MARKET TONE
Broad USD strength is persisting, contrary to our expectations that the second half of the year would present a more challenging environment for it. The Federal Reserve (Fed) raised its policy rate to 5.50% in late July, and US yields have risen significantly since June due to resilient economic data and the belief that Fed policy will remain tight for an extended period. At the same time, the international environment has weakened and China’s growth rebound has failed to develop, leaving a weaker yuan (CNY) and adding to the strong, overall tone of the USD. The USD's essential support comes from its still favourable growth and yield advantages over major currency peers.
Prospects for a US soft landing have improved, and there are signs that the Fed is making progress toward its inflation goals. We do not anticipate the Fed tightening further and still expect growth to slow as the labour market softens and consumers retrench. The USD is trading stronger than expected, but the positive cyclical backdrop is largely factored in, and its broader upside potential is limited. With the Fed's tightening cycle seemingly complete, in our opinion, markets may soon begin to consider more precisely when and how quickly US rates will retreat. More neutral messaging on the policy outlook from the Fed or weaker economic data could be the catalyst for markets to reconsider the outlook for a still relatively expensive-looking USD.
Longer run structural challenges for the USD continue to linger in the background but are not a significant factor in USD sentiment at present. We mentioned rising deficits as a potential headwind for the USD in our July update, something that Fitch’s decision to cut the United States’ credit rating by one notch (to AA+) in August underscores. Fitch noted that it expects the US fiscal backdrop to weaken in the next few years and commented that governance in US fiscal and debt matters had deteriorated. We do not believe the “de-dollarization” issue represents a major challenge to the USD at present as there are no obvious alternatives but these sorts of developments will clearly stoke the debate about the USD’s status as the primary global reserve currency.
The Canadian dollar (CAD) has been unable to resist the broader USD advance since mid-year. The Bank of Canada (BoC) raised its benchmark rate to 5.00% in July and stood pat at its September policy decision. Short-term yield differentials have widened in favour of the USD in recent weeks while the CAD has failed to find any clear support from steady to firmer commodity prices which have boosted Canada’s terms of trade somewhat. Canadian data reports have suggested some slowing in growth momentum but there is still some evident resilience in the economy. The latest employment report delivered a stronger-than-expected increase in jobs and a healthy gain in hours worked in August which rather suggests activity may pick up again. The CAD is trading well below our forecast levels for Q3 but the currency looks undervalued from a fundamental point of view and the risk of more tightening from the BoC before year end is perhaps higher than markets are pricing at present. The CAD could still end the year close to 1.30. The Australian dollar (AUD) and New Zealand dollar (NZD) rank as the weakest performing major currencies in Q3 so far. Disappointing Chinese growth trends are weighing on AUD sentiment while New Zealand terms of trade have remained soft amid sliding dairy prices.
In Mexico, the peso (MXN) weakened in August, posting its first monthly decline this year. Losses have extended in September so far. Mexican yields remain attractive, but investors may be reducing exposure to the MXN after a solid run to multi-year highs against the USD (which is down more than 13% against the MXN over the past year). Domestic yields have likely peaked and focus on the potential for rate cuts to start late this year as well as domestic issues (such as the looming election cycle) may be encouraging profit-taking. We anticipate USDMXN ending the year at 17.90. Elsewhere in the Pacific Alliance, currency performance so far in Q3 largely reflects underlying economic conditions. The Colombian peso (COP) has strengthened modestly amid resilient domestic growth trends; firmer crude oil prices are adding to tailwinds. But the weaker performances of the Peruvian sol (PEN) and Chilean peso (CLP) are a sign of weaker economic conditions and building pressure for more accommodative monetary policy settings.
Both the euro (EUR) and the pound (GBP) have retreated from their mid-year highs against the USD, and the case for renewed gains has been undermined by persistently higher US interest rates and more USD-supportive yield differentials in recent weeks. The European Central Bank (ECB) raised interest rates for the tenth time this month but indicated the policy cycle may be complete. The Eurozone economy slipped into a mild recession around the turn of the year and growth trends remain anemic. Germany’s industrial sector has been weakened by soft foreign demand (China). Inflationary pressures in the Eurozone remain elevated, with headline and core inflation stuck around the 5% mark, but this final rate hike may satisfy ECB policymakers that they have done enough to curb prices. A maturing interest rate cycle may revive foreign interest in Eurozone stocks that helped support EUR gains earlier this year but investors, who remain broadly bullish on the EUR outlook, may start to reconsider positioning amid weak growth trends. The EUR’s recent losses have been disappointing from our point of view but its overall performance so far this year has been resilient.
Positive yield differentials relative to the USD have supported a 3% GBP gain versus the USD in year-to-date terms. While the BoE tightening cycle is maturing, rates may have to stay high for some time to bear down on elevated UK inflation (6.8% in the July year) amid a still relatively resilient economy. Recent economic revisions showed the UK economy returned to pre-pandemic levels at the end of 2021; previously, data had suggested the economy remained just below its pre-Covid peak through Q2 this year. Markets anticipate slower rate reductions in the UK relative to the US and Eurozone in the next few quarters which should provide the GBP with some broader underpinning.
The change in leadership at the Bank of Japan (BoJ) has led to a subtle change in approach to monetary policy settings. The central bank is tolerating somewhat higher long-term yields (the 10Y government bond yield touched 0.7% for the first time since 2014) and Governor Ueda suggested the central bank could exit negative rates next year if it was confident that wages and prices were rising sustainably. The change in policy tack may reflect market and economic conditions but may also have aim of providing the yen (JPY) with some support after the USD strengthened to near JPY148 at the start of September. Recall that the BoJ intervened directly in support of the JPY last year when the USD breached the JPY150 level. Peak US yields should limit broader USD gains but achieving our year-end target of 135 will likely necessitate a more supportive yield differential environment for the JPY.
Shaun Osborne, Canada 416.945.4538
FEDERAL RESERVE & BANK OF CANADA MONETARY POLICY OUTLOOK
FEDERAL RESERVE—TOO SOON TO DECLARE VICTORY
The Federal Reserve is likely to keep its policy rate unchanged at 5.5% on September 20th while leaving the door open to the possibility of further tightening if required. The modest upside surprise in August’s core CPI reading will likely weigh on the minds of FOMC participants as they submit forecasts ahead of the meeting. What is nevertheless likely to dominate caution on the game day decision itself is uncertainty around the lagging effects of what they’ve done to date, the lagging effects of credit tightening net of resilient equities, plus key wildcard risks like a potential government shutdown and a likely UAW strike that could combine to drive GDP negative into Q4 with associated effects on the dual mandate variables. The FOMC will cite progress while remaining loathe to prematurely declare victory over inflationary imbalances especially in light of three prior soft patches for inflation during the pandemic that did not end well.
BANK OF CANADA—STILL ON GUARD
Scotiabank Economics expects the Bank of Canada to set a high bar for further tightening while remaining open to the possibility. One part of the reason is to manage markets that may otherwise prematurely price easing, but there is also a fundamentals argument for elevated inflation risk. Further gains in the terms of trade are being buoyed by energy prices and an undervalued currency that for now are helping to insulate against some of the deterioration in competitiveness. A round of fiscal stimulus measures is likely to unfold across the Federal and provincial governments on the path to upcoming Fall updates. Surging immigration is adding more to demand-side pressures than it is benefiting the supply side. Surging wage gains alongside tumbling productivity are both inflationary effects. Inventories in key sectors like housing and autos remain lean as offsets to other improved measures of supply chains. Transitory shocks from wildfires to strikes across multiple sectors and weather dampened the economy in Q2 but these effects are expected to stabilize and drive improved growth into Q4.
Derek Holt, Canada 416.863.7707
FX FORECASTS
CAD FX FORECASTS
NORTH AMERICA
MAJOR CURRENCIES
MAJOR CURRENCIES (continued...)
LATIN AMERICA
LATIN AMERICA (continued...)
DISCLAIMERS
FOREIGN EXCHANGE STRATEGY
This publication has been prepared by The Bank of Nova Scotia (Scotiabank) for informational and marketing purposes only. Opinions, estimates and projections contained herein are our own as of the date hereof and are subject to change without notice. The information and opinions contained herein have been compiled or arrived at from sources believed reliable, but no representation or warranty, express or implied, is made as to their accuracy or completeness and neither the information nor the forecast shall be taken as a representation for which Scotiabank, its affiliates or any of their employees incur any responsibility. Neither Scotiabank nor its affiliates accept any liability whatsoever for any loss arising from any use of this information. This publication is not, and is not constructed as, an offer to sell or solicitation of any offer to buy any of the currencies referred to herein, nor shall this publication be construed as an opinion as to whether you should enter into any swap or trading strategy involving a swap or any other transaction. The general transaction, financial, educational and market information contained herein is not intended to be, and does not constitute, a recommendation of a swap or trading strategy involving a swap within the meaning of U.S. Commodity Futures Trading Commission Regulation 23.434 and Appendix A thereto. This material is not intended to be individually tailored to your needs or characteristics and should not be viewed as a “call to action” or suggestion that you enter into a swap or trading strategy involving a swap or any other transaction. You should note that the manner in which you implement any of the strategies set out in this publication may expose you to significant risk and you should carefully consider your ability to bear such risks through consultation with your own independent financial, legal, accounting, tax and other professional advisors. Scotiabank, its affiliates and/or their respective officers, directors or employees may from time to time take positions in the currencies mentioned herein as principal or agent, and may have received remuneration as financial advisor and/or underwriter for certain of the corporations mentioned herein. Directors, officers or employees of Scotiabank and its affiliates may serve as directors of corporations referred to herein. All Scotiabank products and services are subject to the terms of applicable agreements and local regulations. This publication and all information, opinions and conclusions contained in it are protected by copyright. This information may not be reproduced in whole or in part, or referred to in any manner whatsoever nor may the information, opinions and conclusions contained in it be referred to without the prior express written consent of Scotiabank.
™ Trademark of The Bank of Nova Scotia. Used under license, where applicable. Scotiabank, together with “Global Banking and Markets”, is a marketing name for the global corporate and investment banking and capital markets businesses of The Bank of Nova Scotia and certain of its affiliates in the countries where they operate, all members of the Scotiabank group and authorized users of the mark. The Bank of Nova Scotia is incorporated in Canada with limited liability and is authorised and regulated by the Office of the Superintendent of Financial Institutions Canada. The Bank of Nova Scotia and Scotiabank Europe plc are authorised by the UK Prudential Regulation Authority. The Bank of Nova Scotia is subject to regulation by the UK Financial Conduct Authority and limited regulation by the UK Prudential Regulation Authority. Scotiabank Europe plc is authorised by the UK Prudential Regulation Authority and regulated by the UK Financial Conduct Authority and the UK Prudential Regulation Authority. Details about the extent of The Bank of Nova Scotia's regulation by the UK Prudential Regulation Authority are available on request. Scotiabank Inverlat, S.A., Scotia Inverlat Casa de Bolsa, S.A. de C.V., and Scotia Inverlat Derivados, S.A. de C.V., are each authorized and regulated by the Mexican financial authorities. Not all products and services are offered in all jurisdictions. Services described are available in jurisdictions where permitted by law.
SCOTIABANK ECONOMICS
This report has been prepared by Scotiabank Economics as a resource for the clients of Scotiabank. Opinions, estimates and projections contained herein are our own as of the date hereof and are subject to change without notice. The information and opinions contained herein have been compiled or arrived at from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness. Neither Scotiabank nor any of its officers, directors, partners, employees or affiliates accepts any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents.
These reports are provided to you for informational purposes only. This report is not, and is not constructed as, an offer to sell or solicitation of any offer to buy any financial instrument, nor shall this report be construed as an opinion as to whether you should enter into any swap or trading strategy involving a swap or any other transaction. The information contained in this report is not intended to be, and does not constitute, a recommendation of a swap or trading strategy involving a swap within the meaning of U.S. Commodity Futures Trading Commission Regulation 23.434 and Appendix A thereto. This material is not intended to be individually tailored to your needs or characteristics and should not be viewed as a “call to action” or suggestion that you enter into a swap or trading strategy involving a swap or any other transaction. Scotiabank may engage in transactions in a manner inconsistent with the views discussed this report and may have positions, or be in the process of acquiring or disposing of positions, referred to in this report.
Scotiabank, its affiliates and any of their respective officers, directors and employees may from time to time take positions in currencies, act as managers, co-managers or underwriters of a public offering or act as principals or agents, deal in, own or act as market makers or advisors, brokers or commercial and/or investment bankers in relation to securities or related derivatives. As a result of these actions, Scotiabank may receive remuneration. All Scotiabank products and services are subject to the terms of applicable agreements and local regulations. Officers, directors and employees of Scotiabank and its affiliates may serve as directors of corporations.
Any securities discussed in this report may not be suitable for all investors. Scotiabank recommends that investors independently evaluate any issuer and security discussed in this report, and consult with any advisors they deem necessary prior to making any investment.
This report and all information, opinions and conclusions contained in it are protected by copyright. This information may not be reproduced without the prior express written consent of Scotiabank.
™ Trademark of The Bank of Nova Scotia. Used under license, where applicable.
Scotiabank, together with “Global Banking and Markets”, is a marketing name for the global corporate and investment banking and capital markets businesses of The Bank of Nova Scotia and certain of its affiliates in the countries where they operate, including; Scotiabank Europe plc; Scotiabank (Ireland) Designated Activity Company; Scotiabank Inverlat S.A., Institución de Banca Múltiple, Grupo Financiero Scotiabank Inverlat, Scotia Inverlat Casa de Bolsa, S.A. de C.V., Grupo Financiero Scotiabank Inverlat, Scotia Inverlat Derivados S.A. de C.V. – all members of the Scotiabank group and authorized users of the Scotiabank mark. The Bank of Nova Scotia is incorporated in Canada with limited liability and is authorised and regulated by the Office of the Superintendent of Financial Institutions Canada. The Bank of Nova Scotia is authorized by the UK Prudential Regulation Authority and is subject to regulation by the UK Financial Conduct Authority and limited regulation by the UK Prudential Regulation Authority. Details about the extent of The Bank of Nova Scotia's regulation by the UK Prudential Regulation Authority are available from us on request. Scotiabank Europe plc is authorized by the UK Prudential Regulation Authority and regulated by the UK Financial Conduct Authority and the UK Prudential Regulation Authority.
Scotiabank Inverlat, S.A., Scotia Inverlat Casa de Bolsa, S.A. de C.V, Grupo Financiero Scotiabank Inverlat, and Scotia Inverlat Derivados, S.A. de C.V., are each authorized and regulated by the Mexican financial authorities.
Not all products and services are offered in all jurisdictions. Services described are available in jurisdictions where permitted by law.