The US dollar continued its three-month rally in July, posting a new 14-month high mid-month. Now, however, American exceptionalism is starting to fade, sapping the dollar of momentum. European growth is no longer surprising to the downside; with the Federal Reserve in the late stages of monetary tightening, the dollar could lose ground to the euro when the European Central Bank begins to normalize monetary policy in the winter.
The yield curve for US Treasurys has continued to flatten, with the 10-year yield currently resting only one-quarter of a percentage point above the two-year yield. The flattening curve on US debt is a reflection of the diminishing returns that late-cycle rate hikes will likely bring for the dollar.
With Congressional midterm elections three months away, political risks are growing. Trade tensions have intensified, with the US threatening tariffs on $200 billion of Chinese imports, and a sweeping round of automotive tariffs targeting European imports. Rising trade tensions would support a stronger dollar against export-driven currencies, but antagonism could also spur investors to seek safe-haven assets that are not denominated in greenbacks.
The yen continued to trade in a narrow band against the US dollar. The currency pair has been remarkably stable throughout the first half of 2018, with only a 7.8 percent margin separating its highest and lowest points so far this year. This lack of volatility is likely due to Japan's narrowing inflation differential with the US, as well as a surge of overseas investment that has partially offset Japan's current account surplus. The Bank of Japan (BoJ) has also done little to shift investor sentiment—a full 21 months have passed since the BoJ's last major policy announcement.
While the BoJ did not signal any specific change in policy, the outcome of the bank's July meeting indicated it will be more flexible for the long-term yield target. BoJ Governor Haruhiko Kuroda has recognized that the policy is hurting revenues for the nation's private banks, and investors will be watching closely for signs that the BoJ is considering allowing 10-year bond yields to rise above the 0.1 percent threshold.
The euro slumped through the first half of 2018 as growth in the common market stumbled and euroskeptic parties dominated Italian elections. But the past month has seen the EU regain its economic momentum. High frequency data is no longer bringing downside surprises, and growth is projected to have accelerated to a 2 to 2.5 percent pace in the second quarter. Firmer growth should support a shallow recovery for the euro in the coming months.
The continent's economic rebound has led to divisions among member nations over the pace of interest rate normalization. The European Central Bank has announced that it will taper its asset-purchasing program in December, but the first rate hike is not expected until fall 2019. If eurozone growth continues as forecast, interest rates could rest approximately 300 basis points below their Taylor Rule rate by next summer, sparking inflationary risks.
Investors are also watching a number of political risks that could limit the euro's rise in August. The US has threatened to raise tariffs on imported automobiles, and while the move would affect less than 1 percent of all European exports, the resulting effects of escalating trade tensions could ripple through the continent's supply chains and dampen capital investment. In September, Italy will unveil a new budget draft, which is expected to include a widening deficit that could lead to a rating downgrade for the nation's bonds.
In early July, British Prime Minister Theresa May released a white paper intended to clarify the government's official stance on Brexit negotiations. Instead of reducing uncertainty, the paper has generated a renewed round of political volatility. Two prominent pro-Brexit ministers resigned in protest, leaving the proposal's future in doubt. The pound moved sideways amid the turmoil as investors appeared to wait out the political storm.
Even without the political turbulence, the government’s proposal would have done little to quell fears of an unnegotiated hard Brexit. The British government has adopted a moderate stance, advocating a harmonization of customs that will allow goods to continue flowing freely to the continent while restricting the movement of labor. Neither the European Union's negotiators nor the United Kingdom's parliament is likely to welcome this proposition. While a negotiated Brexit remains the base case, tail-end risks are rising.
One potential outcome would be a delay in Brexit: If a deal can’t be reached, the UK's departure from the EU might be postponed, possibly leading to a second Brexit referendum. But failed negotiations could also lead to a worst-case hard Brexit scenario, in which Britain leaves the common market with no trade agreement in place. With uncertainty surrounding the outcome, the British pound is likely to continue carrying a significant risk premium.
Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views, published July 13, 2018.
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