Market participants can’t be blamed for being fatigued midway through the month of March, as the last two weeks have brought with them elevated levels of volatility, centered on policy actions from the major central banks. The balance of the month should provide some sense of calm as market participants take stock in the events that have unfolded over the last few weeks, though the outsized moves in foreign exchange markets have left some bamboozled, and the potential for the realization overshooting may have occurred, is likely to keep participants on their toes.
The outcome of the FOMC meeting last week caught many participants off guard, as it had been expected heading into the meeting that if anything, the Fed was likely to acknowledge the optimistic progression in domestic data, and the tone of the statement would either be balanced, or carry a slightly hawkish slant to it. While the dot plot for the Fed’s forecasted interest rate trajectory was revised lower to better align with what the market had expected prior to the meeting, in our opinion, the larger surprise was the Fed’s focus on the concerns for the global economic outlook, and their acceptance on keeping monetary policy unchanged because of uncertainty abroad. Ultimately this can be chalked up to the challenges the Bank of Japan and the European Central Bank have been having trying to stimulate their economies through unconventional monetary policy action; however, the Fed changing its tone from being ‘domestically’ data dependent to ‘globally’ data dependant has left Fed watchers bamboozled, adding to frustration from a long list of central banking misfires, and the resulting implications for foreign exchange markets.
It is easy as a ‘Monday Morning Quarterback’ to feel jaded at the FOMC’s misfire last week, though in the Fed’s mind it appears as if they are willing to overshoot domestically in the near-term in order to make sure the global economic recovery isn’t at jeopardy of crash landing, and if they have to accept inflation running hot as a result, it seems as if the Fed is willing to accept that as a consequence. In addition, while we do feel this was a misfire by the Fed, much like Draghi’s misfire the week before, we would caution market participants putting too much stock in the outcome of the Fed’s interest rate statement. Namely, the frequent changes from hawkish to dovish (and vice versa) are becoming more common as the Fed tries to stickhandle monetary policy against the backdrop of a strengthening dollar. The dovish slant to last week’s statement surprised investors and left many with the takeaway that if the Fed keeps overshooting their interest rate expectations, what is to say that the next summary of economic projections doesn’t display an outlook for no further rate hikes, or essentially suggests additional easing. In our opinion last week’s statement can be chalked up as language to arrest the greenback as opposed to signalling a path towards future easing, and ultimately reiterating our thesis that monetary policy divergence has not yet peaked. Both the ECB and FOMC meetings have done strong technical damage to the American buck, but for longer-term considerations it is suggested to note that these developments have only been able to handcuff further USD appreciation, and not reverse the rise experienced in 2014.
If we can then make the assumption that dovish delays in tightening can only arrest further greenback appreciation as opposed to reversing its course, the risk is that once the Fed decides to reverse its interest rate outlook, the pressure building from policy normalization could trigger another outsized move in the American dollar. We acknowledge it will be a tough uphill climb for the USD to repair the technical damage that has been witnessed in the last few weeks, and warn there may be further selling pressure on the greenback given market sentiment, but ultimately, the monetary policy divergence trade should rear its head again in the future, if only for now it is presumed to be in hibernation.
The persistent strengthening of the Canadian dollar shares many similarities to the decline that was witnessed at the beginning of this year, though in this case negative data is overlooked, while positive data is emphasized. Friday’s retail sales numbers were indeed much better than had been forecast, but the headline reading only recouped the drop from December, while the core number came in well short of its own print. The consequence of the better than expected retail sales number, ignoring the softness inherent in the inflation reading, was for the Canadian dollar to push further and hit levels not seen since October of 2015. It was not until position squaring in oil prior to the weekend caused WTI to slide below $40 that the loonie weakened off, though the technical damage had already been done and like we have mentioned before, there hasn’t been enough constructive price action for USDCAD to suggest we have seen a short-term bottom. Just because the loonie has seemingly reached the top floor, doesn’t mean it can’t remain overstretched until fundamentals (interest rates spreads) exert their force.
The release of the Federal Budget on Tuesday will be influential for price action on USDCAD, though initial trading in the loonie might be overwhelmed by the headline as opposed to the intricacies of the budget we would draw attention to. A larger than expected deficit may provide the loonie with a knee-jerk boost higher given the assumption a greater amount of government spending will act as stimulus and take pressure off the Bank of Canada to wield monetary policy weaponry as a defence against a prolonged slowdown; however, we have been less sanguine the actual numbers will corroborate such an outcome. The devil will be in the details, specifically, how much the government plans to spend on infrastructure as a means of fiscal stimulus, and if this will be raised from the initial campaign promises of $30bln over three years. We would caution that the campaign promises of infrastructure spending should already be well baked into market expectations, and if a bigger than expected deficit hits the tape because the Liberals underestimated royalty revenues and tax receipts due to the lingering nature of low commodity prices, we would suggest that this assessment of the Canadian economy is a net negative as opposed to government stimulus that will have a meaningful impact on the economy.
Further reading:Get the 5 most predictable currency pairs