Through both ‘risk-on’ and ‘risk-off’ episodes this year, the US dollar trend has remained upward sloping with the US seen as both the best-performing developed market and a yielding ‘safe-haven’ amid global uncertainty. Despite President Trump’s actions this month, to our mind, this US dollar trend is set to extend into 2020.
From 96.7 at the time of our July Market Outlook, the US dollar peaked at 98.5 and has since settled around 97.5. This is despite the market’s view on the end-2019 federal funds rate shifting down from 1.73% at July to 1.49%, and the current 10-year yield falling from 1.95% to 1.74%. Why has the US dollar appreciated as US interest rates have moved lower? Simply because the deterioration in expectations has been even more dramatic elsewhere.
Of greatest significance this month ahead of President Trump’s decision to impose new tariffs, EUR/USD broke through support to hit a multi-year low of USD1.1027. Whereas the FOMC described their July rate cut as a “mid-cycle adjustment”, the July ECB meeting signalled preparations for a much broader stimulus package, including asset purchases, amid an outlook mired by persistent global uncertainty and an ailing manufacturing sector.
After the new US tariffs were announced, Euro bounced back to around USD1.12, arguably in relation to European investors reversing financial outflows associated with persistent current account surpluses as they reassessed the souring global economic environment. We believe this ‘return-to-home’ dynamic will prove short lived for two reasons.
First, the past year has shown that disruption from the Sino-US trade war has had an outsized effect on Europe’s open economy versus the more-insular US – total external trade equates to 51% of GDP for the Euro Area compared to 27% in the US. Subsequently, European investors are likely to look to redeploy capital overseas again in line with relative growth fundamentals. Second, even after our forecast three cuts in the federal funds rate to 1.375% at December, US treasuries will remain a high-yielding safe-haven asset, further aiding the US dollar.
With those factors in mind, our base case is for Euro to depreciate to USD1.08 end-2019 and hold that level until at least mid-2020. Even after Euro begins to recover, only a slow drift higher is anticipated, as growth remains around trend, inflation well below target, and risks to the outlook keep the ECB on guard. At end-2020, we see Euro at only USD1.11 – below current spot.
Also aiding the US dollar trend over the coming 12 months will be ongoing turmoil in the UK. As detailed in August Market Outlook, after Boris Johnson’s succession of Theresa May as Prime Minister, the UK has a hard-line leader for Brexit negotiations with little, if any, room to negotiate a better deal than the one repeatedly voted down by UK Parliament. Another exit date extension, a general election, or worse, a no-deal exit come November are therefore growing possibilities. Suffice to say, the persistent uncertainty evident here will take a material and lasting toll on the UK’s economy. It is for this reason that we have reduced our range-low for GBP/USD to USD1.18 at September 2019, after which Sterling only lifts to USD1.26 by end-2020.
Note the above forecasts are still predicated on a deal being reached in the December quarter to nullify the threat of a no-deal Brexit. As mooted above, the risks to this view are sizeable and growing by the day. We must therefore emphasise that Sterling could find itself at a much lower level than our central forecast over the coming year, and further that the modest recovery we foresee after Brexit may not eventuate.
Turning to Asia, Japan’s Yen has recently benefited from the FOMC’s end-July cut and the tariff ‘risk-off’ move, USD/JPY falling from near JPY109 to below JPY106. Looking ahead, this is a level we expect to endure to end-2019, as global uncertainties persist and the FOMC cut the federal funds rate. Note this is in contrast to the above Euro forecast. The difference here is the Yen having greater prominence as a safe-haven, and the ECB having the determination to ease in line with the FOMC while the Bank of Japan does not. In 2020, as the Bank of Japan remains on the sidelines and global risks become less acute, USD/JPY is expected to drift higher to JPY111 by end-2020. The risk here is that global uncertainties remain heightened, the FOMC has to ease further, and hence USD/JPY holds to the low-end of the forecast range.
Finally on China’s Renminbi, the past week has shocked the market as Chinese authorities chose to allow USD/CNY to break through their prior ‘line in the sand’ at CNY7.00 following President Trump’s tariff escalation. With US/China tensions set to persist for some time, a sustained period of trading above this mark is in the offing. However, absent a further deterioration in the US/ China relationship, a material run higher in USD/CNY from current spot seems unlikely. Consequently, we look for USD/CNY to trade as high as CNY7.20 in the six months to March 2020, then move lower with the broad US dollar trend to CNY6.90 at end-2020.