European volatility does not translate into US positivity and we continue to believe the underlying dollar outlook remains negative. The trade-weighted dollar is unchanged following six months of relentless rate spread widening and the US midterms will add to political noise. As Fed tightening approaches neutral rates, we expect the dollar to do poorly against Japan, Australia, the UK and selective EM. The euro is also likely to recover if Italy headwinds subside. Beyond the dollar, volatility breeds opportunity and we identify numerous trades in currency crosses that should not be sensitive to messy American or European politics.
Last Blueprint trades
We were positioned bearishly on the dollar to start the year and closed out our
positions in time so most of our January Blueprint trades performed well. The
averate return on our trades was 1.8% with a 70% hit ratio. Our best performing
trade was shorting CAD/NOK which returned 7.7% and our worst performer was
long BRL/CLP which dropped -6%.
Had it not been for the recent deterioration in Italian politics we would be buying
EUR/USD this week. But Italy is too big to fail and the market is still not pricing
much Eurozone systemic risk suggesting asymmetric downside risks if things get
worse. Beyond Italian developments we cannot get that pessimistic on the euro.
Dollar fundamentals are still weak and we like selling the dollar against the JPY,
GBP and AUD elsewhere in the Blueprint. To account for Italian risk we revise our
EUR/USD year-end forecast to 1.20 with the risks skewed to the downside if Italian
politics get worse. Our baseline assumption remains that Italy stress ultimately
dissipates so we are maintaining an upward trajectory back towards 1.30 and
1.40 for 2019 and 2020 respectively
The recent recorrelation of USD/JPY to US rates led to a sharp move higher in spot
in April and May. However, this FX-rates relationship is unlikely to remain stable.
Not only do we have the example of a dislocation at the start of the year, but
also US rates could become an asymmetric driver – with higher rates associated
with risk-off, while lower rates drag on USD/JPY. Beyond the vagaries of US rates,
there are good reasons to believe a stronger JPY will prevail this year
Buy GBP TWI, buy a 3m EUR/GBP straddle
Trapped between a more hawkish Bank of England and weak flow backdrop, trade
weighted sterling is close to unchanged on the year, even as volatility in GBP/USD
has been high. We turned more bullish on the pound in late March and stick to
our view. Vol in EUR/GBP is also too low as the Brexit endgame nears.
Asia has faced multiple curve balls this year, particularly a) renewed correlation
between rates and the broad dollar; b) higher oil (and which is not just seen
as reflecting the demand dynamic); and c) a high-strung game of negotiations
around trade and geopolitics on the Korean peninsula. The repricing over the past
month – which has taken Asian FX to its second-worst YTD performance since
the crisis – can arguably be put down mostly to having overshot fundamentals
(exports, earnings) at the start of the year, leaving portfolio investors significantly
underhedged on their FX exposures. That this has also been driven by a positive
repricing of growth/inflation fundamentals in DM is comforting. It should find
support in valuations and once positioning has adjusted (the momentum on flows
is near the weakest it has been since the crisis) and policy makers have crystallised
their response. The risk to this baseline is from either a) increased term premium
in global curves forcing more outflows through relatively small exit doors; or b)
if the global growth story comes under pressure, including because the trade
narrative gets poorer again. With the near-term risks on the dollar looking more
evenly balanced after the recent moves, we are more inclined towards relative
value in picking our summer trades.
Call the doctor, CAD’s not well
CAD’s middling performance in an environment of strong crude oil prices is
no accident, Figure 25. We believe CAD fundamentals are more likely to suffer
than USD in the near term, on account of housing weakness, prolonged trade
negotiations, and portfolio flow risks to the basic balance. Current market pricing
for policy rate changes by the end of the year are exactly even at +52 bps for
both the Fed and BoC. We expect a gap to open up as the BoC turns more dovish
relative to the Fed, lifting USDCAD.
The global backdrop is good enough
It might seem an odd time to move bullish on a currency so linked to global risk
– the euro area PMIs continue to slide, and, as we’ve noted , slower Asian export
growth is a soft signal for global growth. But a lot of that seems reflected in
risk assets already – equities are flat on the year and risky currencies are down.
Further, the headwind could soon abate: (1) global data surprises sit around fiveyear
lows (and euro area almost at nine-year lows); (2) EM earnings revisions
(another indicator of global growth) may be showing early signs of stabilising; (3)
metal price movements remain consistent with good growth (figure 35). Global
mining share prices are also holding up very well, another vote of faith in the
persistence of global growth. The relationship of the past few years between
miners’ share prices and AUD suggests material upside for the latter (figure 36)
While we remain structurally constructive on EUR/CHF, we see more downside
risks near term. Three-month risk reversals still look cheap to us.