The US dollar’s slide paused this month as the Federal Reserve accelerated its forecast for interest rate normalization. March’s quarter-point interest rate hike sets the new target for short-term rates at 1.5 to 1.75 percent. Although the Federal Open Market Committee’s statement on the hike wasn’t particularly hawkish, its members indicated the pace of normalization will accelerate. Median forecasts now imply two additional quarter-point hikes this year, followed by three in 2019.
The Fed’s revised forecast prompted a brief respite from the dollar’s first-quarter slide, but it may do little to change the fundamental drivers of the downward trend. The US is relatively late in its tightening cycle—rates have now climbed approximately halfway to their projected long-term equilibrium of 3 percent. Meanwhile, Europe and Japan are still very early in their tightening cycles, giving the euro and yen significant upside potential against the dollar in the medium term.
Political uncertainty and trade tensions may also contribute to the dollar’s weakness. The Trump administration has imposed tariffs on imported steel and aluminum, as well as penalties on Chinese imports. Although the current set of tariffs is relatively limited in scope, the threat of escalation may create a risk premium for the dollar. A broader trade conflict would likely push the dollar down against competing reserve currencies like the euro, yen and Swiss franc.
Volatility in the equity market, growing expectations for inflation and concerns over US protectionism have combined to lift the yen modestly. Although these risk factors were all highly anticipated, their simultaneous occurrence has created conditions for the yen’s rise.
Japanese unions are currently in the midst of spring wage negotiations. Higher wages could create modest inflationary pressure in the fall, fueling expectations that the Bank of Japan (BoJ) will raise its target for the 10-year yield in December. Investors have been unusually sensitive to hawkish rumblings from the BoJ, pushing the currency higher well in advance of any concrete policy shift.
Embattled Prime Minister Shinzo Abe’s approval rating has continued to fall. A scandal surrounding a land sale involving Abe’s wife has led to the resignation of Finance Minister Taro Aso. Abe is no longer assured of victory in the Liberal Democratic Party’s presidential election in September. The impact of Abe’s potential ouster on monetary policy will depend on who replaces him as party leader.
The euro strengthened modestly as the EU’s balance of payments—the combination of its current account balance, foreign direct investment and equity inflows—continued to improve. The currency union ran a trade surplus equal to 3.5 percent of GDP in 2017, which combined with strong investment inflows to give the EU a record 6 percent basic balance surplus—the largest seen in any G3 economy in a decade.
Short-term momentum has softened modestly, however. First-quarter growth forecasts have been revised downward from 3.5 to 2.5 percent, leading the European Central Bank (ECB) to downplay expectations of imminent tightening. The long-term trajectory for monetary policy remains unchanged: the ECB is still expected to taper its asset-purchasing program in September, with a subsequent interest rate hike in the spring of 2019.
After strong expansion through the fall, the British economy appears to be losing momentum after the fourth-quarter growth rate and first-quarter projections were both revised downward. The Bank of England is still expected to hike rates by 40 basis points in 2018, but further tightening may have only a modest impact on the pound—higher interest rates are being driven by inflationary pressure, not above-trend growth.
The UK’s external financing position is now the poorest among the G10. Long-term capital inflows have dried up amid Brexit risks, leaving the nation increasingly reliant on short-term financing. Britain now has a basic balance deficit of 5.6 percent of GDP, significantly less than the eurozone’s 6 percent surplus.
At the European Council summit in March, leaders endorsed a transition period that will allow the UK to trade freely with EU nations for two years while a formal exit agreement is negotiated. Negotiators have set a June deadline for an agreement over restrictions on the flow of goods and people between Ireland—an EU member—and Northern Ireland, which will be exiting the common market. As uncertainty persists, the pound has remained relatively stable, perhaps a sign that investors are taking a patient approach to the UK’s political situation.
Despite below-target unemployment and steady inflation, the Bank of Canada (BoC) has taken a dovish turn, emphasizing the downside risks from global trade conflicts. The Trump administration’s increasingly hard line on trade has not yet derailed NAFTA negotiations, but tariffs on steel and aluminum have sparked concerns of future trade antagonism that could impact the Canadian economy. US tax reform may also divert investment from Canada, and the BoC seems increasingly willing to adopt a dovish stance in hopes of nurturing supply-side economic growth.
The BoC is still expected to raise rates in May, and additional hikes are expected to come on a quarterly basis as the nation’s economy moves toward the peak of its business cycle. The Canadian dollar’s upside potential, however, may depend on the BoC’s willingness to tighten in the face of US trade antagonism.
Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views; published March 16, 2018.
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