05 July 2017
By John. J. Hardy, Saxo Bank's Head of FX Strategy
STANDFIRST: The predominant Q3 risk in forex markets is rising volatility. At present, the “Goldilocks combination” of weakening inflation and a softer USD reigns, but this will weaken as central banks retreat from their hyper-accommodative stance.
PULL QUOTE 1: “The most significant risk to global growth and near-record levels of global complacency is the policy tightening out of China”
PULL QUOTE 2: “EM currencies face the greatest risk of downside in Q3”
BANNER QUOTE: “The Goldilocks narrative will likely prove increasingly difficult to maintain”
The second quarter of 2017 was one of declining volatility across global markets, especially once Europe got beyond the French presidential election. Risky assets rose as complacency reigned.
Indeed, global markets celebrated the “Goldilocks combination”: weakening inflation keeping central bank hawks at bay while the fading Trump trade kept the USD weak. The USD's slow tailspin in Q2 and still hyper-accommodative European Central Bank and Bank of Japan policy kept the global liquidity dial set to 11.
Although the US Federal Reserve managed to pull off its second rate hike of the year, financial conditions remained near their easiest for the cycle, whether measured in corporate credit spreads or emerging-market bond spreads. Beyond the derailed “Trump trade” and low US inflation readings, a general weak patch in the US economic data also helped to weaken the dollar, tempering market expectations for further Fed rate hikes as the market is once again at odds with the Fed's more hawkish policy forecasts.
From here we suspect the Goldilocks narrative will likely prove increasingly difficult to maintain, though there is an appreciable chance that it will drag on for a substantial portion of the summer before yielding to more volatility in the autumn.
As noted, the most significant risk to global growth and near-record levels of global complacency is the policy tightening in China. But the Fed is also tightening policy and may have reasons to continue tightening even if the US economy fails to gather more momentum, as we discuss below. And if the Fed tightens less than expected, it would be likely due to the US economy tilting into a recession – hardly cause for complacency.
Either way, the predominant risk lies toward increasing volatility, a development that would likely support the struggling US dollar at the margin as a safe haven and dampen enthusiasm for emerging-market and the smaller developed market currencies, as we discuss below.
The G3: EUR slowly bogs down, USD resilient, JPY the wild card
USD: Trump trade lost in the swamp
The US dollar had come full circle near the end of Q2, in dollar index terms fully erasing the entire rally sequence from the election of president Trump in November. Trump's inability to move the policy needle and his unsuccessful confrontation with the Washington establishment have seen the market nearly entirely write off the potential of the “Trump trade” (the anticipated combination of tax reforms and fiscal stimulus that was meant to drive US economic outperformance and a strong currency).
The US dollar might have stumbled less on this development were it not for a steady stream of weak economic data in Q2 at a time when Europe and Japan were firing on all cylinders. The USD is still expensive and will likely face further headwinds as long as the Goldilocks trade is ascendant in Q3, but a bumpier road ahead and more volatile asset markets would likely see the USD's traditional safe-haven role providing solid support.
There is some risk that a showdown over the US budget ceiling in late Q3 could keep the pressure on the greenback, but there is also the question (addressed in our sidebar) about the Fed's intentions and whether a less-accommodative-than-expected Fed in Q3 and beyond is a distinct risk.
Sidebar: Does the Fed want out of the ‘Master of the Universe' business?
In Q2, some questioned the Fed's insistence in shrugging off a weak patch in inflation and US data and continuing to look for further rate hikes, while even outlining plans to launch quantitative tightening of the Fed's balance sheet already this year. The market has played a high confidence game in second-guessing the Fed's intentions, and continues to believe that the Fed will not come close to hiking as much as Fed forecasts suggest beyond this year.
One explanation for a slightly more hawkish tilt from the Fed this year could be that chair Janet Yellen is in “legacy mode” as she finds herself at the end of her long career at the Fed, inevitably replaced with a new Trump nominee early next year. She may want to be seen as the chief that finally extracted the Fed from the era of quantitative easing and zero interest-rate policy, however cautiously.
That may be true to an extent, but it's more compelling to believe an alternative explanation: the Fed simply wants out of the “Master of the Universe” role. Deeply concerned about the inefficacy of the ZIRP and QE tools it has employed since the global financial crisis and the aggravation of inequality these tools have wrought, the Fed is finished and wants to pass the policy baton back to the government.
On some level, does the Fed also fear that its policies helped put Donald Trump in the White House? Well, the Fed did help on some level if the metric of inequality has any responsibility for the Trump presidency. Regardless, by wanting to undo some degree of what it has done by playing master of markets for so long, the Yellen Fed may be far less fearful of going too far in tightening policy than the market thinks.
Consequently, when the next recession does roll around, the Fed's role will be vastly reduced – most likely to a role as auxiliary to fiscal stimulus.
Europe – you say you want a revolution?
Emmanuel Macron's French political revolution was completed in Q2, and his new party has a theoretical mandate to shape significant reforms that could boost the French economy, long an underperformer. Europe likely has enough momentum from hyper-stimulative ECB policy to stay on a positive trajectory in Q3, although rising global growth concerns will eventually impact the Union at its core, especially Germany as global exporters are most exposed to changes in global growth.
All of the difficult existential EU questions, like debt relief for Greece, an Italian election, and the structural reform of EU institutions, meanwhile, will have to wait until after the German elections in late September. These questions will inevitably come back, as Greece has shown good faith and debt relief is a mathematical imperative.
For the EU to maintain its current composition beyond the end of the ECB's QE, it will need to slowly move toward mutualised debt. This is particularly true for the EU's weakest link, Italy. Greek debt relief and mutualised euro-debt are non-starters for German chancellor Angela Merkel's re-election, even if she may prove amenable to building a more integrated Europe after the election (when she will be in “EU legacy mode” for her likely final term).
We'll revisit the existential questions for our Q4 outlook, as these remain critical for the longer term. As for Q3, euro upside may fizzle when market volatility picks up, partly because much of the enthusiasm for the single currency has been built on a positive story, and our more negative themes for the quarter don't dovetail with that.
Euro buying, euro sentiment and speculative positioning are getting stretched already rather far to the bullish side.
Still, EURUSD may manage a serious test of the 1.1500-plus resistance in EURUSD that defined the resistance in 2015-16, but we don't look for a major extension.
The yen outlook hinges mostly on the outlook for yields in Q3. If inflation stays low and global growth becomes a concern as in our base-case scenario, persistently low bond yields are likely to drive the JPY stronger as the legendary Japanese savers repatriate assets and foreigners lift their Nikkei hedges as it drops.
Even in a more positive scenario, though, the JPY is already very weak, and the tendency for slowly tightening central banks will inevitably spread even to Japan, where BoJ governor Haruhiko Kuroda might be forced to modify forward guidance given the improved outlook for the Japanese economy.
So the risks point to limited JPY downside potential unless we see a combination of higher rates with little or no pick-up in asset market volatility. This is perhaps possible if the Goldilocks trade extends across the summer, but not likely beyond.
UK stumbling – but towards what?
UK prime minister Theresa May's election miscalculation threw another log on the fire of Brexit uncertainty just before the start of official negotiations in late June. With May now in the less-than-proud possession of a weak domestic mandate on the home front, and given the time scale and complexity of the Brexit process, can we really expect much new in Q3 on the Brexit issue? The first phase of negotiations will focus on the divorce settlement and rights of EU citizens – so not the more GBP-important trade portion of post-Brexit UK.
EURGBP has been coiling in a 4-5 % range all year, and this may continue or it could test higher into 0.9000-plus if the UK economy continues to perform poorly. So downside risks for sterling predominate on the economy and on Brexit uncertainty. However, there remains one potential source of upside: what if, eventually, a second referendum is promised down the road once the Brexit deal is crystallised? Could “Bremain” be the ultimate outcome?
The G10 smalls: nearing the end of the line?
The smaller G10 currencies could see volatility pick up in Q3, particularly the Australian and New Zealand dollars. In fact, all of five “G10 smalls” have similar structural headwinds.
The most prominent of these is that every one of these countries has inflated an enormous private leverage bubble that seems finally at risk of bursting.
Canada's housing market was the first shoe to drop as its largest subprime lender, Home Capital Group, suddenly imploded in Q2. But we're also picking up signs that market concern is rising elsewhere as Australia's big four bank share prices fell in Q2, even before Moody's downgraded their debt on housing worries.
While New Zealand remains on a strong growth trajectory, home sales activity, which often leads actual prices, has dropped off sharply this year. We lump SEK and NOK in here on the housing risks side, though those currencies have already been quite heavily discounted in trade-weighted terms, so there may be less downside potential versus the major currencies relative to the AUD and NZD in particular.
EM road getting bumpier
Emerging-market currencies and equity markets (quite often the same thing) are at the centre of the Goldilocks trade and as a group turned in another strong performance in Q2. The easing of Fed tightening expectations, a weaker US dollar, and the easing of financial conditions globally were strong fundamental supports.
Still, momentum was clearly flagging in places, including in a commodity-linked currency like the Russian rouble where flat-to-lower oil prices weighed. EM currencies face the greatest risk of downside in Q3 in our scenario, whether from a growth slowdown and a backup in global risk spreads, from a more hawkish Fed, or both.