The USD made gains against the majority of currencies through most of June, but gave most of them up in a sell off in a weak final day’s trading. The USD continues to be underpinned by the expectation of higher US rates and an already attractive yield spread in the USD’s favor, but the gains during the month also appeared to be spurred against most currencies by rising concerns about trade wars.
The USD weakness on the last trading day of June may have related to technical end of month/end of quarter hedge adjustments as much as the generally reported optimism following the EU migrant deal agreement, but it did once again indicate that the USD is currently negatively correlated with risk appetite against the majors (the JPY excepted). The focus will remain on trade tensions coming into July, with the imposition of further import tariffs on Chinese goods on July 6 potentially triggering another round of risk aversion as well as any decision from Trump on auto tariffs. Geopolitics and their impact on risk are also likely to be the focus around the Trump-Putin meeting on July 16.
Outlook for July
1) Trade Wars and Other Geopolitics
June was a month in which the headlines were dominated by President Trump and his initiation of trade disputes with China, the EU and Canada and others. On July 6 we see the imposition of more tariffs on Chinese imports. Canada has announced retaliatory tariffs from July 1, and the EU have already responded with retaliatory tariffs on June 22. The retaliatory tariffs are all claimed as “proportionate” i.e. they only match the US tariffs. If it all stops here the impact on global trade and global growth will be small. It will take time before patterns of trade change, if they change much at all. The first impact will be seen on prices, but even this impact is unlikely to be large.
However, Trump has also threatened to increase tariffs on car imports from the EU. If this happened it would start a new round of trade wars and could be expected to trigger a new sell off in equities. If there is Chinese retaliation to the tariffs due to be imposed on Chinese exports to the US from July 6, a further round of tit-for-tat can be expected. Recent market behavior suggests this will lead to USD gains against most other majors. Geopolitical nerves may also be triggered by the Putin meeting on July 16. NATO members are worrying about US commitment to the Alliance being reduced, and evidence of an improving relationship with Putin might well increase this concern, potentially weighing on European currencies.
However, even though at the moment the USD appears to be benefitting from trade tensions (except against the JPY), this cannot be relied upon to continue. The support that the USD has received from large yield spreads in its favor could come under threat if the tensions intensify and threaten growth prospects in the US and globally. Expectations of Fed tightening which are currently USD supportive could fade, and although monetary tightening expectations elsewhere could also be expected to be scaled back, there is much less scope for yields to fall in Europe than in the US. So if trade concerns become serious enough to threaten growth in the medium term, the USD may well start to suffer against the lower yielders.
2) Oil and OPEC
Oil prices surged after the June OPEC meeting even though OPEC agreed to increase production by 1mn bpd. The increase is not currently seen as sufficient to balance the oil market given the imposition of sanctions on Iran. WTI crude is now up 25% this year and at the highest level since 2014. However, thus far oil price gains have had little obvious impact on the traditionally oil sensitive currencies. The CAD and the MXN have both been quite weak in recent weeks, only recovering right at the end of June. This is partly because other factors – notably trade – have taken the headlines, and partly because even now the oil price is not seen to be particularly high by historic standards, and few expect substantial gains from here. Nevertheless, if the price remains underpinned and pushes up to $80 p/b as seems possible if growth and risk appetite remain well supported, some positive effect for the oil sensitive currencies seems overdue.
3) UK-EU Brexit Talks Stall, Migration Deal Creates Problems in Germany
The EU summit produced a deal on migration, but no progress on Brexit. There is now little chance of a Brexit deal by the October Summit which was the original target, largely because the UK hasn’t even decided what it wants yet, never mind negotiated it properly with the EU. The risks of “no deal” are still small, but increasing. The migration deal was initially seen as positive news, but cracks have opened up in the German coalition government as a result with the CSU leader threatening resignation. At this stage it still seems likely that the coalition will survive, at least through the summer and possibly through the Bavarian state elections in the autumn, but nerves will persist.
4) Mexican Election
Andrés Manuel López Obrador (AMLO) has comfortably won the Mexican presidential election. His party, MORENA, also looks set to win an absolute majority in the Chamber of Deputies, and to be the largest party in the Senate. The initial reaction of the MXN has been negative, probably because of the strong performance of MORENA in the Congressional elections (the AMLO win was widely expected). There seems unlikely to be any major immediate impact on markets, as the result were not unexpected, but longer term the more leftist slant of the Mexican government seems likely to increase conflict with the US.
EUR/USD broke to new marginal lows for the year in June but still held above 1.15 as it rallied strongly at the end of the month. The EU migrant agreement at the EU Summit was seen as the proximate cause of the EUR recovery, though end of month/quarter hedging effects are likely to have been at least partially responsible. Concerns about Italian politics have faded but have been replaced by concerns about the trade and political relationship with the US and the stability of the German coalition. The most important news now will relate to any decision on auto tariffs from the Trump administration. If they are imposed, a general sell off in equities is likely and initially the EUR can be expected to suffer too, with risks to 1.12. However, USD gains in this scenario may prove short lived if, as seems likely, it leads to a downgrading of Fed rate hike expectations. A more neutral trade picture may initially prove beneficial for the EUR leading to gains towards the top of the recent 1.15-1.1850 range, but as long as optimism around the US economy continues, a significant upside break seems difficult given the lack of any Eurozone rate hike expectations and continuing risks in Europe from Brexit and internal politics.
The failure of the UK government to agree any coherent stance on Brexit eventually started to weigh on GBP towards the end of June as the EU Summit highlighted the lack of progress. While the market is now looking for a rate hike in August following some better UK data and some more hawkish MPC comments, this looks far from certain with the more dovish members of the MPC still concerned about the potential impact of Brexit uncertainty on the economy, and trade issues still undermining global sentiment. Since it now looks unlikely that we will see any more clarity on Brexit in the coming month, most of the risks to GBP look to be on the downside, but the strong rally at the end of June suggests the 1.30-1.35 range is likely to stay intact without a general USD move.
The CAD was weak through most of June but recovered against a generally weaker USD on the final trading day. The CAD suffered a bit from some dovish comments from Poloz, though his comments still suggested further rate hikes are likely this year. General USD strength, the imposition of US tariffs on steel and aluminum (and the Canadian retaliation) and the risk negative tone to the equity markets also tended to weigh on the CAD. Thus far the CAD has not managed to benefit significantly from the higher oil price. Upside risks could become significant if the trade war escalates triggering severe equity weakness and major risk aversion. But if problems are contained the 1.30-1.35 range should hold.
After peaking near 21 in mid-June, USD/MXN fell back to month opening levels in the mid 19s by the end of the month as concerns about the election faded. Uncertainties remain, but the outlook for USD/MXN is probably more dependent on the general global trade picture and its implications for global markets than Mexican specifics, at least in the short to medium term. The leftist president and Congress may mean more conflict with the US in the future, but Trump has shown that the political color of foreign governments doesn’t really matter too much to his stance on trade relations. If global markets stabilize, USD/MXN still looks to be at high levels historically and has potential for substantial declines below 18. But a significant sell off in global equity markets could be expected to trigger an upside break to new highs above 22.
Compliments of Bannockburn Global Forex, LLC, a member of the EACCNY