support a stronger Canadian dollar. As pipeline issues are resolved in the first half of 2018, Canada’s balance of trade will improve commensurately.

Overall, the Canadian economy is strengthening. Unemployment remains low, wage growth has accelerated and the Bank of Canada is expected to hike interest rates three times in 2018. If NAFTA’s negotiators continue to make progress, the medium-term outlook for the Canadian dollar will remain constructive.

Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views; published February 16, 2018.

 

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