Market Memo: What FX and Missouri have in common

04-11-2017

Unlike their equity and bond siblings, the foreign-exchange (FX) market turned skeptical early on this year over key propositions outlined by the new Trump administration. It wasn’t so much the currency market was rejecting the notion of a reflation trade built around major fiscal stimulus via tax cuts, infrastructure spending and repatriation. It was more about the timing. The result was most currencies had a solid first quarter relative to the dollar as the GOP Congress and White House failed to deliver on their first major initiative, Obamacare replacement legislation, fed into this reflation-timing thesis.

Indeed, the repeal-and-replace implosion extended the dollar’s decline, caused U.S. Treasury yields to slip further and trimmed the stock market’s strong post-election gains in the first quarter’s final weeks as investor doubts grew over the U.S. political and economic agenda. Global bond yields followed suit, gold advanced and the commodity center began to waver as traders began to weigh what lies ahead not only in the U.S. but also in Europe, where upcoming French and Germany elections could signal just how strong the populist wave that delivered Donald Trump’s surprise victory is.

Commodity markets rally
In some ways, the first quarter was as much a commodity play as a policy one as on both a total return and relative basis, most commodity-centric bond markets outperformed their G20 peers. While some currencies in this universe are thought to be rich, many continue to defy gravity. Nowhere is this more evident than in Australia. Practically every pricing model currently suggests its dollar is about 10% overvalued, yet in Q1, it was the best-performing currency in the G10. Part of this is because the Australian central bank remains trapped between soft inflation pressures and an inability to cut rates due to surging housing prices. A central bank in no position to either raise or cut rates is bond friendly.

Despite the continued rise in world oil prices, declining inflation has remained the focal topic in Norway. Inflation contracted materially during the winter and has actually been waning since last summer. The pace of the decline was even more rapid than the Norwegian Central Bank envisaged, causing the Norwegian krone to underperform most of its G10 peers during the quarter even as it eked out a gain against the U.S. dollar.

Brexit headlines worse than reality—so far
Nine months after the European Union (EU) referendum, Brexit was formally activated in March, triggering a 2-year negotiation period after which the U.K. will cease to be an EU member. From an economic standpoint, the U.K. has stood resilient. Its unemployment rate fell to its lowest level since 2005, inflation surpassed expectations, and consumer confidence remained strong and seemingly undeterred by the prospect of leaving the EU. The Bank of England held steady and is unlikely to act on rates anytime soon, helping the British pound appreciate nearly 2% in the first quarter.

In fact, economic activity throughout Europe and the rest of the world continued to show promise—most European PMIs are near multiyear peaks, many emerging-market (EM) countries are beginning to exhibit early shoots of positive growth, and apprehension over China’s economy and U.S. trade policies have diminished. This has, from our perspective, carved out some attractive discounts in a host of EM economies. In Europe, not so much, largely because optimism is being tempered by the aforementioned elections, keeping the euro entrapped in a range, albeit a very volatile one, with the biggest moves coming after European Central Bank (ECB) President Mario Draghi indicated the ECB’s ’s outlook had become less negative, a message investors decoded as possibly being the beginning of the end for European quantitative easing. Right or wrong, this interpretation sent the euro and German yields higher.

Why FX and Missouri are alike
Looking ahead, it appears that many of the drivers and themes that defined global markets in Q1 likely will port over to Q2, the two standouts with significant macro implications being European election outcomes and U.S. fiscal policy. In Japan, “curve control’’ by the Bank of Japan appears to have 10-year yields cemented around 0%. Elsewhere, as we have noted, the bias appears to be for central banks outside of the U.S. to largely remain on hold.

As for the U.S., we believe the recent move lower in the dollar is partly technical and partly qualitative. Mean reversion is a natural and routine force after a surge such as the post-election move. Secondly, currency investors are a bit like the “show me’’ state of Missouri—they want to see evidence of fiscal expansion, corporate tax reforms and repatriation before the dollar can begin to rise again. Until such evidence appears, we are remaining neutral on the dollar.