• Investment
  • 12 July 2018

Limitations to stronger USD

Limitations to stronger USD

Highlights

  • The USD rally is not yet complete but we expect its momentum to ease with the approach of peak policy divergence
  • European growth are showing signs of green shoots, challenging the presumption of US growth exceptionalism
  • Drag from weaker EURUSD on Emerging Market (EM) currencies may be past its worst

The USD rally is not yet complete but we expect its momentum to ease. Trade tensions have returned to the forefront after the US administration proposed 10% tariffs on an additional $200bn of imports from China. This has rekindled anxieties over Asian currencies and G10 China proxies such as AUD and NZD. This tariff announcement starts the process for a public consultation period, which is expected to close by the end of August. During this period, US and Chinese diplomats will likely try to negotiate a compromise to prevent the implementation of this large increase in trade tariffs.

USD approaching peak policy divergence after winning the beauty contest in 1H18

Source: Bloomberg, Bank of Singapore

We classify the recent USD advance as corrective, offering medium-term USD selling opportunities.  USD won the currency beauty contest in the first half of 2018, as strong growth leadership from the US contrasted with negative growth surprises outside of the US, putting the narrative of monetary policy divergence between the Fed and other major central banks in focus. However, the USD could be approaching peak divergence, which supports our medium-term base case for policy re-convergence driving a resumption of USD downtrend.

Protectionism escalation risks linger, but non-US growth indicators are showing signs of green shoots, challenging the presumption of US growth exceptionalism behind the USD run-up in 1H18. 

European data suggest that the region’s early year slumber is ending, with Germany's May factory orders and industrial production exceeding expectations. Improving European data has helped the US-Eurozone economic surprise index divergence to narrow.

EUR may be close to bottoming out as European data surprise index rebounds

Source: Bloomberg, Citigroup, Bank of Singapore

Risk of renewed tension between the EU and Italy when the new Italian government presents its first budget in September remains a headwind to our positive medium-term EUR outlook. However, EUR headwinds have moderated, with the bounceback in European data likely to pull forward market pricing for the first 20bp rate hike by the ECB from around early 2020. It helps that the compromise over migration has kept the German government together and Eurozone political noise should quiet down as parliaments enter summer recess.

Consistent with the evidence that the 1Q18 growth slowdown outside the US could prove temporary, central bankers from Canada, UK, Sweden, Norway and the Eurozone have sent messages that tightening plans remain on course. There were media reports that some ECB policymakers thought market pricing for interest rate hikes by end 2019 were too low.

Just as EURUSD weakness was partly responsible for the EM turmoil earlier in the year, a stabilising EURUSD would be a much needed cushion for EM in a less friendly EM environment of higher US rates as well as trade tensions. With the EURUSD close to bottoming out, it is likely EM FX can start to trade better if the US and China can reach a negotiated settlement on the trade issue before the mid-term US elections in November.

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