Midyear FX Outlook: The Mighty Buck’s Return Is Nigh

The question on every investor’s lips is, “when will the Fed raise interest rates?”

Global currency markets continue to flounder in an environment of low volatility and volume despite being punctuated by periods of geopolitically induced risk events.

The ongoing Russia-Ukraine conflict remains a significant concern that was heightened by a Malaysian jetliner being was shot down by a missile in Ukrainian airspace in mid-July, as does Israel’s military foray into the Gaza Strip. While distressing events such as these predictably prompt investors to charge into safe-haven assets such as the yen, gold, and U.S. Treasurys, financial market indifference to both long-running conflicts is such that risk-averse sentiment doesn’t last long.

The U.S. dollar’s performance has been mixed against a number of currencies in the first half of the year. The greenback gained broad support in July from the Federal Reserve’s monthly Beige Book that showed the U.S. economy is expanding at a moderate pace with consumer spending rising and manufacturing expanding. Questions abound over when the Fed will tighten interest rates, with hawkish members on the Federal Open Market Committee hinting at mid-2015.

In the U.K., economists remain puzzled over country’s recovery. Investors expect the Bank of England (BoE) to raise interest rates before the calendar year is out. Meanwhile in the eurozone, the European Central Bank (ECB) continues to grapple with propping up the currency bloc’s uneven and economic turnaround.

Across the Asia-Pacific region, the yen remains the go-to safe-haven currency. Its support is strong despite economists’ weakening growth outlook for the unit based on the Shinzo Abe government’s controversial consumption tax hike implemented in Japan last April. China’s runaway real estate sector, meanwhile, is giving the world the jitters of late. The Australian economy is mired in doubt – China is Australia’s largest trading partner – while the Reserve Bank of Australia (RBA) governor gives the Aussie repeated tongue-lashings in an effort to talk the currency down.

The Greenback Will Rise Again

Soft data in the early half of the year squelched U.S. economic growth but with the thawing of a severe winter, growth gradually resumed and data has improved significantly as the American unemployment rate fell to 6.1% in June from 6.3% in May.

Excluding GBP, the USD has proven resilient against the EUR but weak against commodity-driven currencies such as the CAD. The picture will likely change in the second half of the year: the greenback is expected by many to strengthen against the euro, yen, and Canadian loonie.

The question on every investor’s lips is, “when will the Fed raise interest rates?” With the Fed’s quantitative easing program due to end in October, Chair Janet Yellen must cautiously navigate the world through uncertain and potentially hazardous economic waters. After all, it’s well known that if the Fed coughs the planet catches a cold, or so to speak.

At the start of the year, U.S. economic growth was expected to be near 3% and it now sits at about 2.5%. As the recovery solidifies stateside, a shift away from consumer-led resurgence toward business investment should bolster the American economy, but many economists have downgraded their U.S. gross domestic product growth expectations for the latter half of 2014 to 1.6% — well below the 2013 pace of 2.6%.

Bets on British Rate Hike

Of all the major central banks investors expect will be the first to raise interest rates, it’s the BoE that most have pegged for a November rate hike. The BoE’s Monetary Policy Committee (MPC) unanimously voted to maintain the bank’s rate at the record low 0.5% and its stimulus program at £375 billion in July.

Unemployment on the British Isles has dropped below the bank’s targeted level – its lowest rate since 2008 – and inflation (at 1.9% in June) has neared the Old Lady’s preferred 2% threshold. But BoE Governor Mark Carney and his cohorts are leery of squeezing the life out of Britain’s tentative economic recovery by acting too aggressively, too soon.

There’s also the matter of Scotland holding a referendum in September to see if there’s a real appetite among the citizenry to break away from England and re-establish its independence. It will indeed be interesting to see how the referendum plays out. The most recent polls suggest the “No” campaign (pro-U.K.) has an estimated 16-point lead over the separatists.

British Prime Minister David Cameron will face the voting public in early 2015 in his bid for re-election. Provided Scotland votes to stay put it is expected he will fare well in the next federal election. That any notion of an independent Scotland would be allowed to share the pound with the rest of the U.K. is a “dead parrot” (apologies to Monty Python) certainly aids both the No campaign’s and Cameron’s election hopes.

As German Economy Weakens, Eurozone Wobbles

The 18-member single currency, the EUR, is under pressure from weaker activity data and asset market underperformance. The unit is currently within striking distance to this year’s low in January (€1.3473). Any momentum through key support levels for the EUR outright should be capable of dragging both the JPY and GBP higher through significant resistance levels on the cross play.

Short of printing money, what else can the ECB do to prop up the currency bloc’s uneven recovery? An accommodative fiscal policy could inject volatility back into the EUR trade and a shift in interest rates would aid the euro by weakening it but there are no guarantees.

Recurring soft data has exacerbated the situation of late with the eurozone’s three biggest economies – Germany, France, and Italy – all experiencing declines in industrial production. That Germany’s economy appears to be slowing down should set off alarm bells across the region as there is no other member state whose economy is anywhere near as resilient.

Abenomics or Abegeddon?

Japan’s economic policy, known as ‘Abenomics’, is based on “three arrows”: fiscal stimulus, monetary easing, and structural reforms. Tokyo’s ultimate goal is to lift Japan’s flagging economic growth rate and the first two arrows have proven successful, but the third arrow of economic reform has yet to be shot. The sales tax hike implemented in Japan last April resulted in a weakening growth outlook for the yen and yet the unit remains well supported. The initial drop in consumer consumption when the tax was introduced has since eased, prompting the Bank of Japan (BoJ) to upgrade its view on the economy in July.

Japan’s export-driven economy requires a weaker yen to boost exports and economic growth. The short-yen trade dominated many forex portfolios in 2013 and it was expected to continue in 2014. The JPY’s role as a safe-haven currency remains intact. Will the EUR/JPY trade force the BoJ to unleash a fresh blast of stimulus?

Further complicating matters is Japan’s quarrelsome relationship with China over territorial claims in the East China Sea. The unending dispute highlights Japan’s need for the Trans-Pacific Partnership (TPP) free-trade agreement to be ratified as a counterweight for Japan to compete with the growing economic behemoth that is China. And the TPP is tightly linked to Abe’s third arrow of economic reform.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.

Dean Popplewell

Dean Popplewell

Vice-President of Market Analysis at MarketPulse
Dean Popplewell has nearly two decades of experience trading currencies and fixed income instruments. He has a deep understanding of market fundamentals and the impact of global events on capital markets. He is respected among professional traders for his skilled analysis and career history as global head of trading for firms such as Scotia Capital and BMO Nesbitt Burns. Since joining OANDA in 2006, Dean has played an instrumental role in driving awareness of the forex market as an emerging asset class for retail investors, as well as providing expert counsel to a number of internal teams on how to best serve clients and industry stakeholders.
Dean Popplewell