June was a cruel month for the U.S. dollar. It fell against all the world’s currencies as investors became convinced that the Federal Reserve would soon embark on an aggressive easing course that will see 75 basis points of rate cuts this year. Most of the major central banks have an easing bias, but it is the greenback that has seen its interest rate support weaken. However, at this juncture, it is difficult to envision investors pricing in even more cuts, suggesting that June may have seen peak dovishness for a while.
St. Louis Federal Reserve President Bullard, the sole dissent at the June meeting for an immediate cut, said he was not prepared to move 50 bp at the July 31 FOMC meeting. Still, the indicative pricing in the derivatives market suggests the collective wisdom of the market is that there is around a 1-in-4 of 50 bp move. The perceived risk of a 50 bp cut may limit the dollar’s ability to recover from the June slide.
The new tariff truce between the U.S. and China can help animate the animal spirits, but there is a deep-seated conviction among many that the future is bleak. It may be impossible to fine-tune the timing, but the "lower for longer" exemplified by around $13 trillion in negative yielding instruments is not normal, and it will have to adjust. Our work leads to a different conclusion—that interest rates will stay low for an extended period. Investors need to adjust expectations to lower returns on their savings, and businesses need to rethink their profitability hurdle for investment.
An agreement between the U.S. and China to resume talks is not the same thing as making a deal. Trump rejected Mnuchin’s deal last year, and by the U.S. reckoning, China spurned the recent one. Nor will a trade deal prevent the U.S. from sanctioning Chinese companies or in other ways, acting against China’s interests.
The resumption of U.S.-China trade talks may see U.S. economic nationalism aimed at Europe and Japan. Japan holds upper house elections on July 21. Trade talks will intensify afterward. The ECB’s willingness to ease monetary policy in the face of global headwinds, partly the result of U.S. penchant for tariffs, got a quick slapdown by Trump for manipulating the currency.
The grievances that Trump expresses toward Germany (e.g., a gas pipeline with Russia, consistently falls short of its NATO obligations, the bilateral trade surplus—$168 bln in 2018 up from $147 bln in 2016) warns of the risk of a rise in trade tensions. Our understanding is that Trump’s particular style may be offputting, but much of the content of his foreign policy—from the willingness to be more aggressive toward China and Iran to pressing Europe to fulfill its commitment to NATO seems to enjoy bipartisan support. Moreover, Europe has launched INSTEX, which is a special-purpose vehicle meant to facilitate non-dollar trade with Iran. Initially, it will be used for items not embargoed, like food and medicine, which will also likely incur the U.S. ire.
At the end of the first half, there were three events for which PredictIt.Org may offer some interesting insight into sentiment. Roughly speaking, participants see a 2/3 chance that 1) the UK does not leave the EU by November 1, 2) the U.S. will not ratify the USMCA by the end of the year, and 3) Italy’s parliament is dissolved this year. We do not disagree.
Dollar: The current expansion is record-long this month. It has not been a strong expansion, which may be one of the reasons it continues. While there is no doubt that the U.S. economy slowed in Q2, what matters more to Fed policy is what the data looks like going forward. Many indicators are consistent with late-cycle activity, and the leading economic indicators warn that sub-trend growth is likely. We suspect the market has priced in even worse. Interest rates are likely to base, and the dollar recoup some of the ground lost, but in the second half the month, positioning for the FOMC meeting may become more important.
Euro: Europe’s manufacturing sector remains weak, but the service sector strength suggests international factors remain a major headwind. The Bundesbank warned that the German economy might have contracted in Q2. Draghi’s term as ECB President ends in October, which may limit how far the central bank is comfortable extending forward guidance, which now extends to the middle of next year. However, Draghi has opened the door to an additional move before he departs. The July 25 meeting may be too soon, but the next one is not until September 12. The rotating voting system means that the Bundesbank's Weidmann will not vote then and that may fuel speculation of action. The euro snapped a five-month losing streak in June with a 1.8% gain. The $1.12-$1.15 range may contain most of the price action in July.
(previous in parenthesis and end of June levels used)
Spot: $1.1373 ($1.1165) Median Bloomberg Forecast $1.1348 ($1.12)
One-month forward $1.1402 ($1.1193) One-month implied vol 5.6% (4.85%)
Yen: The Japanese yen was the weakest of the major currencies in June, rising only about 1.4% against the dollar. The dollar overshot the JPY107 technical target but did not close below it. If U.S. yields have based for the time being, as we suspect, the dollar can trade higher in July. We expect the dollar to approach, and possibly penetrate, JPY109. The upper house election is unlikely to be much of a market factor. The government continues to appear committed to the sales tax hike in October.
Spot: JPY107.85 (JPY108.85) Median Bloomberg Forecast JPY107.90 (JPY110)
One-month forward JPY107.59 (JPY108.55) One-month implied vol 6.6% (6.90%)
Sterling: Brexit issues continue to suck up the oxygen around the UK. The focus in July is on the Tory Party’s leadership contest, the outcome of which will not be known until the third week, though Johnson is favored. Promises to re-open negotiations with the EU ring hollow as the EU has repeatedly rejected it. Some in the UK want to threaten to leave without an agreement as if that would get more concessions from Brussels, but instead spurred opposition in parliament. Although neither Tory candidate wants to have national elections before the end of October, it may not be fully in their hands. The agreement with the DUP to support the minority government expires this fall. The uncertainty surrounding Brexit is deterring some domestic investment decisions. Sterling is at the mercy of the general dollar direction.
Spot: $1.2696 ($1.2590) Median Bloomberg Forecast $1.2697 ($1.30)
One-month forward $1.2717 ($1.2610) One-month implied vol 5.9% (7.0%)
Canadian Dollar: Strong data solidified expectations that the Bank of Canada was one of the few major central banks not considering easing policy. The three macro drivers of the Canadian dollar we follow all supported the Loonie and its 3% gain, which led the major currencies in June. The two-year interest rate premium was cut nearly in half over the course of the month. Oil prices rallied on geopolitical and supply considerations. There was a general risk-on attitude, which we use the S&P 500 as a proxy, though the Canadian stocks underperformed. Our hypothesis that we have reached peak Fed dovishness in the market leads us to expect a consolidative/corrective phase in early July.
Spot: CAD1.3095 (CAD1.3535) Median Bloomberg Forecast CAD1.3199 (CAD1.34)
One-month forward CAD1.3085 (CAD1.3520) One-month implied vol 5.6% (5.0%)
Australian Dollar: Despite widespread expectations that the Reserve Bank of Australia will deliver a rate cut on July 2, the Australian dollar gained about 1% in June. Judging from the derivatives market, investors expect the RBA to lower rates again in Q4. The weaker U.S. dollar may have been around the recovery of the Aussie in the second half of June. After rallying nearly two cents in two weeks, we look for it to peak in the $0.7025-$0.7050 area before pulling back into the $0.6900 area.
Spot: $0.7020 ($0.6915) Median Bloomberg Forecast $0.6979 ($0.7000)
One-month forward $0.7028 ($0.6925) One-month implied vol 6.9% (7.25%)
Mexican Peso: The threat of U.S. tariffs on all of its imports from Mexico, despite NAFTA and the beginning of the ratification process for the new USMCA, sent the peso sharply lower in May (-3.5%). It recouped all of it in June, with the dollar briefly dipping below MXN18.90 before recovering into the end of the month. The economic data has a distinctive weakening bias, but with inflation just at the upper end of the target range (4%), the central is reluctant to cut rates. We expect the peso to be broadly stable in July, allowing investors to earn the carry.
Spot: MXN19.22 (MXN19.73) Median Bloomberg Forecast MXN19.28 (MXN19.19)
One-month forward MXN19.32 (MXN19.83) One-month implied vol 9.4% (12.3%)
Chinese Yuan: The dollar ended a three-month advance against the yuan with about a 0.5% decline. The price action will reinforce the significance of the CNY7.0 cap. Prior to the end of the tariff truce in early May, the dollar was trading around CNY6.75. It quickly spiked to higher and in the second week of June punched through CNY6.94. It fell to around CNY6.84 as the market appeared to price in a new tariff freeze before consolidating as June drew to a close. A broad range trading environment is likely in July. China may not want to see the dollar fall much below CNY6.80.
Spot: CNY6.87 (CNY6.91) Median Bloomberg Forecast CNY6.88 (CNY6.75)
One-month forward CNY6.86 (CNY6.91) One-month implied vol 4.9% (5.1%)