September 2019 FX Outlook

Three forces are shaping the investment climate.  The US-China trade conflict escalates at the start of September as both will raise tariffs on each other’s goods and are threatening another round in mid-December (US 25% tariffs on $250 of Chinese imports will increase to 30% on October 1). 

Some third parties may benefit from the re-casting of supply chains, but the first impact is understood to weaken growth impulses.  That is aggravating the slowdown already evident in several large economies in H1, including the US, China, and the EU.  The deflationary winds of softer economic performance and weaker price pressures are boosting pressure on central banks to ease policy.  The Federal Reserve and the ECB are widely expected to take new accommodative steps in September. The combination of slowing trade, weakening growth and prospects for rate cuts have driven yields lower and spurring curve inversions.   There are around $17 trillion of negative-yielding bonds, including more than $1 trillion of corporate bonds.

In the foreign exchange market, these forces weighed on those currencies that often appear sensitive to world growth.  Among the major currencies, this means the dollar bloc and the Scandis underperformed.  It also means that those currencies that are often used to fund the purchases of riskier assets, like the Swiss franc and Japanese yen, outperformed.  Emerging market currencies weakened in August.  The Thai baht’s 0.8% gain was the sole exception.  The JP Morgan Emerging Market Currency Index fell by a little more than 5% in August.  That is the most since last August (-6.2%), which itself was the most since May 2012.

There has been much discussion in recent weeks about steps that the US may take to drive the dollar lower.  We recognize intervention as an escalation ladder, and the low rungs are about verbal intervention.  Although President Trump has said many provocative things about currency manipulation in China and Europe, we do not expect material intervention.   We are not so much concerned about the operational challenge: Will the Federal Reserve cooperate?  Does the Exchange Stabilization Fund hold sufficient dollars to make the intervention credible?

Our concerns are where the rubber meets the road:  Selling dollars is fine, but what to buy?  Should the US buy the onshore or offshore yuan and help fund the Chinese government, the People’s Liberation Army, the Belt-Road Initiative and help make a larger reserve asset?   If the US intervenes to buy euros or yen, will it really pay Germany or Japan to hold our money, which is what negative interest rates imply?  And how will other countries respond?  After years that many cried wolf, would this trigger the dreaded currency war?  If the US buys the yuan, what if China went in the next day and sold twice the amount of yuan and bought dollars? 

Nor do we expect China to “weaponize” its Treasury holdings by selling them.  Given the near-insatiable appetite demonstrated by the sharp decline in yields, any practical divestment from China can be easily absorbed.  The US 10-year yield fell about 52 basis points in August, the most since January 2015  The 30-year fell by nearly as much to push below 2.0% for the first time ever.  The 2-10 year yield curve inverted while the three-month bill to 10-year curve has been inverted since May.  Inverted curves are associated with the conditions that lead to recessions, usually with a substantial lag. 

With the Queen’s support, UK Prime Minister Johnson suspended Parliament from September 12 through October 14, when the Queen’s Speech will lay out the government’s program.  The idea is that without Parliament’s obstructionism, Johnson has a stronger hand to negotiate with the EU.  The strategy will be legally challenged, as the UK’s Supreme Court ruling had secured the right of Parliament to have a say on how the UK leaves the EU.  

Currency Outlooks

Dollar

There is little doubt that the Federal Reserve will deliver its second rate cut of the year at the conclusion of its meeting on September 18, when it will updates its forecasts as well.  The economy appears to be continuing to grow a little faster than the Fed estimates to be the long-run non-inflationary pace.  While job growth has slowed (165k average through July vs. 227k in the first seven months of 2018), it is sufficiently robust to ensure unemployment and underemployment remain near cyclical lows.   Household consumption remains strong.  Business investment has been dominated by the energy sector, and there are some preliminary signs of that moderating.  The positive yields in the US contrast with the negative yields in Europe and Japan. At the same time, we think it is important that the US premium on two-year borrowing over Europe (Germany) and Japan peaked last November and set new two-year lows in August.   Dollar strength in the face of the narrowing of short-term interest rate differentials that we have seen may be indicative of the last phase of a big dollar bull market.  What has consistently taken the wind from the dollar sails is an escalation of the trade conflict that spurs investors to price in more aggressive Fed easing. 

Euro

Germany, Europe’s largest economy, continues to struggle.  The root of the problem appears to be in the auto sector, which relied more on diesel and China than may have been appreciated.   The economy has contracted in two of the last four including a 0.1% decline in Q2 19.  The Bundesbank warned that the economy may have contracted in Q3 but is reluctant to endorse fiscal stimulus.  The German government may ease its purse strings grudgingly, and it can borrow money out 30 years at negative rates.  The ECB will likely complement it with a dramatic easing at President Draghi prepares to handoff to Lagarde.  The ECB may cut the deposit rate (presently at minus 40 bp) and announce plans to renew its asset purchase program when it meets on September 12.  The euro finished August below $1.10 for the first time since May 2017. The next important chart levels are not found until closer to $1.08.

(previous in parenthesis, end of July indicative levels)

Spot: $1.0982 ($1.1076)    
Median Bloomberg Forecast:  $1.1037 ($1.1228)   
One-month forward: $1.1010  ($1.1106)    
One-month implied vol: 5.8%  (4.9%)

Sterling

Brexit continues to suck up all the oxygen in the UK.  By suspending Parliament from September 12 to October 14, Johnson is pressing harder his case that he is prepared for the UK to leave the EU on October 31.  It appears to be a risky strategy.  It will intensify the effort in Parliament and courts to overturn Johnson’s move (that the Privy Council and Queen made possible). The gamble is that this will make Europe more willing to compromise, but so far the EC seems nonplused.  Sterling recovered from the test on $1.20 in the middle of August but faltered near $1.23.  Implied two-month option volatility that covers the exit date is above 14%, and the uncertainty has lifted the one-month volatility four-month highs above 11%. The euro peaked at a three-year high against sterling near GBP0.9325 in the middle of August before correcting lower to test the GBP0.9000 area.  We suspect that if the collective wisdom that is being expressed in prices is vulnerable, it is that it wants to believe that a solution at the last minute will be found to avoid a no-deal Brexit, which Johnson has previously handicapped as one in a million. 

Spot: $1.2156 ($1.2159) 
Median Bloomberg Forecast: $1.2192 ($1.2402)        
One-month forward: $1.2172 ($1.2180)  
One-month implied vol:  11.0% (7.0%) 

Compliments of Bannockburn Global Forex, LLC  – A member of the EACCNY