November Monthly

Several issues that have cast a pall over the business and investment climate are likely to be lifted shortly.  Many still fear that the results of the US election will not be known for an extended period of time, but we note that a metric of fear, the difference between November and December VIX (S&P volatility) futures was at a six-month low before the surge in contagion spurred the biggest equity sell-off in four months as October wound down   

The underlying drivers of the $6.6 trillion-a-day turnover in the foreign exchange market are about the broad monetary and fiscal policies in both absolute and relative terms.  The policy mix in the US will remain the same in 2021 of easy monetary and accommodative fiscal policy.  Meanwhile, the mid-October deadline for the UK-EU trade talks was extended.  The rhetoric is not nearly as bellicose as it was, and the atmosphere appears to have improved.  The new deadline is the mid-November EU summit, to give the 27 EU countries and the EU Parliament time to ratify an agreement. 

The optimists hope that an effective vaccine can be announced in the coming weeks.  However, the most immediate concern is the surge in the virus in Europe and the United States.  Low nominal and often negative real rates coupled with government borrowing has helped support aggregate demand with few exceptions.  Regardless of the scale, countries, companies, households, and individuals are vulnerable to another shock.  The bar is low, and the pandemic's extension well into next year would likely be sufficient.  The month-long new social restrictions in Europe, for example, way cut quarterly growth by around 0.5%.  At the same time, the game of great powers continues, and potential flashpoints in Asia, the Caucuses and Northern Africa have not been resolved. 

Based on the projected policy mixes and other considerations, we expect the dollar to depreciate on a trend basis.  The dollar was little changed at mid-year against the euro and yen and was about 1.4% higher against the Chinese yuan.  Now, through ten months, the euro is about 5.3% higher, the yen 3.6%, and the yuan has appreciated by almost 3.8% against the dollar.  However, this may be somewhat misleading.  

The dollar has been range against both the euro and yen.  Since the last week of July, the euro has been confined to roughly a $1.16 to $1.20 trading range. The 50-day moving average is flat near the middle of the range.  The contagion, the new restrictions, and the ECB's commitment to ease in December warn of downside risks in the euro.  

For nearly as long, the dollar has been in a JPY104-JPY107 range, as well. The recent range is even smaller, as the dollar has been below JPY106 since the middle of September, with a brief exception earlier in October.  Nevertheless, October was the fourth consecutive month that the dollar recorded lower highs and found bids near JPY104.00.   A move back toward JPY106 is likely in the weeks ahead.  

The Chinese yuan has been trending higher.  Indeed, it has only declined in four of the past eighteen weeks.  After falling by about 6.25% to levels not seen since mid-2018, the dollar consolidated in late October.  If the managed currency has strengthened, it must be assumed that Beijing allows it.  Some currency strength is consistent with the "dual circulation" drive, but more importantly, maybe a signal for global investors.  As China's markets are integrated into global benchmarks, and its sheer size will boost its weight over time. This is going on while trade tensions remain elevated.   Both impulses,  the decoupling on trade and China's inclusion in international capital markets, will likely continue regardless of the US election results.  

This is a different kind of internationalization of the yuan than an offshore currency (CNH) and bond market (Dim Sum) entailed.  Attractive economic fundamentals, coupled with improved access, and inclusion in industry benchmarks, encourage capital inflows from foreign investors.  In turn, the combination of the large current account surplus and the portfolio capital inflows should exert upward pressure on the exchange rate.  Beijing uses such periods of upward pressure on the yuan to relax some rules that discourage capital outflows, like the quota for the Qualified Domestic Institutional Investors for overseas investments or the reserve requirement on forwards.  In late October, the PBOC adjusted how the dollar's reference rate was set, making it somewhat more transparent.  In the weeks ahead, Beijing's intentions may become clearer, and investors will have a better idea of the extent of that of the yuan's appreciation that will be sanctioned.  The currency may become more volatile than it has been.

Dollar:   The dollar generally trended lower from late September through the first of October against most of the major currencies and but turned higher against as the virus surged in Europe and policymakers from Australia and Europe signaled a policy response, while the Federal Reserve expounded on its new average inflation target without committing to fresh actions.  More fiscal stimulus is likely to be forthcoming.  The election will determine the extent and priorities.  Next year, as was the case this year, the US will again likely have the largest budget deficit among the high-income countries. The Federal Reserve meets on November 5.  It does not seem prepared to take new measures.  The possibility of yield curve control appears to have been eclipsed by signals suggesting officials, at some point, may extend the duration of the $80 bln a month of Treasuries currently being purchased.  The decision does not appear imminent.  The Bank of England, the Reserve Bank of Australia, and the European Central Bank are likely to move before the Federal Reserve.  This implies that the dollar may be stronger than we previously anticipated into early next year.  However, when the situation stabilizes, we still expect the twin-deficit meme to frame a trend lower for the dollar.  

Euro:  After falling to nearly $1.16 in late September, the euro trended higher to around $1.1880 in the third week of October. The surging pandemic, which led to new social restrictions that even if they last a month, will sap the recovery that had already appeared to be stalling.  As a rough estimate, a month-long closure may reduce Q4 GDP around 0.5-0.7 percentage points. The ECB has all but formally committed itself to ease policy in December, which could very well include a rate cut in addition to new low rate loans and more bond-buying for longer. The much-heralded joint fiscal initiative (750 bln euro, Recovery Fund) appears bogged down in political negotiations at the European Parliament. Even after the technical details are agreed upon, the use of the funds to enforce the "rule of law" practices will still encounter objections (e.g., Hungary, Poland).  The summer's bullishness toward the euro that had lifted it to $1.20 has been undermined by the virus.  Speculators in the futures market have trimmed their net long euro position, but it remains at a record high but this recent period.  We see these recent developments as tempering the pace of the euro's uptrend we expect, but at this juncture, we do not see it changing the trend.  

 

(end of October indicative prices, previous in parentheses)

 

Spot: $1.1645  ($1.1720) 

Median Bloomberg One-month Forecast $1.1725 ($1.1785) 

One-month forward  $1.1655 ($1.1735)    One-month implied vol  7.9%  (6.5%)    

 

 

Yen:  The Bank of Japan now projects the world's third-largest economy will contract by 5.5% in the current fiscal year that runs through March 2021.  Previously it forecast a 4.7% contraction.  Part of the growth was shifted to FY2021, which is now expected to expand by 3.6% rather than 3.3%.  Prime Minister Suga appears to be preparing for a third supplemental budget for this year that could be formally announced in the weeks ahead.  Talk is of a JPY10 trillion package, of which nearly three-quarters may come from re-directing unspent funds from past budgets.  The US 10-year premium over Japan has trended higher since early August when it was below 50 bp.   Although it is near 80 bp now, it has rarely been lower over the past 30 years.  Moreover, for yen-based investors hedging the dollar currency risk is expensive.  After spending most of the August-September period inversely correlated with the S&P 500 on a purely directional basis, the dollar-yen exchange rate spent most of October positively but albeit slightly, correlated.  

 

Spot: JPY104.65 (JPY105.50)      

Median Bloomberg One-month Forecast JPY104.85 (JPY105.70)     

One-month forward JPY105.00  (JPY105.60)    One-month implied vol  8.0% (5.7%)  

 

 

Sterling:  After falling by about 3.35% in September, sterling rebounded by about 1% in October.  Sterling proved resilient in the face of the brinkmanship tactics that had seemed to end the talks in the middle of the month and rallied when the talks resumed. While many are still hopeful of an agreement, it is not at hand yet, and might not be until closer to the next brink (middle of November).  The implied volatility curve peaks in November and then gradually falls almost two percentage points over the next year.   We remain concerned that many businesses are unprepared, and even with an agreement, disruptions can be significant.   For businesses that rely on product either directly from the UK or EU goods via the UK, inventory management for some industries may be a way to minimize disruption.  The Bank of England meets on November 5 and if it does not extend is Gilt buying, the market will be disappointed.  The bank rate is set at 10 bp, but the bills and Gilt yields through five-years remain below zero.  A ten basis point rate cut is also a possibility.  The BOE has purposely not ruled out adopting a negative interest rate target but has clearly signaled it is not ready.  The UK's budget deficit is expected to be near 14% of GDP this year, among the largest in the G7.  Improvement depends on the course of the virus.   

 

Spot: $1.2950 ($1.2920)   

Median Bloomberg One-month Forecast $1.2975 ($1.2950) 

One-month forward $1.2950 ($1.2930)   One-month implied vol 11.3% (10.7%)

  

 

Canadian Dollar:   The New Democrat Party came to the minority Trudeau government's support twice in recent weeks.  Neither the Liberals nor Conservatives are prepared to go to the polls.  However, minority governments do not typically last more than a couple of years in Canada and the current government has begun its second year.  There is political pressure for Trudeau to re-introduce a new fiscal anchor, but the pandemic does not make it practical. Finance Minister Freeland is expected to provide her first fiscal update in November. The last estimate in July put the deficit at near 16% of GDP, but the new initiatives suggest it may be closer to 18%-19%. The Bank of Canada pledges to keep the target rate at 0.25% until the economic slack is absorbed, which it does not anticipate until 2023.  It no longer will buy mortgage-backed securities.  Perhaps, most importantly, the Bank of Canada will reduce its government bond-buying program to CAD4 bln from CAD5 bln and shift its attention to longer-term bonds.  

 

Spot: CAD1.3320  (CAD 1.3320) 

Median Bloomberg One-month Forecast  CAD1.3285 (CAD1.3275)

One-month forward  CAD1.3300  (CAD1.3325)    One-month implied vol  8.3%  (6.2%) 

 

 

Australian Dollar:  The Australian dollar underperformed last month.  Although the loss was small (~0.5%), it was the only major currency that falls for the second consecutive month.  In addition to the virus, which is daunting enough, Canberra also must cope with expressions of China's displeasure that has impacted trade. The Reserve Bank of Australia has downplayed the efficacy of negative interest rates but has mused aloud about other measures it can take to provide more stimulus.  The next RBA meeting is November 3, and many participants expect a move.  It targets a 25 bp cash rate and three-year bond (yield curve control).  However, the three-year yield is about 11 bp, and the effective cash rare is 13 bp.  The RBA indicated that targeting a longer-dated rate was a possibility.  Although it also cited the possibility of buying foreign bonds, this may be too controversial to venture now.    

 

Spot:  $0.7030 ($0.7160)       

Median Bloomberg One-Month Forecast $0.7115 ($0.7175)     

One-month forward  $0.7030 ($0.7165)     One-month implied vol 12.0%  (10.0%)   

 

 

Mexican Peso:  The Mexican peso was the strongest currency in October, appreciating nearly 6% against the dollar to pare its year-to-date loss to about 9.3%.  The peso's gains are driven by a large trade surplus, strong worker remittances, and portfolio flows attracted by relatively high-interest rates.  The central bank has been signaling that after nearly halving its target rate to 4% and inflation probing the upper end of its 3% +/- 1% target, it was running out of room to cut interest rates further.  However, with President Andres Manuel Lopez Obrador (AMLO) reluctant to use fiscal stimulus, which entails borrowing and boosting debt, it leaves monetary policy as the main tool.  The central bank's decision is finely balanced.  Two of the board's five members thought there is no room to cut rates, and two saw additional scope, leaving one as the tie-breaker.  

 

Spot: MXN21.18 (MXN22.11)  

Median Bloomberg One-Month Forecast  MXN21.60 (MXN22.07)  

One-month forward  MXN21.25 (MXN22.19)     One-month implied vol 20.5% (18.2%)

 

 

Chinese Yuan:  The yuan has been adjusting higher for several months. It finished October near its best level in two years. The increasing integration of China into the global capital markets means that strong portfolio capital inflows compound the yuan's upside pressure stemming from the growing trade surplus. Beijing's strategy appears to be two-fold: accept some appreciation of the yuan and reduce some (not all) regulatory hurdles to capital outflows. We suspect many market participants do not trust the price action and focus instead on the precise mechanism by which the PBOC has managed the pace of the yuan's appreciation. The median year-end forecast in the Bloomberg survey is for CNY6.75.  This may overstate the case.  If, on the other hand, the integration into the global capital markets has required a change in Beijing's strategy, there could be potential toward CNY6.6500 before year-end.  

 

Spot: CNY6.6915 (CNY6.7900)

Median Bloomberg One-month Forecast  CNY6.7210 (CNY6.8125) 

One-month forward CNY6.7150  (CNY6.7935)    One-month implied vol  6.6% (5.9%)

 

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