June 2018 FX Outlook
The USD made strong gains against most currencies in May, though it fell back against the JPY as risk appetite weakened sharply at the end of the month. Italian political concerns dominated the second half of May, but USD strength was already well entrenched as widening yield spreads, fading concerns about trade tensions and optimism around Korea initially all helped to support the USD. Although China trade tensions returned at the end of the month and the proposed Korean summit has been cancelled – for now at least – the USD held on to most of its gains except against the JPY. Concerns around the collapse of the nuclear deal with Iran helped maintain the strength of the oil price and may also have been USD positive, though the typically oil sensitive currencies – the CAD and MXN – appeared to gain little benefit. Brexit concerns continued to weigh on GBP, with concerns growing that the inability of the UK government to agree on a coherent trade policy could lead to another election.
Outlook for May
1) Italian (and Spanish) Politics
The Italian equity market sell off, with European and global contagion, came initially in reaction to the announcement of a coalition agreement between the populist 5* and Lega parties. The surprise was really that it took so long for the markets to react negatively as this coalition had seemed the most likely outcome since the March elections. The losses extended when the Italian president Matarella rejected the proposed euro-sceptic finance minister in the 5*/Lega coalition government, creating the risk of another election. However, the 5*/Lega coalition has now made a new proposal with a different finance minister, and the new government now seems likely to be voted in next week.
While this outcome is not particularly positive for Italy, Europe or the euro, there is no significant danger of Italy proposing an exit from the euro (or the EU). While both 5* and Lega are “euroskeptic”, their skepticism is mostly about challenging the existing EU structures and rules and stops short of calling for euro exit. For the markets, the significance of the new government is likely to be in their proposed expansionary fiscal policies. These will bring the new government into conflict with the EU, but the EU can do little to stop such policies being implemented, at least not in the short run. In the end, any discipline is likely to be imposed by the market, with the government likely to find it much harder to issue bonds with an expansionary program in place. Italian bond yields have already risen substantially, but may rise more if issuance comes with a concrete aggressive fiscal expansion in place. The situation is therefore likely to remain difficult for many months (if not longer) but seems likely to become chronic rather than acute.
In the meantime Spain faces its own political problems with PM Rajoy facing a vote of no confidence on June 1. While opposition parties are not of the same populist ilk as in Italy, and there is consequently less danger of a major clash with the EU even if Rajoy loses, a Spanish election against the background of the recent Catalan independence dispute could be expected to cause further market jitters.
2) Trump, Trade and Korea – Moveable Feasts
The last few months have seen President Trump announce new tariffs on steel and aluminum, and on Chinese imports, only to suspend the tariffs with most major countries and restart negotiations with China. He has also announced and cancelled a summit with North Korea, though hopes of a meeting are not yet dead. More flip-flopping seems likely but steel and aluminum tariffs are set to be imposed on the EU, Canada and Mexico from the beginning of June. While the impact is likely to be small from a macro perspective, and the markets have become more sanguine about news on trade, the imposition of tariffs has already led to a negative reaction from risky assets and seems likely to hold back the USD against the traditional safe haven currencies. .
3) UK-EU Brexit Talks. Key Date – EU Summit June 28/29
The UK government continues to struggle to agree on a coherent position on trade with the EU post Brexit. The EU is pressing for a clear position by the EU summit on June 28/29, but the UK cabinet is split between two factions, one supporting “max-fac” and the other a “customs partnership”. “Max-fac” is favored by the more pro-Brexit faction but seems likely to be too costly, while the customs partnership requires the UK to collect duties on the EU’s behalf and refund where necessary. Even if agreed, it is unclear that either arrangement would be acceptable to the EU. The government may also face difficulties with the EU withdrawal bill which comes to the House of Commons this month having had several amendments added in the Lords against the government’s wishes. If these amendments are supported in the Commons it will add further problems for the government in dealing with the EU, and could also increase risks of a leadership challenge to PM May.
EUR/USD broke to new lows for the year early in May as rising yield spreads continued to support the USD, but subsequent losses through May were triggered primarily by Italian political risk, initially in response to the announcement of the 5*/Lega coalition, and subsequently to the president’s decision to reject the proposed government because of the Eurosceptic finance minister. The president’s decision may actually prove to have had a stabilizing effect, as the new government now looks less likely to have an agenda to exit the euro and the euro rally at the end of the month reflected a more sanguine view of the Italian situation. But the risks still look to be primarily on the downside with yield spreads still heavily favoring the USD and Italian or broader European political risk still having potential to flare up in the coming weeks. While downside momentum may well slow in the short run, and a break below 1.15 is likely to be hard to achieve, there is potential to fall to 1.12 or beyond even with a fairly modest increase in political risk, as futures market data shows speculative positioning is still significantly long EUR despite recent declines. While EUR/USD previously tended to benefit from US protectionism this seems less likely to be the case with European politics in turmoil. With Italian and Spanish political uncertainty unlikely to be resolved any time soon, EUR/USD recovery scope looks quite limited with 1.18 likely to be out of reach for the foreseeable future.
GBP/USD is likely to remain under pressure along with the EUR if the recent USD uptrend remains intact, but unless there is clear negative UK news on Brexit, GBP/USD may hold up a little better than EUR/USD. While Brexit risks are quite significant this month with the EU summit at the end of the month (see above), the exit from the EU looks less problematic against the background of the current Italian (and Spanish) political situation and a deteriorating US trade relationship with the EU. Additionally, positioning in GBP/USD is now quite light. So while the risks for GBP/USD are still tilted to the downside, it will likely require clear negative news on Brexit to trigger a break of 1.30, while GBP could benefit if the government manages to agree a coherent position going into the EU Summit at the end of the month, potentially challenging resistance at 1.35.
With the US announcement that tariffs on steel and aluminum would be imposed on the EU, Canada and Mexico, USD/CAD initially rose quite sharply. The CAD is seen as the most vulnerable currency to these tariffs, as it is the largest exporter of steel and aluminum to the US, and dramatically so relative to its GDP. Even so, the tariffs won’t have a substantial impact on the Canadian economy – even though Canada is the largest exporter the amounts are still modest from a whole economy perspective. The CAD should also gain some support from the environment of higher oil prices and a Bank of Canada that looks set to raise rates at its next meeting on July 11 judging by its latest statement. While the Fed is likely to raise rates in June the hawkish BoC stance should limit the downside for the CAD. So while the risks do seem to be mostly on the downside for the CAD, any break above 1.30 should be contained and there should be value near 1.32 as long as the oil price holds near 3 year highs.
USD/MXN broke above 20 for the first time since early 2017 in response to the news that the US was imposing steel and aluminum tariffs on Mexico (as well as Canada and the EU) because of lack of progress in NAFTA talks. In truth, Mexico is not much of an exporter of steel and aluminum to the US, so there should be little direct impact from the tariffs. However, it could still be significant if the US decision affects the Mexican election on July 1. The left-leaning candidate Lopez Obrador is already widening his lead according to the latest polls, and increasing tension with the US probably increases his chances. Nevertheless, his victory is already largely priced in, and the market reaction will probably depend more on whether his party – MORENA – can gain an absolute majority in Congress, which would make implementation of his policies easier to achieve. USD/MXN remains at historically high levels in real terms and the MXN should be good value above 20 provided the market isn’t spooked by the election outcome.
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