Mid-Year FX Outlook 2018: Will the USD continue to gain during the second half of 2018?
Developments in the FX market in the first half of 2018 can be divided into two broad themes: USD underperformance in Q1 and USD outperformance in Q2 (the greenback strengthened by 5% in Q2 2018 alone).
Will this trend continue into the second half of 2018? How will this impact other currencies?
The USD struggled in the first half of 2018
The greenback’s muted performance against most of the other majors in Q1 2018 was largely due to optimism stemming from synchronized global growth - the overriding theme for much of 2017.
In its January 2018 World Economic Outlook Update, the International Monetary Fund (IMF) stated that the “pickup in growth has been broad based, with notable upside surprises in Europe and Asia”.
The IMF also made upward revisions to its global growth forecast for 2018 and 2019 to reflect increased global growth momentum.
Chart 1: 1H2018 YTD percentage change
Source: Reuters as of 19 July 2018
At the same time, market anticipation of the European Central Bank (ECB) ending quantitative easing (QE) earlier than previously expected as well as hopes of a soft Brexit saw the EUR and GBP gain substantial ground on the dollar.
Elsewhere, other currencies, ranging from majors such as the JPY, NZD and CHF, to emerging markets like CNH and SGD, also registered decent gains in Q1 2018.
We then saw a spectacular rebound in the USD’s fortunes as a result of the following developments in Q2 2018:
- A string of mediocre economic data out of the Eurozone, the UK and Australia, combined with political turmoil in Italy and Germany and fresh Brexit uncertainty, put the EUR, GBP and AUD on the defensive.
- While fresh doubts arose about growth prospects of other major economies, the US economy motored forward, raising expectations that the Fed would proceed with four rate hikes in total before the end of the year.
- The re-coupling of the greenback with higher US Treasury yields, as well as expectations that the US economy is in a much stronger state to weather ongoing trade disputes, also fueled the dollar rally.
- Trade tensions, which tend to work in the USD’s favour in the short term, also played a part.
As a result, the USD strengthened by 5.0% in Q2 2018 alone.
IS THE DOLLAR BULL RUN SET TO CONTINUE?
As we navigate the second half of 2018, we expect USD strength to continue for the near term as the factors that have contributed to the greenback’s recent outperformance remain largely intact:
- The monetary policy divergence between a hawkish Federal Reserve and cautious ECB, Bank of Japan (BoJ), Bank of England (BoE), Reserve Bank of Australia (RBA) and Reserve Bank of New Zealand (RBNZ) is likely to keep the dollar buoyant in the near term.
- With the US economy being less dependent on exports as compared to other major economies such as China, Japan and Australia, trade tensions should continue to act in favour of the greenback in the short run.
- Data divergence between the US and the other major economies remains very much in evidence of late.
Looking further forward however, the dollar bull run is very likely to run out of steam, which is a scenario we expect to see playing out in the longer term.
- Recent USD strength is pricing in Fed hawkishness. However, once market expectations of four US rate hikes are fully priced in, there would be little upside room left for the greenback.
- With the US yield curve already showing signs of flattening, it is unlikely that the Fed, beyond proceeding with the aforementioned four rate hikes, will dial up its hawkishness any further.
- Despite the relative sluggishness in recent non-US economic data, overall global economic growth still remains resilient, and other major economies should start catching up with the US.
- Trade tensions are incompatible with a stronger USD in the longer term. In addition, trade anxieties should gradually fall away as other economies may come to trade agreements among themselves in response to US protectionism.
Chart 2: USD Performance so far in 2018
Source: Reuters as of 19 July 2018
DIVERGENT MONETARY POLICIES
The single currency is expected to be resilient longer term:
- Although EUR is expected to continue to be under pressure in the short term, its performance is likely to improve
- Eurozone economic data is expected to improve as we progress into the year end and beyond, analysts are mostly of the view that US economic activity is close to its peak.
- Markets should start to gradually price in expectations of ECB rate hikes as we approach and move into 2019.
- The EU has already inked new trade agreements with China and Japan after Washington’s imposition of tariffs, with the possibility of more to follow.
- Political uncertainty in Italy and Germany has subsided and is not expected to pose significant contagion risk going forward.
The AUD expected to recover later this year:
- Recent Australian economic data, especially those regarding inflation and employment, have started to improve.
- Central bank divergence between the Fed and RBA looks set to decrease, with the latter likely to turn more bullish as economic data improves heading into late-2018.
- The recent weakening in CNH is likely to continue weighing on the Aussie in the near term, but the outlook is expected to improve as trade tensions ebb.
- Global growth is expected to remain solid and thus fuel demand for Australian commodities and raw materials, while the Chief Investment Adviser’s view is that metal prices are also likely to remain supportive for the Aussie.
Opportunity to accumulate precious metals at attractive prices:
- Despite a sharp recent decline in the face of a stronger US dollar, gold remains a relatively more attractive safe haven asset to hold in times of uncertainty.
- With inflation likely to pick up as global growth recovers later this year, accumulating bullion now may also enable investors to own a popular inflation hedge.
GBP to endure a continuation of its recent struggles in the near term:
- The recent miss in inflation numbers aside, UK data has seen a marked improvement from the first half of Q2 2018. However, despite signs that the British economy is on the recovery from a sluggish Q1 2018, the pound has continued to trade heavily due to Brexit worries.
- Longer term, if political uncertainty is satisfactorily resolved and results in a soft Brexit, we would expect the GBP to strengthen in line with the economy. This is, however, highly dependent on removal of Brexit negativity.
Near-term continuation of CNH weakness:
The USD’s recent strength, combined with the yuan’s relative stability, means that the currency has some catching up to do.
- China’s deleveraging and easing is likely to see a mirror in the CNH.
- Longer term, however, a weaker USD should impact the CNH favourably, resulting in a more positive outlook for the yuan .