The dollar's losses accelerated in July, and further declines are likely even if there is short-lived bounce to correct the over-extended technical condition.
We have been arguing for a year that the third significant dollar rally since the end of Bretton Woods was over, but the disruption of the global capital markets in March gave the old bull market one more push. In the four-day window between March 19 (for the Canadian and Australian dollars and the Norwegian krone) and March 23, when the euro, Swiss franc, and Swedish krona recorded their lows, the dollar peaked against all the major currencies.
The yen was the exception.
The dollar swung violently between February 20 high for the year (~JPY112.25) to the for the year on March 9 (~JPY101.20) and back toward the highs (~JPY111.70) on March 24. Unwinding yen funding trades, speculative flows anticipating gains as a safe haven and cross-rate adjustments appear to be behind the dramatic moves.
The dollar's decline did not only accelerate but the participation seemed to broaden. Speculators (non-commercials) in the futures market have been net long euros since the middle of March and reduced their net short position in the other major currency futures in recent weeks. An industry survey showed fund managers wanted to be overweight European stocks and the euro. The put-call skew in the options market suggests hedge funds may also be turning more negative toward the dollar.
The crossing of the 50 and 200-day moving averages, dubbed the Golden Cross (or the Deadman's cross, depending on what side you are on) gives a sense of the duration and momentum of the dollar's slide. The moving averages crossed for the euro, Swedish krona, and the Australian dollar in late June. For the Dollar Index, the New Zealand dollar, and the Norwegian krone, the moving averages crossed in July. Of the major currencies, the Canadian dollar's 50 and 200-day moving average is set to cross in the first part of August. Sterling has more work to do.
There are several forces that are weighing on the dollar, most of which we have reviewed here in recent months. Our explanation begins with the breakdown of the capital markets in March that saw the dollar soar. As central banks and governments responded and removed the far lefthand tail risk, the flows reversed. It is not coincidental that the S&P 500 and several major currencies, including the euro bottomed on the same day. As risk-appetites were fanned the dollar was gradually abandoned.
The European Central Bank lent more than a trillion euros to member banks at minus 100 bp and increased its Pandemic Emergency Purchase Program. The EU belatedly agreed on a joint bond issue and 750 bln euro of assistance (loans and grants). These actions recharged the ECB's transmission mechanism as the investors bought peripheral bonds, narrowing interest rate spreads.
Separately, Europe appears to have been considerably more successful than the US in controlling the spread of the virus. This can have knock-on effects in the economy and in the last couple of months, the eurozone purchasing managers survey points to potentially a stronger recovery than the US. Some disappointingly high weekly initial jobless claim, the expiration of an extra $600 a week federal unemployment insurance, and the moratorium on evictions from federally-sponsored housing, while the US was reporting a record number of new virus cases, also weighed on sentiment and fueled ideas of European outperformance.
We do not find the balance sheet developments to be particularly helpful in explaining the dollar's decline, though it is true the Fed's balance sheet has increased by around 70% this year. The greenback was stronger when the Fed was buying $75 bln of Treasuries a day and ramping up its balance sheet than it is now. Moreover, in the four-week period from mid-June to mid-July, the Fed's balance sheet shrank by around $350 bln, as the currency swaps and other facilities were unwound now that the market was functioning, but the dollar did not benefit. During that same period, the ECB's balance sheet jumped by nearly 680 bln euros or more than 11%. The euro's gains accelerated.
Nor does the US November election appear to be playing a role yet in the foreign exchange market. That said, political uncertainty often cited as a negative factor. It could increase in importance as the election draws near. Rhetoric during recent election cycles has been particularly zealous when it comes to China. Several candidates had threatened, for example, to cite China as a currency manipulator, only to back down when they took office. Ironically, the Trump Administration cited China, but it was widely lampooned, and then reversed. The steady yuan that China maintains against the dollar, partly at the US insistence, allows it to depreciate against most of its other trading partners while denying the US any advantage against it from a weaker dollar.
Trends in the foreign exchange market sometimes last for years. If the analysis is right and we can take as confirmation that recent price action that the dollar's multi-year bull market is over, the near down market is still in the early stages. Out of the various forces that drive the $6.6-trillion a day foreign exchange market, that which helps a particular country or countries is not among them. Nevertheless, the current pullback helps ease the cost of servicing of dollar obligations (especially problematic in some emerging market economies), helps lift commodity prices (which also helps many emerging market economies), and makes it easier to rebuild reserves that may have been drawn down earlier in the crisis.
The decline in the dollar that we anticipate should not be seen as a crisis or a challenge to its role in the world economy. There has been a rash of such essays in the financial press and arguments themselves appear to be a product of the dollar's cycle. At the start of the downturn and near the end of it, these claims seem common. Yet, this is to confuse price with function. The dollar's last cyclical low in 2008 saw the euro climb to $1.60, sterling above $2.10, and both the Canadian and Australian dollars were above $1.00. Not only was the dollar's role not in jeopardy, but it is arguably even more important now. One of the factors behind the dollar's status is the breadth and depth of the US Treasury market. In terms of security and transparency, it also knows no rivals. In terms of yield, consider that at the end of July a new high in the total amount of negative-yielding bonds in Europe and Japan was set at more than $15.2 trillion.
Dollar: The dollar's decline ought not to be exaggerated. In the year through July, it is stronger against the currencies of its three largest trading partners: ~15% against the Mexican peso, ~3% against the Canadian dollar, and about 0.2% against the Chinese yuan. President Trump has often advocated a weaker dollar, which is also desirable from a monetary policy point of view. The Federal Reserve appears to have laid the groundwork for more supportive action at its next FOMC meeting (mid-September). Electoral considerations may encourage Congress to approve a stimulus bill before its summer recess currently scheduled to begin August 10. In the current context, not reaching an agreement to increase the US debt, that is, provide more stimulus would likely disappoint investors, spurring a second wave of left-hand tail risk. Look for Federal Reserve official comments especially at the confab late in the month to provide some clues into the next policy steps.
Euro: The 4.7% gain in July was the euro's best monthly performance in a decade. It gained on most of the major currencies, but the Scandis, and lagged behind the gains in the central European currencies. Europe has been an important beneficiary of the turn in dollar sentiment, which is not to diminish the role of the EU and ECB actions that coincided with an acceleration of the euro's appreciation. If the multi-year bear market for the euro is over, these are still the early days. The average rate of the euro over its short life is about $1.20, and there may be potential toward $1.25 by the end of the year. August should be a relatively quiet month for European developments, suggesting that factors abroad and technical considerations may be the key drivers.
(end of March indicative prices, previous in parentheses)
Spot: $1.1780 ($1.1235)
Median Bloomberg One-month Forecast $1.1570 ($1.1225)
One-month forward $1.1785 ($1.1245) One-month implied vol 7.8% (7.1%)
Yen: The dollar's roughly 2.0% decline against the yen in July is modest relative to its performance against the other major currencies but the Canadian dollar. However, it is the largest decline in a year, and most of the losses took place in the second half of July as the lower end of the JPY106-JPY108 range gave way before the dramatic snap back on the last trading day of July. While many Japanese businesses can manage with a stronger yen, as it approaches JPY100, margins may be squeezed. The yen has not only appreciated against the dollar but also appreciated most of its trading partners in Asia this year. Japanese officials may be reluctant to say much for fear of antagonizing the US. No fresh policy initiatives are expected in August, but a supplemental budget is increasingly likely in October, especially in light of the new outbreaks of the virus.
Spot: JPY105.85 (JPY107.95)
Median Bloomberg One-month Forecast JPY106.50 (JPY107.65)
One-month forward JPY105.90 (JPY107.90) One-month implied vol 7.3% (5.8%)
Sterling: The British pound underperformed in the first half. It fell 6.4% and was the second weakest major currency after the Norwegian krone at depreciated by about 8.7%. Sterling lost a little more against the euro. However, July was a different story as both the krone and sterling bounced back. The krone led the majors higher in July (+6.0%), but sterling was among the leaders as well with a gain of a little more than 4.8%. Her Majesty's Treasury is expected to sell GBP500 bln of bonds this year and the Bank of England is committed to purchasing GBP300 bln. The Bank of England purposely refuses to rule out adopting a negative rate policy and UK yields through seven-year maturities are below zero. The Monetary Policy Committee meets on August 8 and although it is unlikely to move, the market will be watching closely for cues. August will be an important month for the UK-EU trade talks. If progress is not reported, investors may begin getting concerned about the potential disruptions.
Spot: $1.3085 ($1.2400)
Median Bloomberg One-month Forecast $1.2820 ($1.2415)
One-month forward $1.3090 ($1.2400) One-month implied vol 8.6% (9.0%)
Canadian Dollar: The Canadian dollar continued to underperform in the broad move against the US dollar. Still, it appreciated by 1.3% in July, which was the least of the major currencies. The greenback finished last year near CAD1.3000. In a soft US dollar environment, it is not uncommon for the Canadian dollar to lag behind the other majors. Although Canada appears to have fiscal space with the lowest debt/GDP ratio in the G7 (~40%), supply concerns loom. The Bank of Canada, like the Federal Reserve, is having continued discussions about yield curve control. It does not meet in August. The Canadian dollar's correlation with the S&P 500 is near 5-6 year highs. Oil prices, and commodity prices more generally, continued to recover in July, which also appears common in a weak US dollar environment.
Spot: CAD1.3410 (CAD 1.3580)
Median Bloomberg One-month Forecast CAD1.3515 (CAD1.3585)
One-month forward CAD1.3415 (CAD1.3575) One-month implied vol 6.3% (7.0%)
Australian Dollar: July was the fourth consecutive monthly advance for the Australian dollar, during which time it has appreciated by roughly 16.5%. It is now higher for the year (~1.75%). The flare-up of the virus in Victoria means more government support is needed and the deficit for the fiscal year that is getting underway is projected to be around 10% of GDP. The government will also extend loan guarantees for small businesses and extend the Job Seeking and Job Keeping programs that were to initially terminate at the end of this quarter. The central bank could increase its bond purchases if necessary. Central Bank Governor Lowe has suggested there is room to shave the 25 bp cash rate to 10 bp, but seems reluctant to adopt negative interest rates. Separately, tensions with China are rising, and its relationship with the US, with whom it has a trade deficit, remains strong. The correlation between the Australian dollar and Chinese equities has declined for the second consecutive month.
Spot: $0.7145 ($0.6900)
Median Bloomberg One-Month Forecast $0.7035 ($0.6870)
One-month forward $0.7150 ($0.6905) One-month implied vol 10.4% (10.9%)
Mexican Peso: Banxico meets on August 13 and it has scope to cut the target rate, currently at 5%. Inflation rose to 3.3% in June and it might have accelerated a little more in early July. However, officials see deflationary forces being stronger. The economy contracted by 17.3% quarter-over-quarter in Q2 and is among the hardest-hit economies. There is probably scope for 50-75 bp off the cash rate this year. The optimists think it may take two years for output to return to pre-pandemic levels. The peso appears more a bellwether of global risk appetites than a product of domestic economic forces. The dollar fell about 3.1% against the peso in July, leaving it up about 17.7% for the year. Since the first part of June, the dollar has been confined to a broad range of roughly MXN21.45 to MXN23.23. The lower end of the range held in the second half of July, leaving it poised to test the upper end in the first part of August.
Spot: MXN22.27 (MXN22.99)
Median Bloomberg One-Month Forecast MXN22.12 (MXN22.77)
One-month forward MXN22.37 (MXN23.09) One-month implied vol 14.7% (18.8%)
Chinese Yuan: The yuan remains a closely managed currency even if direct intervention does not need to be relied upon. The 1.25% appreciation in July reflects two main forces: the dollar's broad weakness and the rally in Chinese equities that caught many asset managers underweight. Chinese officials seemed to encourage domestic investors and raised the limit insurance companies can invest in stocks. Beijing's monetary and fiscal response has been relatively muted, but many banks have frontloaded the lending allowed under this year's quota and some decisions will likely be required by early Q4. For over a year, the dollar has been confined to a broad trading range of CNY6.8200 to CNY7.1850. Chinese officials are likely to ensure the adjustment is gradual.
Spot: CNY6.9750 (CNY7.0655)
Median Bloomberg One-month Forecast CNY7.0165 (CNY7.0670)
One-month forward CNY7.0795 (CNY6.9995) One-month implied vol 4.4% (4.2%)