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Quarterly Outlook
Q1 Outlook: The path to a weaker USD may be rocky
John J. Hardy
Global Head of Macro Strategy
Global Head of Macro Strategy
Summary: It may take some time for the Fed to execute a full reversal of its tightening course, and the lack of bright spots elsewhere in the global economy as the year gets under way may mean that the path to a persistently weaker USD is a rocky one.
The last quarter of 2018 was clearly the worst quarter of what many have touted as a downright annus horribilis for global asset markets. Equity markets suffered their worst December in modern market history on concerns that weakening global growth, a tight Federal Reserve, poor USD liquidity and a US-China trade war all spell doom for the global economy.
Even outside of equities, returns were weak, and no asset class put in a strong performance for the calendar year – one of the worst cross-asset market performances in decades. Currencies finished the year with generally low volatility as the USD was caught in the crossfire of conflicting themes and China’s heavy hand in support of a CNY floor muted activity. Still, the very tail end of the year saw a last-minute melt-up in the JPY after the December 20 Federal Open Market Committee and Bank of Japan meetings and subsequent risk deleveraging.
The mood brightened in the first week of 2019 when Fed chair Jerome Powell pivoted from his tone-deaf performance at the December 20 FOMC press conference and made clear that the Fed is listening to the signals that the market is sending, even as he praised the strength of the US economy and argued that the barrage of Treasury issuance (made worse by the Fed’s balance sheet reductions, or quantitative tightening) was not a key part of the market turbulence.
Powell will continue to listen to markets in 2019. He is rightly seen as a different breed from his more academically oriented predecessors, often stressing that financial stability risks are the most likely source of the next crisis, not overheating wages and inflation. That means he will be happy to resume hiking rates if the markets and data permit, and will only pause or reverse at a sufficiently high pain threshold.
Still, the direction change from the Fed towards the end of the year is a first key step in what could prove a drunken stagger towards a weaker USD, and one that will gain momentum once the Fed is forced into a full reverse by a weakening US economy in the coming quarters. The tricky bit is that markets appreciate liquidity in tough times, and the US dollar and US Treasury debt are the most liquid of instruments in times of market volatility. So, if we are headed for a further downdraft in global asset markets on concerns about the US and global growth outlook (and importantly, the earnings outlook), the USD may rally steeply at times, just as it did during the global financial crisis even as the Fed chopped rates towards zero and launched its first round of QE.
Looking beyond the dollar, the most important question across the major currencies is clearly China’s intentions for the renminbi as it faces tremendous pressure to devalue. We’re somewhat torn on what China will choose to do with its currency. When Brent oil was trading well above $80/ barrel just a few months ago, it was easy to argue, as we did, that China would prefer to maintain a floor for its exchange rate, if nothing else to ensure that it could afford its enormous oil import bill. But after the hefty drop in energy prices, China has more leeway to allow a weaker renminbi, even if it will likely continue to keep a floor under the currency at least so long as trade talks with the US continue as proof of good faith. In general, China may be unwilling to devalue the renminbi dramatically against the USD, and it could even rise together with other currencies versus the USD once the greenback rolls over later this year.
As China continues to pursue its deleveraging, now apparently offset slightly by new attempts at stimulus as 2019 gets under way, the one imperative will be to keep nominal growth of China’s economy advancing rapidly to avoid a deflationary dynamic, particularly in housing.
The greatest gift to China’s policy flexibility in that regard would be a US economy that rolls over and requires a more profound shift in the Fed’s stance and outright easing, thus improving the global USD liquidity that is critical for funding too much of the world’s debt. The entire world’s financial system, China included, remains far too vulnerable to USD liquidity shocks, and the next crisis will inevitably bring a more serious effort to develop an international reserve currency.
In our last Quarterly Outlook, we argued that the quickest route to a US dollar reversal was through further rises in US yields and the USD: “The US dollar and US rates can only rise so far from here before something – or rather more things – break.” US yields were the first to break down with Treasuries serving as a safe haven as equity markets sold off heavily last quarter. At the end of the quarter, the USD finally weakened as the Fed was seen feeling around for the strike price of the Powell put.
A few thoughts on the major and emerging-market currencies in Q1:
USD – TURNING, BUT HOW QUICKLY? 2019 is getting under way with a weaker US dollar as the Fed appears to have finally realised that its policy mix and guidance were already beyond what the market can bear. The risk for USD bears is that the market over-celebrates the Fed’s turn, which is so far just a deceleration. A further calming of financial conditions and a continued spike in US wages could even see the Fed making one last hike in March, but in general we think that the Fed is done for the cycle. The question now is the time from the last hike to the first cut – whether to interest rates or to the pace of QT.
EUR – SIDELINED FOR NOW. Last quarter we tried to wax positive on the euro as we sensed that the curtains have closed on the age of austerity and that the European Union is nearing the moment when fiscal expansion will return. Indeed, the yellow vest protesters in France have thrown French president Emmanuel Macron’s budget discipline to the winds even if Italy has backed down this time around in its showdown with the EU over its budget. Our fear now, however, is that the concerns about the rise of populism that weighed on the euro at the beginning of 2017 ahead of key elections have returned and could dog the euro before EU parliamentary elections in May. Will EU leaders pull their message together and open the fiscal window before those elections? It’s doubtful, as EU political leaders seem unable to move until a crisis is in full swing. Furthermore, Brexit weighs at the margins, and the euro could continue to fail to strengthen.
JPY – ANOTHER LEG HIGHER AND THE NEXT WAVE OF BOJ POLICY? The JPY dragon was finally awoken by a tardy response to the wave of risk deleveraging that washed over global markets in Q4, and as the long end of the US yield curve was smashed back from whence it came. Japan’s economy faces an ugly outlook into 2019, as Japan is a large current account surplus country and its economy fell into negative growth in Q3 just as the currency was set to revalue higher coming into 2019. The Kuroda BoJ may be the first global central bank to innovate the next round of unconventional policy, which could potentially be some version of debt monetisation and/or enabling fiscal projects that force money into the economy through wage boosts or similar. Q1 is too early for this, though, and there’s more upside than downside risk in broad terms for the yen until then.
GBP – ARTICLE 50 DEADLINE TO COME AND GO WITH NO END TO BREXIT IN SIGHT? The March 29 Article 50 deadline is rapidly approaching, and we’re none the wiser on where Brexit is headed. Assuming the likely failure of UK prime minister Theresa May’s ill-fated deal, Britain is potentially headed towards a no-deal Brexit that becomes a “semi-deal” Brexit hammered out over the coming months after a significant delay beyond the Article 50 deadline on March 29. Even a second referendum would likely take us beyond the deadline. In any case, sterling may remain bottled up for most of the quarter before eventual significant two-way potential.
CHF – TOO STRONG, BUT FOR A REASON. Market volatility and the risk that we don’t get a firm conclusion on where Brexit is headed in Q1 could keep a bid in place under the Swiss franc. In Q2, the EU parliamentary elections in May and concerns over the populist uprising are existential risks while the EU’s leadership dithers and could continue to drive CHF resilience as well.
CAD, AUD AND NZD – DIVERGING PATHS. AUD and NZD will feel the gravity from a stable renminbi, which has helped prevent more extensive downside for the Aussie on what looks like an Australian housing bubble in full unwind as 2019 gets under way. The bursting of that bubble next year could threaten Australia with its first recession since the early 1990s. AUD may escape more aggravated downside if China keeps the renminbi stable and commodity prices in check. Meanwhile, the CAD faces housing-bubble risks of its own, as well as risks linked to the collapse in crude oil prices next year. Canadian prime minister Justin Trudeau has just rolled out a carbon tax that could also weigh on growth at the margin, though he is likely to do everything in his power to juice the economy ahead of federal elections in October.
NOK AND SEK – TOO LONG NEGLECTED. The Scandies’ comeback we anticipated was derailed by a collapse in crude oil prices in the case of NOK, and by a weakening European economy and weak risk appetite in SEK. SEK did offer resilience over the last few months but couldn’t engineer a more notable break higher against the euro even as European Central Bank tightening appears permanently off the table and the Riksbank managed to carry out its first rate hike in over seven years in December. Still, we prefer SEK strength relative to the euro. Meanwhile, for the coming year, NOK could outperform SEK on an eventual global reflation theme driven by China.
EM CURRENCIES – CHEAPER US DOLLAR VERSUS GLOBAL GROWTH PROSPECTS. EM currencies put on a show of strength in the fourth quarter – not so much in absolute terms, but most certainly relative to the very ugly backdrop of worsening financial conditions and a meltdown in equity markets. Given our global growth concerns for early 2019, we wouldn’t expect notable strength on the risk of USD funding issues and credit spread widening risks, but for forward growth potential, EM economies are strongly preferred. For now, we prefer a stance of fading excessive weakness rather than anticipating trending strength in early 2019.
Even outside of equities, returns were weak, and no asset class put in a strong performance for the calendar year – one of the worst cross-asset market performances in decades. Currencies finished the year with generally low volatility as the USD was caught in the crossfire of conflicting themes and China’s heavy hand in support of a CNY floor muted activity. Still, the very tail end of the year saw a last-minute melt-up in the JPY after the December 20 Federal Open Market Committee and Bank of Japan meetings and subsequent risk deleveraging.
The mood brightened in the first week of 2019 when Fed chair Jerome Powell pivoted from his tone-deaf performance at the December 20 FOMC press conference and made clear that the Fed is listening to the signals that the market is sending, even as he praised the strength of the US economy and argued that the barrage of Treasury issuance (made worse by the Fed’s balance sheet reductions, or quantitative tightening) was not a key part of the market turbulence.
Powell will continue to listen to markets in 2019. He is rightly seen as a different breed from his more academically oriented predecessors, often stressing that financial stability risks are the most likely source of the next crisis, not overheating wages and inflation. That means he will be happy to resume hiking rates if the markets and data permit, and will only pause or reverse at a sufficiently high pain threshold.
Still, the direction change from the Fed towards the end of the year is a first key step in what could prove a drunken stagger towards a weaker USD, and one that will gain momentum once the Fed is forced into a full reverse by a weakening US economy in the coming quarters. The tricky bit is that markets appreciate liquidity in tough times, and the US dollar and US Treasury debt are the most liquid of instruments in times of market volatility. So, if we are headed for a further downdraft in global asset markets on concerns about the US and global growth outlook (and importantly, the earnings outlook), the USD may rally steeply at times, just as it did during the global financial crisis even as the Fed chopped rates towards zero and launched its first round of QE.
Looking beyond the dollar, the most important question across the major currencies is clearly China’s intentions for the renminbi as it faces tremendous pressure to devalue. We’re somewhat torn on what China will choose to do with its currency. When Brent oil was trading well above $80/ barrel just a few months ago, it was easy to argue, as we did, that China would prefer to maintain a floor for its exchange rate, if nothing else to ensure that it could afford its enormous oil import bill. But after the hefty drop in energy prices, China has more leeway to allow a weaker renminbi, even if it will likely continue to keep a floor under the currency at least so long as trade talks with the US continue as proof of good faith. In general, China may be unwilling to devalue the renminbi dramatically against the USD, and it could even rise together with other currencies versus the USD once the greenback rolls over later this year.
As China continues to pursue its deleveraging, now apparently offset slightly by new attempts at stimulus as 2019 gets under way, the one imperative will be to keep nominal growth of China’s economy advancing rapidly to avoid a deflationary dynamic, particularly in housing.
The greatest gift to China’s policy flexibility in that regard would be a US economy that rolls over and requires a more profound shift in the Fed’s stance and outright easing, thus improving the global USD liquidity that is critical for funding too much of the world’s debt. The entire world’s financial system, China included, remains far too vulnerable to USD liquidity shocks, and the next crisis will inevitably bring a more serious effort to develop an international reserve currency.
In our last Quarterly Outlook, we argued that the quickest route to a US dollar reversal was through further rises in US yields and the USD: “The US dollar and US rates can only rise so far from here before something – or rather more things – break.” US yields were the first to break down with Treasuries serving as a safe haven as equity markets sold off heavily last quarter. At the end of the quarter, the USD finally weakened as the Fed was seen feeling around for the strike price of the Powell put.
A few thoughts on the major and emerging-market currencies in Q1:
USD – TURNING, BUT HOW QUICKLY? 2019 is getting under way with a weaker US dollar as the Fed appears to have finally realised that its policy mix and guidance were already beyond what the market can bear. The risk for USD bears is that the market over-celebrates the Fed’s turn, which is so far just a deceleration. A further calming of financial conditions and a continued spike in US wages could even see the Fed making one last hike in March, but in general we think that the Fed is done for the cycle. The question now is the time from the last hike to the first cut – whether to interest rates or to the pace of QT.
EUR – SIDELINED FOR NOW. Last quarter we tried to wax positive on the euro as we sensed that the curtains have closed on the age of austerity and that the European Union is nearing the moment when fiscal expansion will return. Indeed, the yellow vest protesters in France have thrown French president Emmanuel Macron’s budget discipline to the winds even if Italy has backed down this time around in its showdown with the EU over its budget. Our fear now, however, is that the concerns about the rise of populism that weighed on the euro at the beginning of 2017 ahead of key elections have returned and could dog the euro before EU parliamentary elections in May. Will EU leaders pull their message together and open the fiscal window before those elections? It’s doubtful, as EU political leaders seem unable to move until a crisis is in full swing. Furthermore, Brexit weighs at the margins, and the euro could continue to fail to strengthen.
JPY – ANOTHER LEG HIGHER AND THE NEXT WAVE OF BOJ POLICY? The JPY dragon was finally awoken by a tardy response to the wave of risk deleveraging that washed over global markets in Q4, and as the long end of the US yield curve was smashed back from whence it came. Japan’s economy faces an ugly outlook into 2019, as Japan is a large current account surplus country and its economy fell into negative growth in Q3 just as the currency was set to revalue higher coming into 2019. The Kuroda BoJ may be the first global central bank to innovate the next round of unconventional policy, which could potentially be some version of debt monetisation and/or enabling fiscal projects that force money into the economy through wage boosts or similar. Q1 is too early for this, though, and there’s more upside than downside risk in broad terms for the yen until then.
GBP – ARTICLE 50 DEADLINE TO COME AND GO WITH NO END TO BREXIT IN SIGHT? The March 29 Article 50 deadline is rapidly approaching, and we’re none the wiser on where Brexit is headed. Assuming the likely failure of UK prime minister Theresa May’s ill-fated deal, Britain is potentially headed towards a no-deal Brexit that becomes a “semi-deal” Brexit hammered out over the coming months after a significant delay beyond the Article 50 deadline on March 29. Even a second referendum would likely take us beyond the deadline. In any case, sterling may remain bottled up for most of the quarter before eventual significant two-way potential.
CHF – TOO STRONG, BUT FOR A REASON. Market volatility and the risk that we don’t get a firm conclusion on where Brexit is headed in Q1 could keep a bid in place under the Swiss franc. In Q2, the EU parliamentary elections in May and concerns over the populist uprising are existential risks while the EU’s leadership dithers and could continue to drive CHF resilience as well.
CAD, AUD AND NZD – DIVERGING PATHS. AUD and NZD will feel the gravity from a stable renminbi, which has helped prevent more extensive downside for the Aussie on what looks like an Australian housing bubble in full unwind as 2019 gets under way. The bursting of that bubble next year could threaten Australia with its first recession since the early 1990s. AUD may escape more aggravated downside if China keeps the renminbi stable and commodity prices in check. Meanwhile, the CAD faces housing-bubble risks of its own, as well as risks linked to the collapse in crude oil prices next year. Canadian prime minister Justin Trudeau has just rolled out a carbon tax that could also weigh on growth at the margin, though he is likely to do everything in his power to juice the economy ahead of federal elections in October.
NOK AND SEK – TOO LONG NEGLECTED. The Scandies’ comeback we anticipated was derailed by a collapse in crude oil prices in the case of NOK, and by a weakening European economy and weak risk appetite in SEK. SEK did offer resilience over the last few months but couldn’t engineer a more notable break higher against the euro even as European Central Bank tightening appears permanently off the table and the Riksbank managed to carry out its first rate hike in over seven years in December. Still, we prefer SEK strength relative to the euro. Meanwhile, for the coming year, NOK could outperform SEK on an eventual global reflation theme driven by China.
EM CURRENCIES – CHEAPER US DOLLAR VERSUS GLOBAL GROWTH PROSPECTS. EM currencies put on a show of strength in the fourth quarter – not so much in absolute terms, but most certainly relative to the very ugly backdrop of worsening financial conditions and a meltdown in equity markets. Given our global growth concerns for early 2019, we wouldn’t expect notable strength on the risk of USD funding issues and credit spread widening risks, but for forward growth potential, EM economies are strongly preferred. For now, we prefer a stance of fading excessive weakness rather than anticipating trending strength in early 2019.