CAUTIOUSLY OPTIMISTIC ON THE US DOLLAR.
The US dollar (USD) advanced to a 14-year high in January but spent much of the rest of Q1 backtracking and consolidating those gains. We expect the USD to regain strength through the coming quarter as the Federal Reserve continues its gradual policy normalization and the US economy pushes ahead after a bumpy start to the year where weather-related factors may have dampened growth somewhat relative to prior expectations. Business and consumer sentiment readings are running strong following the US election last November and, despite the setback over healthcare reform, we expect the Trump administration to push ahead with its pro-growth agenda which will keep the Fed on track to raise interest rates at least twice more this year. Even considering the recent pull-back in US yields, we think the USD has a little catching up to do to reflect the shift in relative policy that has already occurred. US yields are significantly higher than those of the USD’s main peers and we estimate the USD index (DXY) is roughly 3% undervalued versus the level at which weighted rate differentials (based on the components of the DXY) suggest the USD should be trading. The USD is now one of the top-yielding major currencies in the world (only the NZD and AUD offer better returns).
Higher yield premiums make the USD attractive to buy for speculative investors but more costly to sell for corporate and institutional hedgers. We think the recent softening in the USD can only go so far before buyers step back in.
The Canadian dollar (CAD) has benefited from a run of stronger-than-expected data in the early part of the year that possibly does not fully reflect some of the ongoing challenges in the composition of and momentum behind domestic growth. Trade data has shown a return to surplus, but growth in non-energy exports remains weak (-4.4% y/y in real terms in January).
Domestic businesses also appear concerned about potential challenges in trading with the US going forward, which may hamper the long-awaited strengthening in business investment in Canada.
With trade struggling and capital spending plans poised to remain weak, domestic consumer demand and housing will have to continue doing much of the heavy lifting on growth in the coming months. We think the poor composition of growth and excess capacity, which will keep domestic price pressures subdued, effectively rules out any Bank of Canada (BoC) rate increase through mid-2018 at least. Short-term rate differentials between the US and Canada are poised to remain adverse (for the CAD) for the foreseeable future. With crude oil softening amid signs that US shale producers are stepping up output, the prospect of a significant rebound in energy prices providing more support for the CAD in the near-to-medium term looks remote.
For the other major currencies, like the euro (EUR), sterling (GBP) and yen (JPY), low yields, easy central bank policy and domestic challenges are clear impediments to gains.
The European election cycle remains in focus (with France and Germany due to vote), even though the Dutch general election result suggested that the advance of populism may not be as significant as previously thought. Low core inflation and weak inflation expectations suggest to us that talk of rate increases in the Eurozone remains premature.
In the UK, divorce proceedings with the EU are underway; uncertainties regarding the implications of the UK’s exit from the EU for financial services and the economy more broadly are significant. Higher domestic prices resulting from the drop in the GBP are liable to check consumer demand and keep growth subdued at the same time. We expect BoE policy settings to remain accommodative, despite the rise in measured inflation. Other indicators (wages growth) reflect weak inflationary impulses.
In Japan, meanwhile, the central bank is no nearer its 2% inflation target now than a year ago despite deploying aggressive monetary stimulus and, more recently, explicitly targeting the yield curve. Japan remains one of the weakest performing major economies. Absent any significant and sustained progress toward the Bank of Japan’s inflation goal, we expect Japanese policy makers to continue to pursue extra-ordinary measures which will serve to weaken the JPY.