uneven global growth, diverging monetary policy risks, softer commodity prices and the ongoing fallout from the UK referendum are likely to be the key drivers of movement among the major currencies over the course of August. The US dollar (USD) has performed well in general since basing in May and we expect it to strengthen somewhat over the balance of the year as it remains a more compelling fundamental prospect than many other major currencies. Despite relatively disappointing Q2 GDP growth in the US and the fact that we have revised down our own expectations for Fed policy moves (no tightening until 2017), US bond yields remain relatively elevated versus other G-7 jurisdictions where easy or easier central bank policy settings prevail. Investors remain very conservative with regard to the outlook for Fed policy tightening. Market-determined probabilities show that not even one 25bps tightening is fully expected to occur in 2017 and Scotiabank expects three. A re-pricing of tightening risks (to reflect earlier or more aggressive tightening) will provide additional support for the USD.
We have revised down our forecast for the pound (GBP) in the wake of UK’s vote on EU membership (Brexit) to USD1.25 for yearend. The GBP has stabilized following the initial downdraft in the exchange rate. Additional BoE accommodation in response to the negative growth shock that appears to be manifesting itself in the UK economy and the heightened uncertainty regarding the broader UK economic outlook will depress the GBP further. Previous patterns of trade following significant shocks (in 1992/93 after the GBP was ejected from the Exchange Rate Mechanism and 2008 as the UK entered a prolonged recession) suggest the strong risk of a downside overshoot in the next few months. We think modest GBPUSD gains are an opportunity for sellers. We retain a year-end forecast of USD1.05 for the euro (EUR) and expect the spillover over from Brexit to help EURUSD fall to that target. Eurozone growth will slow modestly in response to Brexit, at least, and may entail additional accommodation from the European Central Bank in September, once its staff has had an opportunity to review more fully the impact of the growth outlook on inflation.
Short-term Euro zone/US interest rate differentials are already at punishing levels for the EUR (+130bps premium for the USD) and our regression modelling suggests that the spot rate should already be significantly lower than it is (near 1.08) in response. There is little prospect of the EUR recovering on a sustained basis under current circumstances and gains towards 1.1250 should attract selling interest. The CAD is conforming largely to expectations. In June, we noted that risks were tilted to the upside for USDCAD towards 1.35 on a 1-3 month view and we continue to think the CAD is likely to struggle against the USD in the near-term before steadying later in the year. Weaker commodity prices (crude oil) and weaker than expected domestic growth in Q2 have weighed on CAD sentiment through July and will keep the CAD tone defensive near-term.
The Bank of Canada remains in neutral mode and prospects for rate increases remain extremely limited, even over the longer-term horizon (we see no change in policy settings through 2017). Recent trends have shifted against the major commodity currencies generally and we expect easier policy settings in both Australia and New Zealand to curb the Australian and New Zealand dollars respectively over H2 2016. We look for USD to remain broadly stable versus the yen (JPY) through the balance of this year (we forecast a year-end rate of JPY105). The Bank of Japan’s (BoJ) latest policy steps did not add materially to the aggressively easy stance it has been pursuing for the past three years, disappointing market expectations. The central bank announced a comprehensive review of its policy framework for its September meeting, suggesting the central bank’s willingness or ability to take further action is limited. With the risk of additional BoJ easing measures reduced and the Fed likely on hold this year, USDJPY should stabilize around current levels supported by recent electoral developments.
New fiscal stimulus measures have also fallen short of market expectations, weighing on local stocks and boosting the JPY.
The Japanese authorities will remain wary of speculative or market-driven bouts of JPY appreciation but we think the risk of intervention to curb JPY gains is limited at the moment, even as USDJPY nears 100. Relatively high local interest rates have attracted support for some developing market currencies in the past month (South African rand). Attractive spreads, benign global policy conditions and sliding market volatility make carry trades a more compelling prospect for currency investors at the moment. These trades are susceptible to a rapid unwind in the event of renewed market volatility or a jump in Fed tightening risks, however. Weaker crude oil prices have undermined the Russian ruble and Colombian peso (less so the Mexican peso, as policy settings remain supportive and valuation looks more compelling). Domestic political strife and the consequent sovereign downgrade have left the TRY weak among its major over the past month. We expect the Chinese yuan (CNY) to remain close to current levels through year end (our end-2016 forecast is CNY6.70) as the Chinese authorities reduce CNY volatility ahead of the September G-20 summit and the currency’s participation in the IMF’s Special Drawing Rights later in the year.