US Dollar

Highlights The key risk to a dollar bearish view is a US-led rebound in global growth. This would allow the Federal Reserve to tighten monetary conditions much faster than other central banks, supporting the dollar in the process. Watch the performance of cyclicals versus defensives and non-US markets versus the S&P 500 as important barometers for this risk. Feature We were on the road last week, visiting clients in South Africa. The biggest preoccupation was what could put a dollar bearish view offside, especially vis-à-vis the rand. Many understand that the dollar is a countercyclical currency and tends to depreciate when global growth is rebounding. Yet there was still a good amount of trepidation on the totality of this argument. The dollar has been in a bull market since 2011, but there have been a couple of growth cycles during that period. One of our last meetings was in the beautiful city of Stellenbosch, a university town lined with majestic landscapes and rooted deep in South African history. A multi-asset fund manager had just met with two FX strategists before meeting with us. One of them was a dollar bull, and the other a bear. We could sense from his demeanor that indecisiveness was not part his ‘modus operandi,’ and he definitely wanted some clarity from our meeting. What transpired was an honest conversation on currencies, especially vis-à-vis our bearish dollar view. The conversation embodied the sentiment we had been getting from most other fund managers, which is that the view on the dollar is highly polarized. As we went through a swathe of charts, I noted his insightful questions, many of which drilled to the core of where the view could go wrong. Is The Dollar That Countercyclical? The observation that the dollar is a countercyclical currency rests on two pillars. The first is that the US economy is driven more by services than manufacturing. As such, when global growth is rebounding, more cyclical economies benefit most from this growth dividend, and as such, capital tends to gravitate to their respective economies. This is aptly illustrated by the fact that whenever global cyclical sectors (higher concentration outside the US) are outperforming defensive ones, the dollar is in a bear market (Chart I-1). In the US, a wider fiscal deficit tends to be partly financed by new money creation.  More importantly, the Fed tends to be the lender of last resort to the global economy, not least because the US dollar remains a reserve currency. In times of crises, the authorities pursue macroeconomic policies that tend to weaken the dollar, such as lowering rates and/or running a wider fiscal deficit. In the US, a wider fiscal deficit tends to be partly financed by new money creation. Part of the feedback loop in this mechanism is that it leads to a flow of greenbacks outside US borders. This eases offshore rates while greasing the international money supply chain (Chart I-2). Chart I-1The Dollar Tends To Weaken When Cyclicals Are Outperforming Chart I-2An Increasing Supply##br## Of Dollars Where can this view go wrong? If the Fed’s mandate is vis-à-vis the domestic US economy rather than maintaining international financial stability, then the biggest risk to a bearish dollar view is one in which global growth rebounds (or decelerates), but the US economy holds up well, allowing the Fed to pursue a relatively tighter monetary stance. This week, we got the US Markit and ISM PMIs, and the gaping wedge between the two is the highest since the 2015 manufacturing recession. Given sampling differences, where the Markit PMI surveys more domestically oriented firms, it is fair to assume it is also a barometer of US domestic growth relative to global output. Put another way, whenever the US services PMI is outperforming its manufacturing component, the dollar tends to appreciate (Chart I-3). If global growth rebounds but the US is leading the rebound (the Fed has been one of the most dovish central banks after all), the dollar can continue to rally. Our view is that this remains a tail risk. The slowdown in the global economy has been driven by the manufacturing sector, so it is fair to assume that this is the part of the economy that is ripe for mean reversion. Not to mention, cyclical swings in most economies tend to be driven by manufacturing and exports rather than services. Meanwhile, on the services front, the US economy appears to be rolling over relative to global. Even relative to China, the US appears to remain victim to the repercussions of the trade war (Chart I-4). This divergence is likely to keep the Fed on the sidelines, at least relative to other central banks. Meanwhile, on the political spectrum, our geopolitical strategists  observe that historically, it has been extremely rare for the Fed to raise interest rates a few months ahead of an election cycle. Chart I-3The Risk To A Bearish Dollar View Chart I-4Conflicting Messages A source of support for this view arises from the German bund versus US Treasury spread. In short, it is a battle of manufacturing versus services. Ever since the European debt crisis, the velocity of money in the euro area has collapsed relative to that of the US. In the financial world, relative long bond yields have followed suit in tight correlation (Chart I-5). If this reverses, it will be a key sign that the neutral rate of interest in the Eurozone is rising relative to that of the US, albeit from a low starting point. The message from bond markets is that such a shift is already taking place. Chart I-5R-Star For The Euro Area Could Move Higher There have been two powerful disinflationary forces for the velocity of money in the US. The first is the lagged effect from the Fed’s tightening policies in 2018. This is especially important given that the fed funds rate was eerily close to the neutral rate of interest, providing little incentive for firms to borrow and invest. Inflation is a lagging indicator, and it will take a sustained rise in economic vigor to lift US inflation expectations. This will not be a story for 2020 (Chart I-6A). Second, the recent rise in the dollar and fall in commodity prices is likely to continue to anchor US inflation expectations downward (Chart I-6B). This should keep the Fed on the sidelines. Chart I-6AVelocity Of Money Versus Inflation Chart I-6BVelocity Of Money Versus Inflation Bottom Line: The key risk to a bearish dollar view is a US-led global growth rebound, allowing the Fed to adopt a much more hawkish stance relative to other central banks. This would be an environment in which US inflation would also surprise to the upside. So far, the move in bond markets suggests this remains a tail risk (Chart I-7). Chart I-7Stalemate Equity (And Bond) Capital Flows The nascent upturn in a few growth indicators is also coinciding with a positive signal from financial variables. Global cyclical stocks have started to outperform defensives, and the traditional negative correlation with the dollar appears to be holding (previously referenced Chart I-1). Correspondingly, flows into more cyclical ETF markets are accelerating. These are usually a small portion of overall FX flows, but the information coefficient is directionally quite good. The key risk to a bearish dollar view is a US-led global growth rebound, allowing the Fed to adopt a much more hawkish stance relative to other central banks. The S&P 500 has been the best performing market for a few years now, so a crucial part of the dollar call lies in international equity markets outperforming the US. Markets such as the Swedish OMX, the Swiss Market Index and the TSX, among others, have broken out – indices with large international exposure and which are very much tied to the global cycle. Such market breakouts also tend to correspond with a weaker dollar, especially when the return on capital appears marginally higher outside the US. In a nutshell, the performance of more cyclical currencies will require confirmation of a breakout in their relative equity market performance. This applies to both the South African rand and other emerging and developed market currencies (Chart I-8A and Chart I-8B). The catalyst will have to be rising relative returns on the capital outside the US, but the starting point is also extremely attractive valuations. Chart I-8ACapital Flows And Exchange Rates Chart I-8BCapital Flows And Exchange Rates Over a shorter horizon, sentiment might drive stock market performance, but valuations matter a lot for the longer term. Chart I-9A shows the composite valuation indicator for the US relative to other developed markets. The message is quite clear: Any investor deploying fresh capital into the US today is doing so with the prospect of much lower longer-term returns, at least compared to the euro area and Japan. With inflows into US assets having rolled over, this will likely remain a source of concern for longer-term investors. This is compounded by the fact that expectations for the US technology sector going forward are likely to be hampered by regulatory concerns and lofty valuations. For South African investors, structural reforms will be needed for much more juicy long-term equity returns, beyond a terms-of-trade benefit (Chart I-9B). Chart I-9AReturns To US Equities Look Dire Chart I-9BReturns To US Equities Look Dire On the fixed-income front, international investors may still find US bond markets attractive in an absolute sense due to higher interest rate spreads. However, the currency risk is just too big a potential blindside to bear. Markets with the potential for currency appreciation such as Australia, Canada, Norway or even Sweden might be better bets. Flow data also highlight just how precarious it is to be long US dollars. As of September, overall flows into the US Treasury market have been negative, which may have contributed to the bottom in bond yields. Net foreign purchases by private investors are still positive, but the momentum in these flows is clearly rolling over. This is more than offset by official net outflows that are running at $350 billion (Chart I-10). As interest rate differentials have started moving against the US, so has foreign investor appetite for Treasury bonds. Chart I-10A Growing Dearth Of Treasury Buyers Bottom Line: Flows into US assets are rapidly dwindling. This may be partly because as the S&P 500 makes new highs amid lofty valuations, long-term investors are slowly realizing that future expected returns will pale in historical comparison. Given that being long Treasurys and the dollar remains a consensus trade, international investors run the risk of being potentially blindsided by a sharp drop in the dollar. Rebuy NOK/SEK We were stopped out of our long NOK/SEK position last week. We are reinstating this trade as relative fundamentals, especially from an interest rate perspective, still favor the cross. We are reinstating long NOK/SEK as relative fundamentals, especially from an interest rate perspective, still favor the cross. We remain oil bulls on the back of a pickup in global demand and OPEC production discipline. This should lead to the outperformance of energy stocks, benefiting inflows into Norway (Chart I-11). Chart I-11No Near-Term Replacement For Oil Chart I-12Interest Rates Favor NOK/SEK Interest rate differentials continue to favor NOK over SEK. The Riksbank will probably – at the margin – be more hawkish than the Norges Bank in an attempt to exit negative interest rates, but the carry will remain wide (Chart I-12). Meanwhile, Norway mainland GDP growth continues to outpace that of Sweden (Chart I-13). Finally, the cross has approached an important technical level, with our intermediate-term indicator signaling oversold conditions. Should the NOK/SEK pattern of higher lows and higher highs in place since the 2015 bottom persist, we should be on the cusp of a powerful rally (Chart I-14). Chart I-13Growth Favors NOK/SEK Chart I-14Rebuy NOK/SEK   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The ISM and Markit data are sending conflicting signals: the Markit manufacturing PMI edged up to 52.6, while the ISM number dipped towards 48.1 in November. On the services front, the Markit PMI was unchanged at 51.6, while the ISM PMI fell to 53.9. ADP employment recorded an increase of 67K jobs in November, well below expectations. The jobs report on Friday will be especially important. The trade deficit narrowed by $4 billion to $47.2 billion in October. The DXY index fell by 0.9% this week. Incoming data have been consistent with our base case view that global growth has bottomed and will rebound in 2020. Along with a manufacturing sector recovery, pro-cyclical, or higher-beta currencies are poised to outperform the US dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 201 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area signal a tentative recovery: Preliminary headline and core inflation both rebounded to 1% and 1.3% year-on-year, respectively in November. The Markit manufacturing PMI increased to 46.9 in November. The Services PMI also edged up to 51.9. Retail sales grew by 1.4% year-on-year in October, lower than the 2.7% yearly growth from the previous month. GDP growth was unchanged at 1.2% year-on-year in Q3. EUR/USD appreciated by 0.6% this week. The recent rebound in both inflation and PMI has brightened the outlook for the euro area and boosted investor confidence. Our Global Investment Strategy upgraded euro area equities to overweight recently. We continue to remain positive on the euro against the US dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been positive: Construction orders soared by 6.4% year-on-year in October. Manufacturing PMI increased to 48.9 from 48.6 in November. Consistently, the services PMI also increased to 50.3. Vehicle sales fell by 14.6% year-on-year in November. This series is extremely volatile, especially given the front-loading of purchases ahead of the consumption tax hike. USD/JPY fell by 0.8% this week. Sluggish growth in Asia, together with the consumption tax hike have weighed on the Japanese economy through 2019. However, the Japanese yen remained resilient due to its safe-haven nature. The Abe government has revealed a sizeable fiscal stimulus, but the potential impact on the economy is still being digested. At the margin, fiscal stimulus reduces the scope for the BoJ to adopt more experimental monetary policies, which is bullish the yen. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been upbeat: On the PMI front, both Markit manufacturing and services PMIs increased to 48.9 and 49.3, respectively in November. The construction PMI also rebounded to 45.3 from 44.2. Consumer credit increased by £1.3 billion in October. The British pound has appreciated by nearly 2% against the US dollar this week, making it the best performing G10 currency over the past few weeks. Our Geopolitical strategists believe that the UK election will not reintroduce a no-deal Brexit risk, either in the short-term or long-term. This is positive for the UK economy overall, and bullish for the British pound especially given it is still trading well below its long-term real effective exchange rate. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been robust: GDP growth soared to 1.7% from 1.4% year-on-year in Q3. On the PMI front, both AiG manufacturing and services PMIs fell to 48.1 and 53.7, respectively in November. The Commonwealth manufacturing PMI was little changed at 49.9, while the services PMI increased to 49.7.   The current account balance increased to 7.9 billion from 4.7 billion in Q3. AUD/USD increased by 0.8% this week. On Monday, the RBA kept interest rates unchanged at 0.75%. Governor Lowe implied that after 3 rate cuts this year, the current low cash rate is already boosting Australian asset prices and household spending. Combined with government spending and a growing population, this should help underpin the Australian economy and the Aussie dollar in the long run. We remain overweight the Aussie dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 There was scant data from New Zealand this week: Terms-of-trade increased by 1.9% quarter-on-quarter in Q3. NZD/USD increased by 1.7% this week. As a small open economy, New Zealand should benefit once global growth stabilizes. Moreover, rising terms-of-trade, mainly in dairy and meat prices, are lifting New Zealand exports and the trade balance this year. We remain positive on the kiwi against the US dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Place A Limit Sell On DXY At 100 - November 15, 2019 USD/CNY And Market Turbulence - August 9, 201 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mixed: Annualized GDP increased by 1.3% quarter-on-quarter in Q3, well below the 3.5% quarterly growth in the second quarter. The Markit manufacturing PMI slightly increased to 51.4 in November. The Ivey PMI also soared to 60 from 48.2 on a seasonally-adjusted basis in November. Imports slightly increased to C$51 billion in October. Exports also increased to C$49.9 billion. The trade deficit, as a result, narrowed to C$1.1 billion. USD/CAD fell by 1% this week. On Wednesday, the BoC held interest rates unchanged at 1.75%. A catalyst was probably early signs of a global growth recovery. The BoC is one of the few central banks that haven't eased monetary policy this year amid the trade war and a manufacturing sector slowdown. Going forward, we are positive on energy prices, and believe that the loonie is primed for a breakout. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been soft: The KOF leading indicator fell to 93 from 94.8 in November. Real retail sales increased by 0.7% year-on-year in October, from 1.6% the previous month. Headline inflation increased from -0.3% to -0.1% year-on-year in November. The Swiss franc increased by 1.2% against the US dollar this week, amid broad dollar weakness. Inflation has been negative for a second consecutive month in November, and a strong franc does not offer any help. While we remain positive on the Swiss franc, the biggest risk to an appreciating franc is intervention from the central bank. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Retail sales fell by 0.8% month-on-month in October. The current account surplus narrowed by NOK 2.6 billion to NOK 23.9 billion in Q3. The Norwegian krone increased by 0.8% this week against the US dollar, supported by rising oil prices and a brightened outlook for global growth. The EIA reported a decrease of crude oil stocks by 4.9 million barrels for the week ended November 29th. Combined with a revival in oil demand, this is bullish for the oil prices and the Norwegian krone. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mostly positive: GDP increased by 1.6% year-on-year in Q3, an improvement from 1% the previous quarter. The manufacturing PMI fell to 45.4 from 46 in November. This was in contrast to other euro area countries. The current account surplus improved to SEK 69 billion from SEK 37 billion in Q3. USD/SEK decreased by 1% this week. Typically, a weak krona helps the manufacturing sector by a lag of about 12 months. Moreover, the weak krona is also improving balance of payments dynamics in Sweden. Going forward, we remain bullish on the Swedish krona, and are playing krona strength via the New Zealand dollar. Report Links: Updating Our Balance Of Payments Monitor - November 29, 2019 Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights A few indicators suggest that global growth will soon bottom. The bottoming process could prove volatile, but the duration of the slowdown suggests a V-shaped rather than U-shaped recovery. The dollar should weaken as higher-beta cyclical currencies rebound from deeply oversold levels. Sell the DXY index at 100. Aggressive short USD bets can be played via the NOK and SEK. The euro is also a natural beneficiary. Our favorite dollar-neutral bets include long AUD/CAD, SEK/NZD, GBP/JPY and short CAD/NOK. Feature The biggest question facing global investors is whether growth will pick up next year, and if so, what the durability of such a rebound will be. Any additional growth hiccups will cause the dollar to soar, and this week’s disappointing credit and industrial production numbers from China are a sober reminder that we are not out of the woods yet. Nevertheless, we believe a pickup in demand, especially emanating from outside the US, is forthcoming. This will favor more pro-cyclical currencies. Cyclical sectors of the equity market are already sniffing a growth rebound, and the dollar is off its peak for the year (Chart I-1). Historically, these have been good reflation indicators, especially when they are sending the same message. This is also a reminder to focus on where economic data will be six to 12 months from now rather than trade on yesterday’s news. Chart I-1The Dollar Tends To Weaken When Cyclicals Are Outperforming Policy shifts affect the economy with a lag, with a bottoming process that can be volatile and/or protracted. However, the duration of the current slowdown suggests we might be entering a V-shaped rather than U- or W-shaped recovery. Investors can track a few indicators to help calibrate the probability of the different scenarios playing out. The Message From Economic Variables There are a swath of economic variables one can follow to track the health of an economy, but we tend to focus on purchasing managers’ indices. This is because they are timely and have a good track record of confirming cyclical shifts in the economy. The problem is that for the most part, they tend to be coincident rather than leading indicators. Gauging the magnitude and duration of the cycle is also important to avoid false starts. The message is that the European manufacturing recession will be over by the first quarter of 2020.  In the US, financial conditions lead the ISM manufacturing index with a tight correlation (Chart I-2). Over the past 18 months, US bond yields have fallen. The historical precedent is that manufacturing activity should be reviving about now. The current reading is consistent with a rather explosive rise in the ISM manufacturing index, towards 60. Chart I-2The Drop In Bond Yields Is Consistent With An ISM Near 60 In Europe, the Sentix sentiment index, which surveys the balance of investors’ emotions between greed and fear, tends to be coincident. However, the ratio of the expectations component to the current situation, a second derivative measure of exuberance or capitulation, tends to lead changes in the PMI indices by six months (Chart I-3, top panel). Again, the message is that the European manufacturing recession will be over by the first quarter of 2020. Applying the same formula to the ZEW survey gives a similar message for Germany (Chart I-3, bottom panel). Even within the Japanese economy, which was heavily hit by the October consumption tax hike, some green shoots can still be uncovered. The expectations component of the Economy Watchers Survey, a comprehensive read across much of the smaller entrepreneurs that drive the local economy, is improving. This has nudged the difference between the expectations component and the current situation to the highest in 5 years. The message is corroborated by the economic surprise index (Chart I-4). Chart I-3A V-Shaped Recovery In European Manufacturing? Chart I-4Japan Green ##br##Shoots   Chinese credit growth was uninspiring in October, but the Caixin manufacturing PMI is now firmly above the 50 boom/bust level. More and more financial intermediation is being done through the bond market, and the drop in Chinese bond yields has eased financial conditions tremendously. This should encourage lending, which should lead to stronger economic activity, boosting demand for imports (Chart I-5). Rising Chinese imports will boost global growth. Chart I-5Chinese Imports Could Soon Rebound Bottom Line: For the most part, PMIs across many countries remain weak, but a few indicators are starting to point to an improvement next year. Given PMIs tend to be coincident, the most potent gains will be made by being early in the cycle. What Are Financial Markets Telling Us? The nascent upturn in our growth indicators is also coinciding with a positive signal from financial variables. Usually, when financial and economic data are in sync, the move in markets tends to be durable and powerful. Below are a few examples.  Usually, when financial and economic data are in sync, the move in markets tends to be durable and powerful.  Global cyclical stocks have started to outperform defensives, and the traditional negative correlation with the dollar appears to be holding (previously referenced Chart I-1). Correspondingly, flows into more cyclical ETF markets are accelerating. These are a small portion of overall FX flows, but the information coefficient is directionally quite good. The message is that in six months, EUR/USD will hit 1.16, GBP/USD will be at 1.4, AUD/USD at 0.75 and the USD/SEK at 8.5. Paradoxically, these are also closer to our own internal targets (Chart I-6). Chart I-6Inflows Into Cyclical ETFs The copper-to-gold, oil-to-gold, and CRB Raw Industrials-to-gold1 ratios often capture the transmission mechanism between easing liquidity conditions and higher growth. It is encouraging that these also tend to move in lockstep with US bond yields, another global growth barometer. The power of the signal is established when all three indicators peak or bottom at the same time, as is the case now (Chart I-7). The next confirmation will come with a clear breakout in these ratios. Chart I-7Global Growth Barometers Flashing Amber Correspondingly, in China, scrap steel prices have begun to rise faster than imported iron ore prices, suggesting an improving margin for steel producers. This is probably an indication that steel destocking has reached a nadir (Chart I-8). A renewed restocking cycle should benefit iron ore and other commodity imports and prices. In sympathy, the LMEX index appears to be making a tentative trough.  AUD/JPY breached the important technical level of 72 cents this year but has since recovered. The cross has failed to sustainably break below this level both during the euro area debt crisis in 2011-2012 and the China slowdown in 2015-2016. Again, it appears reflation is winning the tug-of-war. Given speculators are neutral the cross, it suggests that any move either way will be powerful and significant (Chart I-9). Chart I-8Bullish Bottom-Up Signals From Metals Chart I-9Breakdown Avoided For Now An improving liquidity environment will be especially favorable for carry trades. High-beta currencies such as the RUB/USD, ZAR/USD and BRL/USD have not yet broken down. These currencies are usually good at sniffing out a change in the investment landscape. The message so far is that the drop in US bond yields may have been sufficient to backstop any cascading selloff (Chart I-10). Chart I-10Carry Trades May Be Back In Style Soon Finally, bond yields across major markets are off their lows. Our strategy is to be selective as US dollar tailwinds shift to headwinds, by initially expressing tactical USD shorts via the more potent Norwegian krone and Swedish krona. We have discussed at length our rationale for picking these currency pairs,2 but the bottom line is that they are deeply oversold and have probably been the primary vehicles used to express US dollar long positions. Bottom Line: It is too early to tell if the dollar will retest its highs before ultimately cresting, because part of the move has been driven by risk aversion/political uncertainty. Our bias is that some sort of trade détente is sufficient to rejuvenate economic activity given part of the slowdown, especially vis-à-vis capex, has been driven by uncertainty. Meanwhile, lots of monetary ammunition has already been fired over the past year.  Notes On Australia And New Zealand This week, the Reserve Bank of New Zealand surprised markets by keeping rates on hold, a volte-face to its dovish surprise this summer. In retrospect, this makes sense. First, the RBNZ may be watching the same indicators as us, and as such is seeing an imminent turnaround in the global economy. Keeping some ammunition will allow for more room to ease down the road. Second, the weakness in the currency has probably done the heavy lifting in boosting exports and supporting domestic income. Finally, Australia and China are New Zealand’s biggest trading partners, and the trade war along with rising pork prices have allowed for a terms-of-trade boost for New Zealand’s agricultural exports (Chart I-11). Slowing migration will go a long way in eroding a meaningful supply of employment and domestic demand in New Zealand. We are positive on the kiwi but believe it will underperform its antipodean neighbor. First, the AUD/NZD is cheap on a real effective exchange rate basis (Chart I-12). Meanwhile, a more pronounced downturn in Aussie house prices has allowed some cleansing of sorts, bringing them further along the adjustment path relative to New Zealand. We are willing to overlook this week’s disappointment in Australia’s job numbers, given the unfortunate wildfires that are destroying businesses and homes. Fiscal stimulus will be forthcoming, and reconstruction efforts will go a long way to boosting domestic demand Chart I-11A Terms Of Trade Boost Chart I-12AUD/NZD Is Cheap Meanwhile, the RBNZ began a new mandate on April 1st that now includes full employment in addition to inflation targeting. But given the RBNZ has been unable to fulfill its price stability mandate over the past several years, it is hard to argue it will find a dual mandate any easier. Slowing migration will erode a meaningful supply of employment and domestic demand in New Zealand (Chart I-13). The final catalyst for the AUD/NZD cross will be a terms-of-trade shock (Chart I-14). Iron ore prices may face further downside, given supply from Brazil is back online, but China’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix. Given eliminating pollution is a strategic goal in China, this will be a multi-year tailwind Chart I-13Loss Of A Meaningful Tailwind For Employment Chart I-14Terms Of Trade Favors ##br##Aussie Bottom Line: Remain long AUD/NZD as a strategic position and SEK/NZD as a tactical position. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com   Footnotes 1 The CRB Raw Industrials-to-gold ratio is not shown here because of the steep correction in iron ore prices, after a resolution to a supply disruption. That said, iron ore prices are up 28% this year, versus 14% for gold. 2 Please see page 24 for a summary of our recent reports. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the US have been positive: The Michigan consumer sentiment index edged up to 95.7 from 95.5 in November. The NFIB business optimism index slightly increased to 102.4 from 101.8 in October. Headline inflation recorded modest growth to 1.8% year-on-year in October while core inflation fell to 2.3%. Headline and core producer prices both slowed to 1.1% and 1.6% year-on-year respectively in October. The housing market remains healthy, with mortgage applications up 9.6% for the week. The DXY index appreciated by 0.2% this week. During his testimony this week, Fed Chair Powell suggested the growth outlook for the US remained favorable, based on labor market trends. That said, Europe and EM probably have more scope to outperform amid a global growth recovery, which will be a headwind for the US dollar.  Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been improving: The ZEW economic sentiment index rebounded to -1 from -23.5 in November. Industrial production contracted by 1.7% year-on-year in September, however it is better than the contraction of 2.8% in the previous month and the expectations of a 2.3% drop. The preliminary GDP report showed that growth increased to 1.2% year-on-year in Q3, up from 1.1% in the previous quarter. Impressively, Germany steered clear of a recession. The euro fell by 0.2% against the US dollar this week. We expect the euro to recover along with the gradual improvement in the data. Moreover, the increased issuance of euro-denominated debt suggests some inflows into European corporate bond markets. This will benefit the euro. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: The trade surplus plunged to JPY 1 billion in September. The current account surplus narrowed to JPY 1.6 trillion from JPY 2.2 trillion. Machinery orders contracted by 2.9% month-on-month in September. On a yearly basis however, they grew by 5.1% year-on-year. Preliminary machine tool orders kept falling by 37.4% year-on-year in October. Preliminary annualized GDP growth slowed to 0.9% quarter-on-quarter in Q3. USD/JPY fell by 0.6% this week. Forward-looking data are showing more optimism on the domestic economy. This might prove that the damage from the tax hike is only a one-off effect. Continue to hold the yen, as both portfolio insurance, and a bet against more aggressive monetary stimulus from the BoJ. Report Links: Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the UK have been mostly negative: The total trade deficit (including EU) widened to £3.4 billion in September. Preliminary GDP growth slowed to 1% year-on-year in Q3, from 1.3% in the previous quarter. Industrial production contracted by 1.4% year-on-year in September. Average earnings kept growing by 3.6% year-on-year in September. Moreover, the ILO unemployment rate fell further to 3.8%. Headline inflation fell to 1.5% year-on-year in October, while core inflation remained at 1.7%. GBP/USD increased by 0.4% this week. Despite the recent small rally, the pound is still undervalued on a PPP basis. With a lower probability of a hard-Brexit, our bias remains that the pound has more upside and will converge towards its long-term fair value. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: NAB business conditions and confidence both increased to 3 and 2 in October. Moreover, Westpac consumer confidence increased by 4.5% in November. The wage price index grew by 2.2% year-on-year in Q3. The labor market data was however disappointing, the unemployment rate slightly increased to 5.3% in October. There was a loss of 19K jobs in October, with 10K full-time and 9K part-time. AUD/USD fell by 1.3% this week, weighed down by the recent slide in iron ore prices and employment data. Given speculators are already very short the cross, this could be capitulation. We discuss Australia in this week’s front section. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly negative: Inflation expectations fell slightly to 1.8% in Q4. The REINZ house price index grew by 1.1% month-on-month in October, down from 1.4% in the previous month. Migration into New Zealand continues to slow, with only 3440 newcomers in September. The New Zealand dollar rose by 0.6% against the US dollar this week. The main driver is that the RBNZ unexpectedly kept its interest rate unchanged at 1% this Wednesday. We are positive on the kiwi, but remain underweight against both the Australian dollar and the Swedish krona on valuation grounds. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The US Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mostly negative: Housing starts fell by 20K to 202K in October. Building permits fell by 6.5% month-on-month in September. The unemployment rate was unchanged at 5.5% in October. There was a loss of 1.8K jobs in October. However, average hourly wages yearly growth accelerated to 4.4%. New house prices contracted by 0.1% year-on-year in September. The Canadian dollar fell by 0.4% against the US dollar this week, given broad US dollar strength. CAD has handsomely outperformed its G10 commodity counterparts and some measure of rotation is due. We are short CAD/NOK and long AUD/CAD. Report Links: Making Money With Petrocurrencies - November 8, 2019 Signposts For A Reversal In The Dollar Bull Market - November 1, 2019 Preserving Capital During Riot Points - September 6, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Producer and import prices contracted by 2.4% year-on-year in October. The Swiss franc has appreciated by 0.6%, and the latest PPI numbers suggest deflation is becoming more and more rampant. Our bias remains that the SNB is likely to soon weaponize its currency like other central banks. We have a limit buy on EUR/CHF at 1.06. Stay tuned. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Producer prices fell by 13.8% year-on-year in October. This can largely be explained by the petroleum sector. Headline inflation increased to 1.8% year-on-year from 1.5% in October. Core inflation was unchanged at 2.2% year-on-year. The mainland GDP growth was unchanged at 0.7% in Q3. The Norwegian krone fell by 0.8% this week. The weakness in the krone remains much more than is warranted by underlying economic conditions. Should the DXY hit 100, we will be aggressive buyers of the krone. Report Links: Making Money With Petrocurrencies - November 8, 2019 A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Headline inflation increased to 1.6% year-on-year from 1.5% in October. The unemployment rate fell to 6% from a downward-revised 6.6% in October. The Swedish krona depreciated by 0.3% against the US dollar this week. Statistics Sweden has revised down the unemployment rate for the period from July 2018 to September 2019, due to a flaw in data quality. This has dampened the credibility of the employment data in Sweden and its effect on the exchange rate. That said, we maintain a pro-cyclical stance and remain bullish on the Swedish krona.  Report Links: Where To Next For The US Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights An expansion in the Federal Reserve’s balance sheet will increase dollar liquidity. This should be negative for the greenback, barring a recession over the next six to 12 months. Interest rate differentials have largely moved against the dollar. The biggest divergences are versus the more export-dependent NOK, SEK and GBP. A weak dollar will supercharge the gold uptrend. Gold will also benefit from abundant liquidity, and persistently low/negative real rates. Remain short USD/JPY. The path to a lower yen is via an overshoot, as the BoJ will need a shock to act more aggressively. The Bank of Canada left rates on hold, but may be hard-pressed to continue meeting its inflation mandate amid a widening output gap. Go long AUD/CAD for a trade. Feature Chart I-1A Well-Defined Channel The DXY index has been trading within a very narrow band this year, defined by the upward-sloped channel drawn from the February lows (Chart I-1). At 97, the DXY index is just a few ticks away from the lower bound of this channel, which could be tested in the coming weeks. A decisive break below will represent an important fundamental shift, since it will declare the winner in the ongoing battle between deteriorating global growth and easing financial conditions. Global Growth And The Dollar One of the defining features of the currency landscape last year was that U.S. interest rates became too tight relative to underlying conditions. This tightened dollar liquidity both domestically and abroad. Chart I-2 plots the neutral rate of interest in the U.S. relative to the fed funds target rate. A widening gap suggests underlying financing conditions are low relative to the potential growth rate of the economy. Not surprisingly, this also tends to track the yield curve pretty closely, assuming long-term rates are a proxy for the economy’s structural growth rate, while short-term rates reflect borrowing costs. For economic agents, a narrowing spread suggests a rising risk of capital misallocation, as the gap between the cost of capital and return on capital closes. This is most evident for banks through their net interest margins. At the epicenter of this shrinking spread are the Fed’s macroeconomic policies. These include raising interest rates (especially in the face of a trade slowdown) and/or shrinking its balance sheet. These are the very policies that also tend to strengthen the greenback. The result is a rise in the velocity of international U.S. dollars, pushing up offshore rates and lifting the cost of capital for borrowing countries. A widening gap between U.S. neutral rate of interest and fed funds target rate suggests underlying financing conditions are low relative to the potential growth rate of the economy.  This has been the backdrop for the dollar for much of the past two years. The good news is that more recently, the Fed has been quick to rectify the situation. The funding crisis among U.S. domestic banks will be resolved through repurchase agreements and a resumption of the Fed's bond purchases. Chart I-3 shows that the interest rate the Fed pays on excess reserves may soon exceed the effective fed funds rate, meaning the liquidity crisis among U.S. banks may soon be over. Correspondingly, banks’ excess reserves should start rising anew. The drop in rates and the easing in funding conditions have been partly sniffed out by a steepening yield curve (Chart I-3, bottom panel). This will incentivize banks to lend, which in turn, will boost U.S. money supply. As the economy recovers and demand for imports (machinery, commodities, consumer goods) rises, this will widen the current account deficit and increase the international supply of dollars. This should further calm dollar offshore rates, helping short-circuit any negative feedback loops that might have hampered growth in the past. Chart I-2The Fed Has Pivoted Chart I-3Easing Liquidity Strains The message from both global fixed-income markets and international stocks is that we may have reached a tipping point, where easing in financial conditions is sufficient to end the manufacturing recession. This is especially the case given this week’s breakout in the S&P 500, the Swedish OMX, and the Swiss Market Index (Chart I-4) – indices with large international exposure and very much tied to the global cycle. Such market cycles also tend to correspond with a weaker dollar, especially when the return on capital appears marginally higher outside the U.S. (Chart I-5). Chart I-4A Few Equity Breakouts Chart I-5Europe And EM Leading The Rally Chart I-6Less Stress In Offshore USD Funding Bottom Line: Rising dollar liquidity appears to have started greasing the international financial supply chain. One way to track if dollar funding is becoming more abundant is through the convenience yield, or cross-currency basis swap.1 This measures the difference in yield between an actual Treasury bond and a synthetic one trading in the offshore market. On this basis, we are well below the panic levels observed over the past decade (Chart I-6). Interest Rate Differentials And International Flows If the rise in global bond yields reflects a nascent pickup in growth, then the message from interest rate differentials has been clear: This growth pickup will be led by non-U.S. markets, similar to the message from international equities. Should the nascent pickup in global growth morph into a synchronized recovery, this will go a long way in further eroding the U.S.’ yield advantage. More specifically, the currencies that have borne the brunt of the manufacturing slowdown should also experience the quickest reversals. This is already being manifested in a very steep rise in their bond yields vis-à-vis those in the U.S. (Chart I-7A and Chart I-7B). For example, yields in Norway, Sweden, Switzerland and Japan have risen by an average of 75 basis points versus those in the U.S. since the bottom. Should the nascent pickup in global growth morph into a synchronized recovery, this will go a long way in further eroding the U.S.’ yield advantage. Chart I-7AInterest Differentials And Exchange Rates Chart I-7BInterest Differentials And Exchange Rates International investors might still find U.S. bond markets attractive in an absolute sense, but the currency risk is just too big a potential blindside at the current juncture. Markets with the potential for currency appreciation such as Australia, Canada, Norway or even the European periphery within Europe might be better bets. Flow data highlights just how precarious being long U.S. dollars is. As of last August, overall flows into the U.S. Treasury market have been negative, which may have contributed to the bottom in bond yields. Net foreign purchases by private investors are still positive at an annualized US$166 billion, but the momentum of these flows is clearly rolling over. This is more than offset by official net outflows that are running at $314 billion (Chart I-8). As interest rate differentials have started moving against the U.S., so has foreign investor appetite for Treasury bonds. More importantly, private purchases have not been driven on a net basis by foreign entities, but by U.S. domestic concerns repatriating capital on the back of the 2017 Trump tax cuts. On a rolling 12-month basis, the U.S. was repatriating back close to net $US400 billion in assets, or about 2% of GDP. Given that the tax break was a one-off, flows have since started to ease, contributing to the ebb in Treasury purchases (Chart I-9). Chart I-8A Growing Dearth Of Treasury Buyers Chart I-9Repatriation Flows Are Ebbing Meanwhile, while U.S. residents have been repatriating capital domestically, foreign investors have been fleeing U.S. equity markets at among the fastest pace in recent years. On a rolling 12-month total basis, the U.S. saw an exodus of about US$200 billion in equity from foreigners earlier this year, the largest on record. Foreigners are still net buyers of about $265 billion in U.S. securities (mostly agency bonds), but the downtrend in purchases in recent years is evident. Bottom Line: Flows into U.S. assets are rapidly dwindling. This may be partly because as the S&P 500 makes new highs amid lofty valuations, long-term investors are slowly realizing that future expected returns will pale in comparison to history. Given that being long Treasurys and the dollar remains a consensus trade (Chart I-10), international investors run the risk of a potential blindside from a sharp drop in the dollar. Chart I-10Unfavorable Dollar Technicals Dollar Reserve Status And Gold The decline in the dollar may not mark the ultimate peak in the bull market that began in 2011, but at least it will unveil some of the underlying forces that have been chipping away at the dollar’s reserve status over the past few years. China has risen within the ranks to become the number one contributor to the U.S. trade deficit over the past few years. At the same time, Beijing has been destocking its holding of Treasurys, if only as retaliation against past U.S. policies, or perhaps to make room for the internationalization of the RMB. In a broader sense, there has been an underlying shift in the global economy away from dollars and towards a more diversified basket of currencies. This makes sense, given that a growing proportion of trading – be it in crude, natural gas, bulk commodities or even softs – is being done outside U.S. exchanges. Gold continues to outperform Treasurys, which has historically been an ominous sign for the U.S. dollar. Ever since the end of the gold/dollar link in the early ‘70s, bullion has stood as a viable threat to dollar liabilities. With the Fed about to embark on a renewed expansion of its balance sheet, we may have just triggered one of the necessary catalysts for a selloff in the U.S. dollar. This means that holding gold in dollars may become more profitable compared to other currencies (Chart I-11). Given that being long Treasurys and the dollar remains a consensus trade, international investors run the risk of a potential blindside from a sharp drop in the dollar.  The one tectonic shift that has happened over the past decade is that central banks have become net gold buyers, holding 20% of all gold that has ever been mined. If that number were to rise to say 25% or even 30%, it could have the potential to propel the gold price up towards $2800/oz (Chart I-12). If you think such an idea is far-fetched, just ask the Swiss, who a few years ago called a referendum to increase their gold holdings from 7% of total reserves to 20%, or Russia that has seen its gold holdings rise from 2% to over 20% of total reserves. Chart I-11Watch Gold In ##br##USD Terms Chart I-12What If Central Banks Bought Gold More Aggressively?   Bottom Line: Reserve diversification out of U.S. dollars is a trend that has been underway for a while now, and unlikely to change anytime soon. Gold will be a big beneficiary of this tectonic shift. A Few Trade Ideas If the dollar eventually weakens, the more export-dependent economies should benefit the most from a rebound in global growth, and by extension their currencies should be the outperformers. Within the G-10 universe, there would notably be the European currencies led by the Swedish krona, the Norwegian krone and the pound. The countries currently experiencing the steepest rise in interest rate differentials vis-à-vis the U.S. could be a prelude to which currencies will outperform (previously mentioned Chart I-7A). We expect commodity currencies to also hold firm, but this awaits further confirmation of more pronounced Chinese stimulus, which so far has not yet materialized. The Canadian dollar should also be a beneficiary from dollar weakness, with a technical formation that looks categorically bearish USD/CAD (Chart I-13). Should the 1.30 level be breached, the next level of support is around the 2017 lows of 1.20. The BoC left rates unchanged this week, but the dovish tone from Governor Stephen Poloz was a big reminder that no central bank wants to tolerate a more expensive currency for now. Looser fiscal policy and rising oil prices will eventually become growth tailwinds. Chart I-13A USD/CAD Breakout Or Breakdown? Chart I-14Canadian House Prices However, we will favor the Aussie over the loonie since the downturn in the Australian housing market appears much further advanced compared to Canada. And with macro-prudential measures already implemented in Vancouver and Toronto, there is a rising risk that Montreal could follow suit (Chart I-14). Historically, policy divergences between the Reserve Bank of Australia and the BoC have followed the relative growth profiles of their biggest export markets, and the message so far is that the RBA is well ahead of the curve in its dovish bias (Chart I-15). Go long AUD/CAD for a trade. Chart I-15Buy AUD/CAD Finally, the Bank Of Japan left interest rates unchanged but signaled it was willing to ease should the path towards their 2% inflation target be in question. As the central bank that has been pursuing the most aggressive monetary stimulus over the last few years, it is fair to say this week’s policy meeting was a non-event. The yen will continue to be buffeted by powerful deflationary tailwinds that are holding the Japanese economy hostage, as well as global economic uncertainty. In the event that global growth picks up, the yen will depreciate at the crosses, but can still rise versus the dollar. This puts long yen bets in a “heads I win, tails I don’t lose much” scenario. Bottom Line: Go long AUD/CAD and stay short USD/JPY. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Arvind Krishnamurthy and Hanno Lustig, “Mind the Gap in Sovereign Debt Markets: The U.S. Treasury basis and the Dollar Risk Factor,” Stanford University, August 29, 2019. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mixed: Preliminary GDP growth slowed to 1.9% quarter-on-quarter from 2% in Q3. PCE slowed to 1.5% quarter-on-quarter in Q3. Core PCE, on the other hand, increased to 2.2%. New home sales contracted by 0.7% month-on-month in September, while pending home sales grew by 1.5% month-on-month. The trade deficit narrowed marginally by $2.7 billion to $70.4 billion in September. Initial jobless claims increased by 5K to 218K for the week ended October 25th. The DXY index fell sharply after the Fed's press conference, ending with a loss of 0.6% this week. On Wednesday, the Fed cut interest rate by 25 bps for the third time this year to 1.75%, as widely expected. The fading interest rate differential will continue to be a headwind for the U.S. dollar. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been firm: GDP growth in the euro area slowed marginally to 1.1% year-on-year in Q3, down from 1.2% in the previous quarter. On a quarter-on-quarter basis, the growth was unchanged at 0.2%. Headline inflation in the euro area slowed slightly to 0.7% year-on-year in October. Core inflation however, increased to 1.1% year-on-year. Retail sales in Germany grew by 3.4% year-on-year in September, up from 3.1% in the previous month. EUR/USD increased by 0.5% this week amid broad dollar weakness. The current debate among central bankers in the Eurozone is whether ultra accommodative monetary policy is still warranted. This espouses the view that at least, to some members of the ECB, the neutral rate of interest in the Eurozone is higher than perceived. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-6JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mostly positive: Headline inflation was unchanged at 0.4% year-on-year in October. Core inflation however, increased marginally to 0.7% year-on-year in October. Retail sales soared by 9.1% year-on-year in September in anticipation of the consumption tax hike. Industrial production grew by 1.1% year-on-year in September, compared to a contraction of 4.7% year-on-year the previous month. Consumer confidence increased marginally to 36.2 from 35.5 in October. The yen appreciated by 0.5% this week against the U.S. dollar. The BoJ left its policy rate unchanged this Thursday, while reassuring markets that more stimulus could be added if needed in the future. Report Links: A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mixed: On the housing front, nationwide house prices increased by 0.4% year-on-year in October. Mortgage approvals increased marginally to 65.9K in September. Money supply (M4) grew by 4% year-on-year in September, up from 3.3% in the previous month. GfK consumer confidence fell further to -14 in October. The pound appreciated by almost 1% against the U.S. dollar this week. The E.U. has agreed on yet another Brexit extension until January 31st. An earlier exit is also possible if the U.K. so chooses. Meanwhile, the U.K. economy is holding up quite well despite the cloud of uncertainty. We remain tactically long GBP/JPY. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: Headline inflation increased to 1.7% year-on-year in Q3, up from 1.6% in the previous quarter. HIA new home sales grew by 5.7% month-on-month in September. Building permits contracted by 19% year-on-year in September. However on a monthly basis, it grew by 7.6% in September. AUD/USD surged by 1.2% this week. During a speech this Monday, RBA Governor Philip Lowe ruled out the possibility of negative interest rates in Australia, and urged businesses to start investing given historically low interest rates. Going forward, we expect the Aussie dollar to rebound amid a global growth recovery.  New Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Building permits increased by 7.2% month-on-month in September. Business confidence came in at -42.4 in October. This was an improvement from -53.5 in the previous month. The activity outlook fell further to -3.5 from -1.8 in October. The New Zealand dollar soared by 0.9% against the USD this week. While we expect the kiwi to outperform the USD amid global growth recovery, it will likely underperform its pro-cyclical peers. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in the Canada have been firm: GDP grew by 0.1% month-on-month in August. Bloomberg Nanos confidence index fell marginally to 57.4 for the week ended October 25th. The Canadian dollar has depreciated by 0.7% against the U.S. dollar, making it the worst performing G-10 currency this week. The BoC decided to keep interest rates on hold this Wednesday, with relatively strong domestic growth and inflation on target. While growth in Canada has surprised to the upside, it might not prove sustainable. We are shorting the Canadian dollar this week against the Australian dollar. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15HF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mixed: KOF leading indicator increased to 94.7 in October, up from 93.9 in the previous month. ZEW expectations fell further to -30.5 in October. The Swiss franc has increased by 0.7% against the U.S. dollar this week. Domestic fundamentals remain strong in Switzerland, but are at risk from the global growth slowdown. As a safe-haven currency, a rising gold-to-oil ratio points to a higher franc. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Retail sales increased by 0.8% year-on-year in September. USD/NOK is flat this week amid broad dollar weakness. The Norwegian krone has diverged from the ebb and flow of energy prices, and is currently trading around two standard deviations below its fair value. While energy prices have recently been soft, the selloff in the Norwegian krone is exaggerated. We are looking to short CAD/NOK. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Consumer confidence rebounded to 92.7 in October. Retail sales increased by 2.6% year-on-year in September. Trade balance of goods shifted back to a surplus of SEK 2 billion in September, following the deficit of SEK 5.5 billion in August. Both imports and exports increased by SEK 6.6 billion and SEK 14.1 billion month-on-month, respectively. USD/SEK fell by 0.6% this week. The Swedish krona is much undervalued. A cheap krona should help to improve the balance of payments dynamics in Sweden. We expect the krona to bounce back sharply once global growth shows more signs of recovery amid a U.S.-China trade war détente. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The lack of dollar liquidity has been a tailwind behind the dollar bull market. Going forward, an end to a contraction in the Federal Reserve’s balance sheet should help stem the global shortage of dollars. Outside of a few basket cases, there remains scant evidence that the shortage of dollars has begun to trigger widespread negative feedback loops, symptomatic of a funding crisis. If the global economy picks up steam, a deterioration in the U.S. current account and rising FX reserves will improve the dollar liquidity situation. A trade war remains the key risk to this view. For the remainder of the year, portfolio managers should focus on relative value trades on the crosses rather than outright dollar bets. The European Central Bank’s resumption of quantitative easing could be paradoxically bullish for the euro beyond the near term. For now, stay short the euro versus a basket of petro-currencies. Feature At the center of the global financial architecture is the U.S. dollar and the Federal Reserve. The process behind the creation of dollars is a simple one, which goes as follows: In order to stimulate the U.S. economy, the authorities pursue macroeconomic policies that tend to weaken the dollar, such as lowering rates and/or running a wider fiscal deficit. The central bank helps finance this fiscal deficit via expanding the monetary base (seignorage). The drop in rates causes the yield curve to steepen. This incentivizes banks to lend, which in turn boosts U.S. money supply. As the economy recovers, and demand for imports (machinery, commodities, consumer goods) rises, the current account deficit widens. As a reserve currency, the U.S. trade deficit is settled in dollars. This leads to a flow of greenbacks outside U.S. borders. Wary of losing competitiveness via a rising exchange rate, other central banks will purchase these dollars from the private sector in exchange for local currency. The rise in foreign exchange reserves can be reinvested back into Treasurys and held in custody at the Fed, meaning that the current account deficit (or capital account surplus) finances the budget deficit. Call this an exorbitant privilege. The key question is whether dollar liquidity will ease over the near term or the shortage will intensify. A few factors suggest the former.  The sum of the Fed’s custody holdings together with the U.S. monetary base constitutes the root of global dollar liquidity. Each time this measure has severely contracted, the reduction in dollars has triggered a blowup somewhere, typically among other countries running twin deficits (Chart I-1). For example, since the Global Financial Crisis, a fall in the growth of this measure below the critical zero line coincided with the European debt crisis, China’s slowdown, and more recently slowing global trade and a manufacturing recession. Importantly, the slowdown in global trade preceded escalation in trade tensions between the U.S. and China, meaning other endogenous factors were also at play. Lack of dollar liquidity was perhaps a factor. Chart I-1A Liquidity Squeeze Of Dollars Chart I-2The U.S. Budget Deficit Needs To Be Financed In the past, the Fed was quick to correct the situation:  most episodes when the U.S. current account deficit was shrinking, the domestic economy was on the cusp of a slowdown or recession. This time around, easy fiscal policy and a trade-hawkish President have allowed the Fed to ignore the liquidity crisis happening outside the U.S. Key to this is that the lines are now blurred between how much of the trade slowdown is tariff escalation, and how much is due to endogenous factors. As a result, the Fed no longer felt obliged to intervene for markets outside the U.S., especially if the U.S. domestic economy was faring well. A shrinking U.S. current account deficit is incompatible with a resolution to the dollar crisis, especially as the greenback remains the global reserve currency (Chart I-2). On the surface, this is dollar bullish. Meanwhile, our geopolitical strategists contend that the trade war is just a symptom of a much larger battle for hegemonic supremacy, which will last for many years to come. However, the key question is whether dollar liquidity will ease over the near term or the shortage will intensify. A few factors suggest the former. Balance Sheet, Current Account And Foreign Debt Chart I-3The Contraction In Custody Holdings Is Over The Fed’s tapering of asset purchases has been a net drain on global dollar liquidity. But that is slated to change. The Fed’s balance sheet peaked a nudge above US$4.5 trillion in early 2015 and has been falling since. This has triggered a severe contraction in the U.S. monetary base, and severely curtailed commercial banks’ excess reserves. The Federal Reserve’s custody holdings argue that this was a huge drag on international dollar liquidity, even worse than during the 2008 crisis (Chart I-3). The good news is that the Fed has ended the tapering of its balance sheet and has started cutting rates. This combination will improve dollar's liquidity going forward. Meanwhile, balance-of-payment dynamics are heading in the wrong direction. Over the next five years, the U.S. Congressional Budget Office (CBO) estimates that the U.S. budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit and then stabilizes, this will pin the twin deficits at around 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. Part of these deficits will need to be funded through money printing. One difference between now and the past is that over the last several years, the dollar has become expensive. The narrowing of the U.S. current account balance might therefore be over. The U.S. saw its twin deficits swell to almost 13% of GDP following the financial crisis. However, then the dollar was cheap and commodity currencies were overvalued, following a natural resource bust. One way to solve an overvaluation problem is to increase the supply of dollars. Dollar liquidity shortages tend to be vicious because they trigger negative feedback loops. As the velocity of international U.S. dollars rises, offshore dollar rates begin to rise, lifting the cost of capital for borrowing countries. Debt repayment replaces capital spending. Yet there is little evidence that a dollar shortage has been triggering this sort of negative feedback loop. U.S. dollar funding to external entities is growing by circa 4% a year and has slowed to a crawl among both developed and emerging markets (Chart I-4). Historically, this slowdown has been symptomatic of a funding crisis in EM. Yet this time around, there have been other forces at play: The growth in euro- and yen-denominated debt is exploding, which mirrors the gradual shift in the allocation of FX reserves away from dollars into other currencies. The growth in euro- and yen-denominated debt is exploding (Chart I-5). This is much smaller in outstanding amounts than U.S.-denominated debt, but mirrors the gradual shift in the allocation of FX reserves away from dollars into other currencies. If the U.S. has started to weaponize the U.S. dollar, foreign entities may have no other choice than to rally into other currency blocs, which may eventually entail the Chinese yuan. Chart I-4Growth In The Dollar Short Position Has Eased Chart I-5Lots Of Yen And Euro Debt ##br##Issuance The fall in the use of dollars gradually redistributes the “exhorbitant priviledge” of the U.S. currency. This alleviates the need for the U.S. to run a wider current account deficit (President Trump’s goal). This means lower growth in foreign exchange reserves could become the norm rather than the exception (Chart I-6). Historically, current account imbalances have been a major source of currency crises, meaning the system could actually be more stable. Chart I-6The Drop In FX Reserves Is Not Precarious The performance of some emerging market currency pairs will determine if the so-called funding crisis stays benign or becomes more malignant. Despite a deeper liquidity shortage than during the 2015-2016 crisis, most EM currency pairs are still trading within well-defined wedges and/or above critical thresholds (Chart I-7). Meanwhile, EM volatility remains much subdued – not symptomatic of a funding crisis (Chart I-8). Chart I-7EM Currency Pairs Remain Outside The Danger Zone Chart I-8EM FX Volatility##br## Is Low Bottom Line: One way to track if a dollar-funding crisis is becoming more acute is through the convenience yield, or cross-currency basis swap.1 This measures the difference in yield between an actual Treasury and a synthetic one trading in the offshore market. On this basis, it remains well below the panic levels observed in 2008, 2011 and 2015-2016, suggesting the dollar shortage is not as acute as back then (Chart I-9). Chart I-9The Convenience Yield For The Dollar Remains Low The ECB Bazooka Chart I-10Relative R-Star* In The Eurozone Could Rebound The ECB provided the stimulus the market wanted: they cut rates 10 basis points, offered a tiered system for their marginal deposit facility, and are starting an open-ended QE program at €20 billion a month in November. Yet the euro bounced. Our bias is that European rates were already well below equilibrium compared to the U.S., and the ECB’s dovish shift will help further lift the euro area’s growth potential (Chart I-10). If a central bank eases financing conditions at a time when growth is hitting a nadir, it is hardly bearish for the currency. Since the introduction of the euro, most of the economic imbalances from the region have stemmed from the standard contradiction of a common currency regime. This has been that interest rates have always been too low for one nation, while expensive for others. As such, the euro has typically been caught in a tug-of-war between a rising equilibrium rate of interest for one country, but a very low neutral rate for others.2 In the early 2000s, Spanish and Irish long-term rates were too low, and the reverse was true for Germany. The result was a massive boom in Spanish real estate, the accumulation of debt and buildup of major imbalances. Once bond vigilantes started punishing the periphery for their sins after the Great Recession, Germany found itself with rates that were too low relative to its newly reformed economy, while the periphery deflated. Capital spending in the peripheral countries has been rising faster than in core Europe, suggesting the spread between the cost of capital in these countries and the return on capital remains wide. The good news is this has not been the case for a few months now: 10-year government bond yields in France, Spain and even Portugal now sit at -24 basis points, 22 basis points and 24 basis points respectively, much below the neutral rate. This is severely easing financial conditions across the entire euro zone (Chart I-11). Chart I-11The Common-Currency Dilemma Solved There has been a reason behind the collapse in spreads, aside from a dovish ECB. Labor market reforms in Mediterranean Europe have seen unit labor costs in Greece, Ireland, Portugal and Spain collectively contract by almost 10%. This has effectively eliminated the competitiveness gap that had accumulated over the past two decades (Chart I-12). Italy remains saddled with a rigid and less productive workforce, but overall adjustments have still come a long way to closing a key fissure plaguing the common-currency area. The result is in the numbers. Capital spending in the peripheral countries has been rising faster than in core Europe, suggesting the spread between the cost of capital in these countries and the return on capital remains wide (Chart I-13). More rapid capital spending in the periphery is a key channel to close the productivity gap between member nations and lift the neutral rate of interest for the entire euro zone. Chart I-12The Competitiveness Gap Has Closed Chart I-13The Cost Of Capital Is Low In The Periphery The euro tends to be largely driven by pro-cyclical flows. Fortunately for investors, European equities, especially those in the periphery, remain unloved, given they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Analysts began revising up their earnings estimates for euro zone equities earlier this year. If they are right, this tends to firmly lead the euro by about nine to 12 months (Chart I-14).  Meanwhile, European bonds in hedged terms still remain very attractive (Table I-1). Chart I-14The Euro Might Soon Pop Table I-1Bond Markets Across The Developed World A key barometer to watch will be the performance of European banks. So far, they have avoided falling below the critical death zone (Chart I-15). We are awaiting further evidence that the global growth environment is becoming less precarious to place outright long euro bets. Stay tuned. Chart I-15Watch Eurozone Banks Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Arvind Krishnamurthy and Hanno Lustig, “Mind the Gap in Sovereign Debt Markets: The U.S. Treasury basis and the Dollar Risk Factor,” Stanford University, August 29, 2019. 2 Please see Foreign Exchange Strategy Weekly Report, titled “EUR/USD And The Neutral Rate of Interest,” dated June 14, 2019, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in U.S. have been mostly positive: Starting with labor market, nominal average hourly earnings were little changed at 3.2% year-on-year in August, however real average hourly earnings yearly growth increased from 1.3% to 1.5% year-on-year. The unemployment rate was unchanged at 3.7%. Nonfarm payrolls increased by 130,000 in August, below expectations of 158,000. NFIB small business optimism index fell from 104.7 to 103.1 in August. Both headline and core PPI increased by 1.8% and 2.3% year-on-year in August. While headline inflation somewhat slowed to 1.7% year-on-year in August, core inflation came in strong at 2.4% year-on-year. DXY index appreciated initially by 0.6% post ECB, then soon plunged, ending -0.2% this week. BLS reported a large increase in temporary positions in the federal government, reflecting the preparation for the 2020 Census. Notable job gains also occurred in health care and finance, while mining lost jobs. During a Q&A session in Zurich last Friday, Powell noted that the outlook remains a favorable one despite global trade risks. The most likely scenario for the U.S. is continued moderate growth.  Report Links: Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mostly negative: GDP growth increased to 1.2% year-on-year in Q2, from a downwardly-revised 1.1% in the previous quarter. Sentix confidence came in at -11.1 in September, remaining in negative territory but higher than expected. Industrial production contracted by 2% year-on-year in July. EUR/USD fell by 0.9% post ECB meeting, followed by a quick rebound, gaining 0.3% in total this week. Mario Draghi’s last meeting as governor delivered another “bazooka.” The deposit facility rate was cut by 10 bps to a new low of -0.5%, and the ECB will restart QE at €20 billion monthly in November. It will also introduce a two-tiered system for interest rates. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Average cash earnings contracted by 0.3% year-on-year in July. Annualized GDP growth slowed from 1.8% to 1.3% quarter-on-quarter in Q2. The adjusted BoP current account balance narrowed to ¥1.65 trillion in July. The BoP trade balance shifted to a deficit of ¥74.5 billion. While the ECO watchers current index rebounded to 42.8 in August, the outlook component dropped to 39.1, the lowest since 2014. Preliminary machine tool orders kept contracting by 37.1% year-on-year in August. Core machinery orders yearly growth fell from 12.5% to 0.3% in July. PPI decreased by 0.9% year-on-year in August. USD/JPY increased by 1% this week. The outlook for Japan remains worrisome in anticipation of the scheduled consumption tax hike next month. Besides that, the relationship between Japan and South Korea is in the worst state in decades. Tourist arrivals between the two neighbors are both deteriorating. However, the BoJ remains out of policy bullets. This puts a floor under the safe-haven yen, until the BoJ acts. Report Links: Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in U.K. have been slightly improving: Manufacturing production grew by 0.3% month-on-month in July. On a year-on-year basis, it contracted by 0.6%, an improvement from the previous -1.4%. Industrial production contracted by 0.9% year-on-year in July, higher than the consensus of -1.1%. Total trade deficit (including EU) slightly increased to £0.22 billion in July. Trade deficit (non-EU) widened to £1.93 billion. ILO unemployment rate fell to 3.8% in July. Average earnings growth increased to 4% year-on-year in July. GBP/USD increased by 0.4% this week. We believe that the probability of a no-deal Brexit remains low, but for the time being, we are standing aside while waiting for the chaos to settle. Next week we will be publishing an update on the U.K. economy. Stay tuned. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: Home loans grew by 4.2% month-on-month in July, up from 0.4% in the previous month. Westpac consumer confidence fell by 1.7% month-on-month in September. National Australia Bank (NAB) business confidence fell from 4 to 1 in August. AUD/USD appreciated by 0.5% this week. Investor and consumer sentiment remain depressed amid global trade worries and the diminishing returns from Chinese stimulus. However, we are seeing tentative signs of recovery as the housing sector stabilizes. We maintain a positive view on the Australian dollar. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been neutral: Net migration increased by 5100 in July. Manufacturing sales contracted by 2.7% quarter-on-quarter in Q2. The New Zealand dollar has been more or less flat against the U.S. dollar this week, but fell by 0.5% against the Australian dollar. China granted several U.S. products a one-year exemption from tariffs this week. While the good news regarding a potential U.S.-China trade deal could benefit pro-cyclical currencies, we believe the kiwi will underperform at the crosses. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been solid: In August, 81,100 jobs were added, the unemployment rate was unchanged at 5.7%, and average hourly wages grew by 3.8% year-on-year. Ivey PMI increased to 60.6 in August, from the previous 54.2 in July. Bloomberg Nanos confidence was little changed at 56.5 for the past week. Housing starts increased by 226,600 in August.  Building permits grew by 3% month-on-month in July. New house price index fell by 0.4% year-on-year in July. USD/CAD increased by 0.2% this week. While the oil prices and robust job numbers could benefit the Canadian dollar in the near term, a rising exchange rate, and increasing interest rate differentials might tighten financial conditions, and thus limit the upside of the loonie. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There is scant data from Switzerland this week: Producer and import prices contracted by 1.9% year-on-year in August. Unemployment rate was unchanged at 2.3% in August. USD/CHF has been flat this week. Last Friday, during the Q&A session in Zurich, SNB chairman Jordan emphasized that as a small open economy, Switzerland is heavily impacted by global economic developments, notably what is happening in the U.S., Europe, and China. The recent slowdown has weighed on the Swiss economy. More importantly, Jordan noted that price stability remains an important mandate for the Swiss people and the bank. Further policy adjustments, besides interest rates, might be necessary to stimulate the economy. The ECB policy meeting this week has also put more pressure on SNB to further ease monetary policy. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been neutral: Manufacturing output grew by 1% in July. Headline and core inflation both slowed to 1.6% and 2.1% year-on-year in August. USD/NOK fell by 0.4% this week, as oil prices continued to rally. Prince Abdulaziz Bin Salman was appointed as the new Energy Minister of Kingdom of Saudi Arabia (KSA), and he is committed to oil production control. Moreover, the possible good news over a U.S.-China trade deal is likely to revive oil demand, thus lifting Norwegian krone. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mostly negative: Household consumption increased by 2.8% year-on-year in July. Headline inflation slowed from 1.7% to 1.4% year-on-year in August. Core inflation also slowed to 1.6% year-on-year, from the previous 1.7%. USD/SEK fell by 0.4% this week. Last week, the Riksbank kept interest rates on hold, and said that they are still planning to raise interest rates but at a slower pace. The slowdown in inflation this week might further delay their plan for a rate hike.  Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Dear Clients, In addition to this Weekly Report, you will also be getting a Special Report authored by some of our top strategists on global growth. The manufacturing recession that began in early 2018 has lasted longer than most expected. The risk is that this is an additional end-of-cycle indicator, with important ramifications for the U.S. dollar. The dollar tends to stage meaningful rallies in recessions. In this week’s publication, we highlight some of the key indicators we are watching for justification on maintaining a pro-cyclical stance, but the internal debate from the Special Report highlights how delicate the balance of forces for this stance are. A fortnight ago we suggested a few portfolio hedges, and recommend maintaining tight stops on all positions until September. Next week, we will be sending you a Special Report on gold, from our colleagues in the Commodity & Energy Strategy team. In the interim, I will be learning from our clients in Latin America about some of the forces currently shaping global FX markets. I will report back with my findings in a few weeks. Kind Regards, Chester Ntonifor Foreign Exchange Strategist Highlights There is very scant evidence that global growth is bottoming. That said, it is usually darkest before dawn. A few key indicators are beginning to flash amber, which we will continue to closely monitor. The deceleration phase this cycle has been as prolonged as others, warning that the rebound could also be V-shaped. The AUD/JPY cross will be a very useful barometer. Stay long a basket of petrocurrencies versus the euro and short USD/JPY. Feature One of the most cyclical developed-market indices is the Japanese Nikkei (Table I-1).1 Almost 60% of all sectors are concentrated in just three: consumer discretionary, information technology and industrials. Boasting a wide spectrum of global robotic, automotive and construction machinery giants, Japanese companies sit at the epicenter of the global manufacturing supply chain. As such, it is very telling when Japanese share prices – which track global bond yields very closely – appear to be making a tentative bottom (Chart I-1). On the currency front, a lower greenback has also tended to be a very useful confirmation signal that we are entering a reflationary window. A slowing global economy on the back of deteriorating trade is positive for the greenback. As a reserve and counter-cyclical currency, the dollar has tended to rise during times of capital flight. On the other hand, a dovish Federal Reserve knocks down U.S. interest rate expectations relative to the rest of the world. This has historically been bearish for the dollar, and positive for global growth (Chart I-2). More importantly, even if the Fed does not proceed to cut rates as much as the market expects, it will be because global growth has bottomed, which will also favor non-U.S. rates. Chart I-1Japanese Share Prices Usually Bottom Before Bond Yields Chart I-2A Dovish Fed Will Be Dollar Bearish The commodity and export channel also helps explain why rising global growth is negative for the dollar. In theory, rising commodity prices (or rising terms of trade) allow for increased government spending in export-driven economies, making room for the resident central bank to tighten monetary policy. This is usually bullish for the currency. Rising terms of trade also further increases the fair value of the exchange rate. Balance-of-payments dynamics also tend to improve when exports are booming. Altogether, these forces combine to be powerful undercurrents for pro-cyclical currencies. Both political and domestic pressure for central banks to ease policy is the highest it has ever been. Chart I-3Both Economic And Political Pressure For Central Banks To Alter Policy Both political and domestic pressure for central banks to ease policy is the highest it has ever been.2 This suggests that either they have already done so or the conditions warranting stimulus have hit climactic pressure. Going forward, such a synchronized move by global central banks is usually accompanied by a synchronized recovery, for the simple reason that central banks are usually behind the curve (Chart I-3). Finally, the starting point for long dollar positions is one of an overcrowded trade, along with U.S. Treasury bonds. The latest downdraft in global manufacturing has nudged U.S. net speculative long positions to a point where they typically experience exhaustion (Chart I-4). This suggests there may be a scarcity in fresh dollar bulls. 2018 was particularly favorable for the dollar, as a liquidity crunch (the Fed’s balance sheet runoff) underpinned a sizeable rally. The big surge in cryptocurrencies this year (and gold) could suggest that the liquidity environment is once again becoming favorable.  Chart I-4Dollar Positioning Is Stretched Chart I-5Carry Trades Are Usually Consistent With Higher Yields   An improving liquidity environment will be especially favorable for carry trades. High-beta currencies such as the RUB/USD, ZAR/USD and BRL/USD have stopped falling and are off their lows of the year. These currencies are usually good at sniffing out a change in the investment landscape. The message so far is that the drop in U.S. bond yields may have been sufficient to make these currencies attractive again (Chart I-5). Bottom Line: There is very scant evidence that global growth is bottoming. That said, it is usually darkest before dawn. A few key indicators are beginning to flash amber, which we will continue to monitor closely. A Few Growth Barometers A key difference from last year is that U.S. growth leadership is set to give way to the rest of the world. The U.S. ISM manufacturing Purchasing Manager’s Index (PMI) peaked last August and has been steadily rolling over relative to its trading partners. Historically, the relative growth differential between the U.S. and elsewhere has had a pretty good track record of dictating trends in the dollar. The message is that the manufacturing PMI should pick up from 47.6 currently to the 50 boom/bust level in the coming months. Meanwhile, there is some evidence that there are tentative signs of a bottom in global growth: Chart I-6Euro Area Might Be Close To A Bottom Europe: The Swedish new orders to inventory ratio has a long and pretty accurate track record of calling bottoms in European growth, and the message is that the manufacturing PMI should pick up from 47.6 currently to the 50 boom/bust level in the coming months. Importantly, the recoveries have tended to be V-shaped pretty much throughout the past two decades. Any further decline in the PMI will pin it at levels consistent with the last European debt crisis (Chart I-6). Japan: Japan is closely impacted by the industrial cycle, especially demand from China. And while overall machinery orders remain weak, machine tool orders from China have bottomed. China: The Chinese credit impulse has bottomed. This suggests the contraction in imports, along with Korean and Taiwanese exports, is near its nadir (Chart I-7). The domestic bond market in China is becoming pretty good at signaling reflationary conditions for domestic demand (Chart I-8). Singapore exports this week were deeply negative, but this could be the bottom if all credit-injection so far in China starts flowing. Shipping indices are already recovering very strongly, and global machinery stocks are re-rating. Chart I-7A Modest Recovery For Exports Chart I-8Chinese Imports Should Bounce A pickup in Chinese growth should begin to benefit commodity currencies, especially the Australian dollar. A lot of the bad news already appears to be priced into the Aussie, which is down 14% from its 2018 peak and 37% from its 2011 peak. This suggests outright short AUD bets are susceptible to either upside surprises in global growth or simply forces of mean reversion. Importantly, the AUD/JPY cross is sitting at an important technical level. Ever since the financial crisis, the 72-74 cent zone has proven to be formidable resistance, with the cross failing to break below both during the euro area debt crisis in 2011-2012 and the China slowdown of 2015-2016. Speculators are now massively short the cross, suggesting that any upward move could be powerful and significant (Chart I-9). A rally in the Swedish krona will be another confirmation that global growth may have bottomed.  A rally in the Swedish krona will be another confirmation that global growth may have bottomed. On a relative basis, the Swedish economy appears to have troughed relative to that of the U.S., making the USD/SEK an attractive way to play USD downside. From a technical perspective, USD/SEK failed to break decisively above 9.60, and is now trading below a major resistance at 9.40 (Chart I-10). Aggressive investors can slowly begin accumulating short positions, while being cognizant of the negative carry. Chart I-9AUD/JPY Near A Critical Zone Chart I-10The Swedish Krona Is Attractive Bottom Line: We are already long the SEK versus NZD, and the thesis remains intact from our June 7th recommendation. The AUD/JPY cross is very close to a bottom.  Hold EUR/CAD For A Trade Chart I-11EUR/CAD Technicals: Limited Downside The EUR/CAD has reached an important technical level, and what will follow is either a major breakdown or a powerful bounce (Chart I-11). With Canadian data firing on all cylinders and the euro area in the depths of a manufacturing recession, the cross has rightly responded to growth divergences. On the downside, the EUR/CAD is at the bottom of the upward trending channel that has existed since 2012, in the vicinity of 1.45-1.46. A bounce here will not meet initial upside resistance until the triple top, a nudge above 1.6. The biggest catalyst for this cross going forward will likely be interest rate differentials, since any improvement in euro area data will continue to reduce the scope by which the European Central Bank stays dovish relative to the Bank of Canada. European rates are further below equilibrium, and the ECB’s dovish shift will help lift the growth potential of the euro area. Meanwhile, the Canadian neutral rate will be heavily weighed down by the large stock of debt in the Canadian private sector, exacerbated by overvaluation in the housing market. Valuations and balance-of-payment dynamics also favor the euro versus the CAD on a long-term basis. Bottom Line: Hold the EUR/CAD for a trade with a stop at 1.45. Chart I-12Gold/Silver Ratio Near Speculative Extreme Trade Idea: Buy Silver, Sell Gold The gold/silver ratio is reaching a speculative extreme. Usually, reflationary cycles benefit silver more than gold, with 100 usually the upper bound of the gold/silver ratio. We are very close to such a tipping point. Stay tuned (Chart I-12). Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com               Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have continued to soften: Headline PPI fell to 1.7% year-on-year in June. Core PPI was unchanged at 2.3% year-on-year in June. NY Empire State manufacturing index increased to 4.3 in July. Retail sales increased by 0.4% month-on-month in June. Import and export prices contracted by 0.9% and 2% year-on-year respectively in June. Building permits contracted by 6.1% month-on-month in June. Housing starts softened by 0.9% month-on-month. Philadelphia Fed manufacturing index rose to 21.8 in July from 0.3 in June. Continuing jobless claims fell to 1.686 million this week, while initial jobless claims increased to 216 thousand. DXY increased by 0.4% this week. On Tuesday, Fed Chair Powell gave a short speech in Paris, regarding the current developments in the U.S. economy, and some post-crisis structural shifts. While U.S. economy has been on the 11th consecutive year of expansion, Powell highlighted concerns towards softer growth this year, in the manufacturing sector in particular, weighed down by weaker consumer spending, sluggish business investment, and trade war uncertainties. Report Links: On Gold, Oil And Cryptocurrencies - June 28, 2019 Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been weak: Industrial production contracted by 0.5% year-on-year in May. Trade balance widened to €20.2 billion in May. Headline and core inflation increased by 1.3% and 1.1% year-on-year respectively in June. EUR/USD fell by 0.36% this week. ZEW data continue to soften in July: The sentiment index in the euro area fell to -20.3, and the sentiment in Germany decreased to -24.5. Moreover, the European Commission’s summer forecast released last week cut the 2020 euro area GDP projection from 1.5% (spring forecast) to 1.4%, and lowered inflation to 1.3% for both this year and next year. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Industrial production contracted by 2.1% year-on-year in May. Capacity utilization increased by 1.7% in May. Exports contracted by 6.7% year-on-year in June. Imports also fell by 5.2% year-on-year. Total trade balance increased to ¥589.5 billion. USD/JPY fell by 0.2% this week. The weak Q2 data worldwide, driven by a significant slowdown in the manufacturing sector have raised concerns for a possible near-term recession. This has been exacerbated by a trade war, U.S.-Iranian tensions and Brexit uncertainties. We continue to favor the yen as a safe-haven currency. Hold to the short USD/JPY and short XAU/JPY positions. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mixed: Rightmove house price index contracted by 0.2% year-on-year in July. On the labor market front, ILO unemployment rate was unchanged at 3.8% in May. Average earnings including bonus increased by 3.4% in May. Headline inflation was unchanged at 2% year-on-year in June. Core inflation increased to 1.8% year-on-year. Retail sales increased by 3.8% year-on-year in June. GBP/USD fell by 0.5% this week, now trading around 1.2486. The Brexit uncertainties still loom over the U.K. Boris Johnson and Jeremy Hunt are fighting to take over from Theresa May as the leader of the Conservative Party and the UK’s next Prime Minister. In addition, the Q2 credit conditions survey released this Thursday indicates that default rates on loans to corporates increased for small and large businesses in Q2. Meanwhile, these are expected to increase for businesses of all sizes in Q3. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: Westpac leading index fell by 0.08% month-on-month in June. On the labor market front, unemployment rate was unchanged at 5.2% in June. Participation rate was steady at 66%. 500 new jobs were created in June, including 21.1 thousand new full-time positions, and a loss of 20.6 thousand part-time positions. AUD/USD increased by 0.3% this week. The RBA minutes released this week reiterated that the central bank is ready to adjust interest rates if required, in order to support sustainable growth and achieve the inflation target overtime. The easing financial conditions and rising terms of trade all underpin the Aussie dollar in the long term. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly positive: House sales keep contracting by 3.8% year-on-year in June. Business manufacturing PMI increased to 51.3 in June. Headline inflation increased to 1.7% year-on-year in Q2. NZD/USD rose by 0.6% this week. Solid incoming data have lifted the New Zealand dollar for the past few weeks. However, the kiwi might lag the Aussie given the RBNZ is behind the RBA. The market is currently pricing in an 84% probability of a rate cut at the beginning of next month, but more cuts could be needed down the road. Hold to our long AUD/NZD and SEK/NZD positions. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mostly positive: Headline and core inflation both fell to 2% year-on-year in June.  ADP employment shows an increase of 30.4 thousand new jobs in June. USD/CAD increased by 0.3% this week. Just last week, the BoC kept its interest rate on hold. With a more dovish Fed, this might narrow the interest rate differentials between the Fed and the BoC. We favor the loonie in the near-term based on the interest rate differentials, crude oil prices, and relatively more positive data incoming from Canada. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mixed: Producer and import prices contracted by 1.4% year-on-year in June. Exports increased to CHF 20,328 million, while imports fell to CHF 17,131 million in June. This lifted the trade balance up to 3,251 million. USD/CHF increased by 0.35% this week. We continue to favor the Swiss franc in the long term. The rising market volatility has increased the appetite for the Swiss franc. Moreover, the Swiss franc is still cheap compared to its fair value. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been negative: Trade balance narrowed to NOK 5.2 billion in June. USD/NOK increased by 0.8% this week. The recent energy price volatility, mostly due to the uncertainties of oil demand has knocked down the Norwegian krone. In the long term, we continue to believe that the OPEC 2.0’s production strategy of reducing global oil inventories, and U.S. – Iran tension will drive oil prices higher, thus bullish for petrocurrencies including the Norwegian krone. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive. Industrial orders increased by 3.2% year-on-year in May. Budget balance came in at SEK -24.8 billion in June. USD/SEK fell by 0.28% this week. Recent data shows that the Swedish government debt is sliding below 35% of GDP. This is triggering political pressure on the government to expand fiscal support. More fiscal expenditure will allow for a more hawkish Risksbank, supporting the Swedish Krona.  Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Footnotes 1      The Global Industry Classification Standard (GICS) classification does not really apply for euro zone companies, so we used the Industry Classification Benchmark (ICB) for the euro area, the U.S., and Japan. The difference between GICS and ICB is that the new GICS standard (which took effect last year) splits Telecom into an additional Communication Services sector. ICB may also apply this later this year. 2      Carola Binder, “Political Pressure on Central Banks,” SSRN, December 16, 2018. Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights It remains too early to put on fresh pro-cyclical trades, but the Federal Reserve’s dovish shift is a positive development at the margin. As the market fights a tug of war between weak fundamentals and easier monetary policy, bigger gains are likely to be made at the crosses rather than versus the dollar. Safe-haven currencies are also winners in the interim. Continue to hold short USD/JPY positions recommended last week. Watch the gold-to-bond ratio for cues on where the balance of forces are shifting, with a rising ratio negative for the dollar. Once investors eventually shift their focus towards the rising U.S. twin deficits, de-dollarization of the global economy and low expected returns for U.S. assets, the dollar will peak. New idea: Buy SEK/NZD for a trade. Feature Global markets have once again decided that the U.S. is due for rate cuts, and the Federal Reserve appears to be heeding their message. Both Fed Governor Lael Brainard and Fed Chair Jerome Powell have suggested that policy should be calibrated to address the downside risks posed by the trade war.   The question du jour is the path of the dollar if the Fed eventually does ease monetary policy. A slowing global economy on the back of deteriorating trade is positive for the greenback, since it is a counter-cyclical currency. A Fed rate cut will just be acknowledging the gravity of the slowdown. On the other hand, a dovish Fed knocks down U.S. interest rate expectations relative to the rest of the world. This has historically been bearish for the dollar, and positive for global growth. Our bias remains that the dollar will emerge a loser in this tug of war, especially if Beijing and Washington come to a trade agreement. However, for currency strategy, it is important to revisit our indicators to see where the balance of forces for the dollar lie. We do this via the lens of interest rate differentials, global growth, liquidity trends, and positioning. Expectations Versus Reality Markets are mostly wrong about Fed interest rate expectations, but do get it right from time to time. Since the 1990s, most Fed rate-cutting cycles were initially predicted in advance by the swaps market. Moreover, the current divergence between market expectations and policy action is as wide as before the Great Recession, and among the deepest in over three decades (Chart I-1). The fact that the Fed seldom cuts interest rates only once during a mid-cycle slowdown suggests expectations could diverge even further. Outside of recessions, falling rate expectations relative to policy action have historically been bearish for the dollar, and vice versa. This makes intuitive sense. As a reserve and counter-cyclical currency, the dollar has tended to rise during times of capital flight. However, if we are not on the cusp of a recession, then easier monetary policy by the Fed should improve global liquidity, which is bullish for higher-beta currencies and negative for the dollar. On this front, our discounter suggests rate cuts of about 80 basis points are penciled in by the swaps market over the next 12 months. This will put downward pressure on the dollar. It also helps that sentiment on the greenback remains relatively bullish, and speculators are very long the currency (Chart I-2). Chart I-1Big Divergences Are Rare Chart I-2Lots of Room For The Dollar To Fall     Chart I-3Relative Rates Moving Against The Dollar Relative interest rate differentials between the U.S. and the rest of the world continue to suggest that the greenback should be slightly higher. However, the Treasury market tends to be a global interest rate benchmark rather than specific to the U.S. With global growth in a downtrend and the Fed becoming relatively more dovish, U.S. interest rates are falling much faster than elsewhere and closing the interest-rate gap vis-à-vis the rest of the world. A peak in U.S. interest rates relative to its G10 peers has always been a bad omen for the greenback (Chart I-3). Market action following the Reserve Bank of Australia’s (RBA) interest rate cut this week is a case in point. The initial reaction was a knee-jerk rally in AUD/USD. Australian 10-year government bond yields are already 65 basis points below U.S. levels, the lowest since the 1980s. But the structural growth rate in Australia remains higher than in the U.S., suggesting there is a natural limit as to how low relative interest rates can go. We remain long AUD/USD, but are maintaining a tight stop at 68 cents should rising volatility nudge the market against us.1 Australian 10-year government bond yields are already 65 basis points below U.S. levels, the lowest since the 1980s. Bottom Line: Interest rate expectations between the rest of the world and the U.S. are already at very depressed levels. This suggests that unless the world economy tips into recession, rate differentials are likely to shift against the greenback. A dovish Fed could be the catalyst that triggers this convergence. Portfolio Flows The change in the U.S. tax code to allow for the repatriation of offshore cash helped the dollar in 2018, but not to the extent that might have been expected. On a rolling 12-month basis, the U.S. has repatriated about $400 billion in net assets, or close to 2% of GDP. Historically, this is a very huge sum that would have had the potential to set the greenback on fire – circa 10% higher. The issue today is that the tax break was a one-off, and net flows into the U.S. are now rolling over as the impact fades (Chart I-4). Historically, portfolio flows into the U.S. have been persistent, so it will be important to monitor how fast repatriation flows run off. The Fed’s tapering of asset purchases has been a net drain on dollar liquidity. In the meantime, foreign investors have been fleeing U.S. capital markets at one of the fastest paces in years. On a rolling 12-month total basis, the U.S. is seeing an exodus of about US$200 billion in equity from foreigners, the largest on record (Chart I-5). In aggregate, both foreign official and private long-term portfolio investment into the U.S. has been rolling over, with investor interest limited only to agency and corporate bonds. Foreigners are still net buyers of U.S. securities, but the downtrend in purchases in recent years is evident. Chart I-4Repatriation Flows Have Peaked Chart I-5Investors Stampeding Out Of U.S. Equities The one pillar of support for the dollar is falling liquidity (Chart I-6). Internationally, the Fed’s tapering of asset purchases has been a net drain on dollar liquidity, despite a widening U.S. current account deficit. The Fed’s balance sheet peaked a nudge above US$4.5 trillion in early 2015 and has been falling since. This has triggered a severe contraction in the U.S. monetary base, and has severely curtailed commercial banks’ excess reserves. However, with the Fed turning more dovish and its balance sheet runoff slated to end in September, dollar liquidity will likely improve at the margin. Chart I-6A Dollar Liquidity Squeeze Bottom Line: Currency markets continue to fight a tug of war between deteriorating global growth and easier monetary conditions. Our bias is that the dollar will emerge a loser. Falling interest rate differentials, portfolio outflows, soft relative growth and easing liquidity strains support this thesis. Another Dovish Shift By The ECB The European Central Bank (ECB) kept monetary policy unchanged following this week’s meeting, while highlighting that it will be on hold for longer – at least until mid-2020. The EUR/USD rallied on the news, suggesting the market expected a much more dovish ECB. Our bias is that with European long-term rates already at rock-bottom levels relative to the U.S., the currency market will continue to be disappointed by ECB policy actions for now. Economic surprises are rising in Sweden relative to New Zealand.    Terms for the new Targeted Longer-Term Refinancing Operation (TLTRO III – in other words, cheap loans), were announced at 10 basis points above the main refinancing rate. They can fall as low as 10 basis points above the deposit rate if banks meet certain lending standards. There was no mention of a tiered system for its marginal deposit facility, which would have alleviated some cash flow pressures for euro area banks. We remain of the view that TLTROs are a better policy tool than a tiered central bank deposit system. Chart I-7A Tentative Bottom In Euro Area Data In the case of a TLTRO, the ECB can effortlessly decentralize monetary policy, since liquidity gravitates towards the countries that need it the most. While a tiered system can allow a bank to offer higher rates and attract deposits, there is no guarantee that these deposits will find their way into new loans. It is also likely to benefit countries with the most excess liquidity. The euro’s bounce suggests that the ECB’s dovish shift is paradoxically bullish for the euro. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that it is bearish for the currency. Meanwhile, fiscal policy is also set to be loosened. Swedish new orders-to-inventories lead euro area growth by about five months, and the recent uptick could be a harbinger of positive euro area data surprises ahead (Chart I-7). Bottom Line: European rates are further below equilibrium compared to the U.S., and the ECB’s dovish shift will help lift the euro area’s growth potential. Meanwhile, investors are currently too pessimistic on euro area growth prospects. Our bias is that the euro is close to a floor. Buy SEK/NZD For A Trade A few market indicators suggest there is a trading opportunity for the SEK/NZD cross: Since 2015, the cross has been trading into the apex of a tight wedge formation, defined by higher lows and lower highs. From a technical standpoint, the break above the 50-day moving average is bullish, suggesting the cross could gap higher outside its tight wedge (Chart I-8). Economic surprises are rising in Sweden relative to New Zealand. Going forward, this trend is likely to persist given that investor expectations toward the Swedish economy are very bearish (on the back of depressed sentiment towards the euro area). Relative economic surprises have a good track record of capturing short-term swings in the currency (Chart I-9). Chart I-8A Breakout Seems##br## Imminent Chart I-9Sweden Could Perform Better Than New Zealand Interest rates are moving in favor of the SEK/NZD cross. For almost two decades, relative interest rate differentials between Sweden and New Zealand have been a powerful driver of the exchange rate (Chart I-10). The housing downturn appears well advanced in Sweden relative to New Zealand. Rising relative house prices have historically been supportive of the cross (Chart I-11). The undervaluation of the krona has begun to mitigate the effects of negative interest rates, mainly a buildup of household leverage and an exodus of foreign direct investment. Chart I-10Relative Rates Favor SEK/NZD Chart I-11Swedish House Prices Could Stabilize The USD/SEK and NZD/SEK cross tend to be highly correlated, since the SEK has a higher beta to global growth than the kiwi (Sweden exports 45% of its GDP versus 27% in New Zealand). On a relative basis, the Swedish economy appears to have bottomed relative to that of the U.S., making the SEK/NZD an attractive way to play USD downside. Meanwhile, the carry cost of being short NZD is lower compared to being short the U.S. dollar. Housekeeping We recommended a short USD/JPY position last week, which is currently 1.3% in the money. Our conviction remains high that this could be the best performing trade over the next one-to-three months. For one, the cross has “underperformed” its safe-haven status. The AUD/JPY is back to its 2016 lows, suggesting the market is flirting with another riot point, but the USD/JPY is still well above 100. We expect the latter to eventually give way as currency volatility rises (Chart I-12). Chart i-12Hold Short USD/JPY Positions   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “A Contrarian View On The Australian Dollar,” dated May 24, 2019, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been negative: Headline and core PCE were both unchanged at 1.5% and 1.6% year-on-year, respectively. Personal income increased by 0.5% month-on-month in April. However, personal spending increased by only 0.3% month-on-month, lower than expected. Michigan consumer sentiment index fell to 100 in May. Markit composite PMI fell to 50.9 in May, with manufacturing and services PMIs both falling to 50.5 and 50.9, respectively. ISM manufacturing PMI fell to 52.1 in May, while non-manufacturing PMI increased to 56.9. MBA mortgage applications increased by 1.5% in May. The trade deficit fell from $51.9 billion to $50.8 billion in April. On the labor market front, initial and continuing jobless claims rose to 218 thousand and 1.682 million, respectively DXY index fell by 0.8% this week. Chairman Powell gave the opening remarks at the FedListens conference organized by the Chicago Fed this Tuesday, during which he stated that the Fed is closely monitoring trade developments, and will act to sustain the expansion. This signals the potential for rate cuts in the coming monetary policy meetings. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative with inflation well below target: Markit manufacturing PMI in the euro area fell to 47.7 in May, as expected. Markit services and composite PMI increased to 52.9 and 51.8 respectively in May. Unemployment rate fell to 7.6% in April. Preliminary headline and core CPI both fell to 1.2% and 0.8% year-on-year respectively in May, dropping to the lowest levels in more than one year. Producer price inflation fell to 2.6% year-on-year in April. Retail sales growth fell to 1.5% year-on-year in April. Employment growth was unchanged at 1.3% year-on-year in Q1. EUR/USD increased by 0.8% this week. On Thursday, the ECB decided to leave interest rates unchanged. The Governing Council also expects the key rates to remain at current levels at least through the first half of 2020. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Housing starts fell by 5.7% year-on-year in April. Construction orders fell by 19.9% year-on-year in April. Consumer confidence fell to 39.4 in May. Nikkei manufacturing PMI increased to 49.8 in May, while Markit services PMI fell to 51.7 in May. Capital spending was positive in Q1, rising 6.1% year-on-year versus expectations of 2.6%. USD/JPY fell by 0.6% this week. Our “Heads I Win, Tails I Don’t Lose Too Much” bet on a short USD/JPY position is currently 1.3% in the money since entered last Friday.                                                                                        Report Links: Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mixed: Nationwide house prices grew by only 0.6% year-on-year in April. Mortgage approvals increased to 66.3 thousand in April. Money supply (M4) increased by 3% year-on-year in April. Markit manufacturing PMI fell to 49.4 in May, the lowest since 2016. Construction PMI also fell to 48.6, while services PMI increased to 51. GBP/USD increased by 0.5% this week. During Trump’s visit to U.K. this week, he said that U.S. companies should have market access to every sector of the British economy as part of any deal. The pound is likely to trade higher until political uncertainty is reintroduced in July, ahead of elections for a new Conservative leader. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: Private sector credit increased by 3.7% year-on-year in April, slightly lower than expected. AiG performance of manufacturing index fell to 52.7 in May, while the services index increased to 52.5. The current account deficit narrowed to from A$6.3 billion to A$2.9 billion in Q1. Retail sales contracted by 0.1% month-on-month in April. GDP came in at 1.8% year-on-year in Q1, in line with expectations. Trade surplus fell to A$4.9 million in April. AUD/USD increased by 0.76% this week. The RBA cut interest rates by 25 bps to a record low of 1.25% on Tuesday, the first move since August 2016. Governor Philip Lowe emphasized that this decision is not due to deterioration in the Australian economy. Moreover, he believes that while the cut might reduce interest income for many, the effects will be fully passed to mortgage rates, thus lowering payments and boosting disposable income. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mostly negative: Consumer confidence fell to 119.3 in May. Terms of trade increased by 1% in Q1. ANZ commodity price was unchanged in May. NZD/USD increased by 1.4% this week. The New Zealand dollar is benefitting from rising soft commodity prices, on the back of a poor U.S. planting season. However, we believe terms of trade over the longer term will be more favorable for Australia, compared to New Zealand. Hold strategic long AUD/NZD positions. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mostly positive: Industrial product prices increased by 0.8% month-on-month in April. GDP growth increased by 1.4% year-on-year in Q1, above expectations.  Markit manufacturing PMI fell to 49.1 in May. Labor productivity increased by 0.3% quarter-on-quarter in Q1. The trade deficit narrowed to C$0.97 billion in April. Exports increased to C$50.7 billion, while imports fell to C$51.7 billion. USD/CAD fell by 1% this week. The latest downdraft in oil prices is likely to have a negative impact on the loonie. We remain short CAD/NOK as a play on better pricing for North Sea crude, versus WTI. Norway will also benefit more from a pickup in European growth.  Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been neutral: Real retail sales fell by 0.7% year-on-year in April, versus the consensus of -0.8%. Headline inflation fell from 0.7% to 0.6% year-on-year in May. Manufacturing PMI increased to 48.6 in May. USD/CHF fell by 1.1% this week. The franc will benefit from rising volatility as penned in our Special Report three weeks ago. Moreover, the franc is still cheap relative to its fair value. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was little data out of Norway this week: Manufacturing PMI came in at 54.4 in May, from 54 in April. Current account surplus increased from NOK 47.3 billion to NOK 67.8 billion in Q1. USD/NOK fell by 0.6% this week. Our Commodity & Energy team continue to favor oil prices, but have revised down their forecasts from $77/bbl to $73/bbl for Brent this year and next. Despite the recent plunge in crude oil prices, rising inventories in the U.S. allow for OPEC production cuts, which will eventually be bullish. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Manufacturing PMI jumped to 53.1 in May, versus 50.9 in the previous month. Retail sales grew by 3.9% year-on-year in April. Industrial production increased by 3.3% year-on-year in April. Manufacturing new orders rose by 0.1% year-on-year in April.  Lastly, the current account surplus increased to SEK 63 billion in Q1.  USD/SEK fell by 0.6% this week. We like the Swedish krona as a potential reflation play and are going long SEK/NZD this week for a trade. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The clear and present deterioration in Sino-U.S. trade negotiations suggests the dollar will remain bid in the near term. While the probability of a trade deal has fallen, the situation remains highly fluid, and the odds could shift either way rather dramatically. Ultimately, it is beneficial for both parties to come to an agreement. We highlighted last week that in an environment where volatility was low and falling, it paid to have insurance in place. The yen and Swiss franc remain attractive from this standpoint. Our thesis remains that the path of least resistance for the dollar is down, but gauging how high the dollar can catapult before ultimately reversing course is paramount for strategy. Our estimation is that the trade-weighted dollar could rise 2-3% before ultimately cresting. Expect more pronounced USD moves vis-à-vis growth-sensitive currencies. We were stopped out of our short USD/SEK position with a 1.9% loss. If global growth rebounds, this will be a high-conviction trade, but we are standing aside for risk-management purposes. Feature Markets received a dose of volatility this week. First, evidence has emerged that China is retracting on previous commitments toward a Sino-U.S. trade deal. A systematic volte face to core pledges such as legally addressing the theft of U.S. intellectual property and trade secrets, fair competition policy, and removing foreign caps on financial services, aggravated the Trump administration and prompted a new round of tariffs. As we go to press, the final details have not been revealed, but the proposal is to raise tariffs on $200 billion worth of Chinese goods from 10% to 25%, while slapping an additional 25% tariff on the remaining $325 billion of Chinese goods “shortly” after (Chart I-1). Almost simultaneously, tensions between the U.S. and Iran are flaring up following President Trump’s decision not to extend sanction waivers to Iranian oil exports beyond May. The Iranian response has been to threaten to claw back some of the commitments it made in the landmark 2015 nuclear deal, mainly a halt to its uranium enrichment program. The risk of miscalculation and escalation is high. With an aircraft carrier strike group departing from U.S. shores, Tehran could be forced into a corner and begin striking key pipelines in the Iraqi region of Basra, which is home to significant oil traffic. Meanwhile, investor exuberance towards green shoots in the global economy continues to be watered down with incoming data. Chinese export data has weakened anew, both in April and on a rolling three-month basis, following weak PMI numbers last week. Money and credit numbers were soft. Swedish manufacturing data, a strong proxy for global growth, continue to disappoint, with industrial new orders contracting by 8.1% in March – the worst pace since November 2016. And after a brisk rise since the start of the year, many China plays including commodity prices, the yuan, emerging market stocks and even A-shares are rolling over (Chart I-2). Chart I-1Back To The Firing Lines Chart 1-2Reflation Indicators Are Topping Out These developments have unsurprisingly put a bid under the dollar against pro-cyclical currencies. However, the euro is up versus the dollar this week, while the DXY marginally down. The lack of more pronounced volatility in currency markets despite a ramp-up in trade-war rhetoric is eery. Our thesis remains that the path of least resistance for the dollar is down, but gauging how high the dollar can catapult before ultimately reversing course is paramount for strategy. Tariffs And Exchange Rates Standard theory suggests that exchange rates should move to equalize prices across any two countries. This is simply because if prices rise significantly higher in country B versus Country A, it pays to buy the goods from A and resell them to B for a profit, assuming other costs are minimal. Country A’s currency rises following increased demand, while that of Country B falls, until the price differential is arbitraged away. This very simple concept originated from the School Of Salamanca in 16th century Spain, and still applies to this day in the form of Purchasing Power Parity (PPP). The question that naturally follows is by how much should the currency increase? The answer is that the exchange rate will move by exactly the same percentage point as the price increase, everything else equal. If both countries produce homogeneous goods, then it is easy to see why, since there is perfect substitution. But assuming they produce heterogeneous goods, then the loss of purchasing power in Country A will lead to less demand for Country B’s goods. This means Country B’s currency will have to adjust downwards for the markets to clear. The decrease has to match the magnitude of the price increase, since there are no other outlets to liquidate Country A’s goods. If, say, Country A moves to hike prices as well, then both currencies remain at par. This is obviously a very simplified version of the real world economy, but it highlights an important point that is central to the discussion: The currency move necessary to realign competitiveness will always be equal to, or less, in percentage point terms to the price increase. In the case where the entire production base is tradeable, it will be the former. But with a rise in the number of trading partners, a more complex export basket, import substitution, shipping costs and many other factors that influence tradeable prices, the currency adjustment should be a fraction of the price increase. Since the onset of 2018, the U.S. has slapped various tariffs on China, the most important of which was 10% on $200 billion worth of Chinese goods. Assume for the sake of argument that only China and the U.S. were trading partners. The U.S. currently imports $522 billion worth of goods from China, about 17% of its total imports. However, as a percentage of overall U.S. demand, this only represents 2.5% (Chart I-3). This suggests that at best, a 25% increase on all Chinese imports will only lift import prices by 4.3% and consumer prices by much less. On the Chinese side of the equation, exports to the U.S. account for 20% of total exports, so a tariff of 25% should only lift export prices by 5%. The conclusion is that the yuan and dollar only need to adjust by 4-5% to negate the impact of a 25% tariff. Chart 1-3Sino-U.S. Trade Is Small Relative To Domestic Demand Chart 1-4No Disorderly Rise In ##br##The Dollar   The DXY index is up 10% since the 2018 trough (Chart I-4), and the dollar was up an average of 74 basis points versus the Chinese Yuan from the day major tariffs were announced until the peak in trade-war rhetoric (Table I-1). This would be in line with economic theory. But there is a caveat: With no corresponding export subsidy for U.S. goods, the rise in the dollar makes exporters worse off. And with over 40% of S&P 500 sales coming from outside the U.S., this would have a meaningful dent on corporate profits. A paper by the Peterson Institute for International Economics showed that imposing a border adjustment tax caused the real effective exchange rate (REER) of the country to rise, hurting competitiveness.1  In quantity terms, the IMF estimated that a 20% import tariff from East Asia would lift the U.S. dollar’s REER by 5% over five years, while dropping output by 0.6% over the same timeframe.2  With the dollar not currently overvalued on a REER basis, this does not bode well for future competitiveness (Chart I-5). Finally, trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides toward an agreement. For President Trump, a deteriorating U.S. manufacturing sector in the Midwestern battleground states is a thorn in his side. The U.S. agricultural sector has continued to bleed from falling grain prices (Chart I-6). For President Xi, rising unemployment is a key constraint. April manufacturing and credit numbers out of China show that the economy is relapsing anew. So, either China compromises and inches towards a trade deal or launches another round of stimulus. Chart I-5The Dollar Is Not Undervalued On A REER Basis Chart I-6A Drought In Cash Flows For ##br##U.S. Farmers   Bottom Line: Standard theory suggests the dollar’s bid should be capped at 2-3% on the imposition of new tariffs. Getting the global growth picture right will be more important in dictating the dollar’s trend. Of course, a full-blown trade war puts the entire thesis in jeopardy. Questions From The Road We were on the road this week, talking to clients and teaching the BCA Academy. Most clients agreed that the dollar is in a transition phase, given the presence of emerging green shoots in the global economy (Chart I-7). However, most were also concerned to what degree this view could be offside. The concerns centered around the fact that the growth differential between the U.S. and the rest of the world remains wide, yield differentials still favor the U.S., profit leadership also continues to favor the U.S. and it is unclear to what degree the world is short of U.S. dollars. U.S. profit leadership in the world continues, but one prescient indicator for the dollar is whether banks are easing lending standards for large firms relative to smaller ones.  We continue to lean towards the narrative that most of the factors driving the dollar higher are behind us. U.S. growth tends to be low-beta relative to the world, so a rebound in the global economy will be negative for the dollar. An end to the Federal Reserve’s balance sheet runoff will steer growth in the U.S. monetary base from deeply negative to zero. Meanwhile, a rising external profit environment will lead to an increase in foreign central bank reserves. The yield differential between the U.S. and the rest of the world remains wide, but this has a natural limit since global bond yields tend to converge towards each other over time. Chart I-7Global Growth Should##br## Rebound Chart I-8Positive Earnings Revisions Bodes Well For Growth   U.S. profit leadership in the world continues (Chart I-8), but one prescient indicator for the dollar is whether banks are easing lending standards for large firms relative to smaller ones. A better external environment will suggest banks will allow credit to flow to larger firms relative to smaller ones, since the latter tend to be more domestic. This is also an environment where global equities tend to outperform. The latest Fed Senior Official Loan survey showed that on the margin, lending standards are easing for large relative to small firms. This may suggest that return on capital is starting to improve outside the U.S., which will be a headwind for the dollar (Chart I-9). Chart I-9S&P 500 Foreign Earnings Need A Weak Dollar From a technical standpoint, almost all currencies are already falling versus the U.S. dollar – a trend that has been in place for several months now. This means most of the factors putting upward pressure on the dollar are well understood by the market. For example, global growth has been slowing for well over a year, based on the global PMI. Putting on fresh U.S. dollar long positions is at risk of a washout from stale investors, just as it was back in 2015, a year after growth had peaked (Chart I-10). It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions.  Dollar technicals are also very unfavorable. Speculators are holding near-record long positions, sentiment is stretched, and our intermediate-term indicator is also flagging yellow. Over the past five years, confirmation from all three indicators has been followed by some period of U.S. dollar indigestion (Chart I-11). This may help explain relative stability in the broad trade-weighted dollar, despite a flare up in global risk aversion. Chart I-10Dollar Bull Case Is Well Known Chart I-11Dollar Technicals Are Unfavorable   Finally, with U.S. interest rates having risen significantly versus almost all G10 countries in recent years, the dollar has itself become the object of carry trades. This has also come with a good number of unhedged trades, as the rising exchange rate has lifted hedging costs. It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. The strength in EUR/USD this week despite the rise in global risk aversion is testament to this thesis. Bottom Line: Aside from the renewed specter of a trade war, most of the factors driving the dollar higher are behind us. House Keeping Chart I-12Buy Some Insurance Rising market volatility suggests some trades could be at risk from being stopped out. First, our long AUD/USD sits right at the epicenter of any growth slowdown in China. Maintain stops of 68 cents. Second, in an environment where volatility is low and falling, it pays to have insurance in place. We continue to favour CHF/NZD (Chart I-12). Third, we were stopped out of our short USD/SEK position for a 1.9% loss. If global growth rebounds, this will be a high-conviction trade. However, we are standing aside for risk-management purposes. Finally, the Reserve Bank Of Australia kept rates on hold this week, while the Reserve Bank Of New Zealand cut rates. This bodes well for our strategic AUD/NZD position.     Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Caroline Freund and Joseph E. Gagnon, “Effects of Consumption Taxes on Real Exchange Rates and Trade Balances,” Peterson Institute for International Economics, April 2017. 2 Maurice Obstfeld, “Tariffs Do More Harm Than Good At Home,” IMFBlog, September 8, 2016. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mostly positive: To begin with the labor market, the unemployment rate fell to a 50-year low of 3.6% in April, despite a slight fall in the participation rate to 62.8%. Change in nonfarm payrolls came in above expectations at 263K in April, while average hourly earnings was unchanged at 3.2%. Moreover, JOLTS job openings came in at 7.5 million, above expectations. On the PMI front, the Markit composite PMI fell to 53 in April. ISM non-manufacturing PMI fell below expectations to 55.5. On the housing market front, mortgage applications increased by 2.7%, an improvement from the last reading of -4.3%. This nudged the MBA Purchase Index from 259.4 to 270.2. DXY index fell by 0.2% this week. On Sunday, Trump tweeted that tariffs on $200 billion worth of Chinese imports will increase from 10% to 25%, which again toppled the market. The ongoing trade disputes increase uncertainty in the global growth outlook. Report Links: Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area are improving: Headline and core inflation in the euro area rose to 1.7% and 1.2% year-on-year, respectively in April. Markit composite and services PMI came in at 51.5 and 52.8, respectively, both surprising to the upside. The French composite and services PMI increased to 50.1 and 50.5. The German composite and services PMI increased to 52.2 and 55.7. Sentix investor confidence rose to 5.3 in May, well above consensus. Retail sales increased by 1.9% year-on-year in March. EUR/USD appreciated by 0.3% this week. The European Commission (EU) released the spring 2019 Economic Growth Forecasts this week, citing that “growth continues at a more moderate pace.” While the global growth slowdown and trade policy uncertainties could weigh on the European economy, domestic dynamics are set to support the economy. According to the forecast, growth will continue to pick up in all EU member states next year. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been neutral: Nikkei composite PMI increased to 50.8 in April. The manufacturing PMI increased to 50.2, while the services PMI fell slightly to 51.8. Vehicle sales increased by 2.5% year-on-year in April. Consumer confidence index fell to 40.4 in April. USD/JPY fell by 0.9% this week. Volatility caused by the ongoing trade disputes has reduced risk appetite, enhancing the outperformance of the safe-haven yen. According to the BoJ minutes released this Wednesday, Japanese financial conditions remain highly accommodative, and the domestic demand is likely to bounce, despite the drag from external growth. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been solid: Markit composite PMI increased to 50.9 in April. Services PMI also came in above expectations at 50.4 in April, an improvement from the last reading of 48.9. The British Retail Consortium (BRC) like-for-like retail sales increased by 3.7% year-on-year in April, outperforming expectations. Halifax house prices increased by 1.1% month-on-month in April and 5% year-on-year. GBP/USD fell by 0.9% this week, erasing the gains from last Friday after positive PMI data. We continue to favor the pound given its cheap valuation and healthy domestic fundamentals. However, the window for pound upside will rapidly close as we approach Brexit 2.0. Report Links: Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 A Trader’s Guide To The Yen - March 15, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: CBA Australia composite and services PMI both outperformed, increasing to 50 and 50.1, respectively. Building permits contracted by 27.3% year-on-year in March. However, this looks like a volatile bottoming process on a chart. Retail sales increased by 0.3% month-on-month in March. The trade balance came in at a surplus of A$4.95 million in March. AUD/USD has been flat this week. The Reserve Bank of Australia kept interest rate on hold at 1.5% this week, which disappointed the bears. Moreover, in the monetary policy statement, the RBA estimates the economy will grow around 2.75% in 2019 and 2020, supported by increased investment and a pickup in the resources sector. Report Links: Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 Into A Transition Phase - March 8, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: ANZ commodity prices increased by 2.5% in April, higher than expected. 2-year inflation expectations remain at 2%. Dairy price index increased by 0.4% in April, above the estimated -1.1%. NZD/USD fell by 0.5% this week. On Tuesday, the RBNZ lowered its interest rate by 25 bps to 1.5%. Our long AUD/NZD position, which is currently 0.8% in the money, is likely to profit from the widened interest rate differential. In the monetary policy statement, the RBNZ stated that a lower rate is mostly consistent with the current employment and inflation outlook in New Zealand. Moreover, global uncertainties, coupled with domestic housing market softness and reduced immigration remain a headwind to the economy. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been positive: Ivey Purchasing Managers’ Index increased to 55.9 in April, well above estimates. Housing starts increased by 236K year-on-year in April. Imports and exports increased to C$52 billion and C$49 billion respectively in March, resulting in a small deficit of C$3 billion. New housing price index increased by 0.1% year-on-year in March. USD/CAD has been flat this week. On Monday, Governor Poloz gave a speech focusing on the Canadian housing sector. He aims to provide more flexible mortgage choices for Canadian consumers, which could help the housing market to stabilize. The possible measures include diversifying mortgage terms, developing an MBS market, and encouraging different mortgage designs. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been neutral: Headline inflation fell to 0.2% in April on a month-on-month basis, while unchanged at 0.7% on a year-on-year basis. Core inflation was unchanged at 0.5% year-on-year. Foreign currency reserves increased to 772 billion CHF in April. Unemployment rate was unchanged at 2.4% month-on-month in April. The SECO consumer climate fell to -6 in Q2. USD/CHF fell by 0.2% this week. While the trade disputes and increased global growth uncertainties could support the Swiss franc in the near term, we continue to favor the euro over the franc on a cyclical basis. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Registered unemployment fell to 2.3% in April. Manufacturing output contracted by 0.8% in March. House prices rose by 2.2% year-on-year in April, below March’s 3.2% annual growth. USD/NOK increased by 0.2% this week. On Thursday, the Norges Bank kept interest rates on hold at 1%, in line with expectations. The monetary policy continues to be accommodative, which is a tailwind for the Norwegian economy. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Industrial production contracted by 1.3% year-on-year in March. Manufacturing new orders decreased by 8.1% year-on-year in March, the worst since November 2016. USD/SEK increased by 0.8% this week. Our short USD/SEK position was stopped out at 9.6, due to the weaker-than- expected Swedish data and unexpected U.S. dollar resilience. We will look to put the trade back on when we see more clear signs of a global growth bottom. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights Currency markets continue to fight a tug-of-war between deteriorating global growth and easing global financial conditions. Meanwhile, history suggests that the trade-weighted dollar should have been 10-15% higher, based on portfolio flows and interest rate differentials. The more-muted bounce is a cause for concern. As the battle unfolds, likely winners in the interim will be safe-haven currencies such as the yen. Watch the gold-to-bond ratio for cues on where the balance of forces are shifting, with a rising ratio negative for the dollar. We expect a day of reckoning to eventually arrive for the U.S. dollar, once investors shift their focus towards the rising twin deficits, de-dollarization of the global economy and low expected returns for U.S. assets. Feature The recent calm in developed currency markets seems very eerie, given the storm that has gripped global financial markets over the past week. Dismal manufacturing PMI readings from Europe and Japan last week sent equity markets into a tailspin. The closely watched U.S. 10-year versus 3-month spread inverted, triggering panic selling among investors who favor this spread as their most reliable recession indicator. Equity markets in Asia are off the year’s highs, while regional bond yields are holding close to trading lows. Outside of oil, commodity markets have also been soft. Despite these moves, the trade-weighted dollar has been relatively stable. Over the last few months, most currency pairs have been narrowly trading towards the apex of very tight wedge formations. This has severely dampened volatility (Chart 1). Over the longer term, the stability of these crosses relative to gold has spooky echoes of a fixed exchange rate regime a la Bretton Woods (Chart 2). Chart 1An Eerie Calm In Currency Markets Chart 2Fixed Exchange Rates Versus Gold?   In physics, centripetal systems tend to stay in equilibrium, while centrifugal forces can explode in spectacular fashion. In the post-Bretton Woods world, it has been very rare for periods of extended currency stability to persist. This means constantly monitoring both the trend and magnitude of imbalances between economies to gauge where the pressure points are, and in what direction the corresponding exchange rates might eventually give way. The balance of forces driving the dollar outlook seems like a natural starting point for this exercise.  Global Liquidity And The Dollar Judging by most measures of relative trends, the dollar should be soaring right now. The March Markit manufacturing PMI releases last week showed that while both Japan and the euro area remain in contraction territory, the U.S. reading of 52.5 puts it solidly above the rest of the world. It is true that the momentum of this leadership has been rolling over recently, but historically such large growth divergences between the U.S. and the rest of the world have generated anywhere from 10-15% rallies in the greenback over a period of six months (Chart 3). So far, the DXY dollar index is up 1.9% since October. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a blowup somewhere. Until the U.S. Federal Reserve’s recent volte-face on monetary policy, relative yields also favored the greenback. The 2-year swap differential between the U.S. and the rest of the world pinned the DXY dollar index at 105, or 8% above current levels (Chart 4). Meanwhile, relative policy rates also suggest the broad trade-weighted dollar should be 6% higher. And even today, unless the Fed moves towards outright rate cuts, the dovish shift by other central banks around the world remains an immediate tailwind for the U.S. dollar. Chart 3USD Should Be Higher Based On Growth Divergences   Chart 4USD Should Be Higher Based On Swap Differentials   Internationally, the Fed’s tapering of asset purchases has been a net drain on dollar liquidity, despite a widening U.S. current account deficit. The Fed’s balance sheet peaked a nudge above US$4.5 trillion in early 2015 and has been falling ever since. This has triggered a severe contraction in the U.S. monetary base (Chart 5), and severely curtailed commercial banks’ excess reserves, which are now contracting by over 20% on a year-on-year basis. One of BCA’s favorite key measures of international liquidity is foreign central bank reserves deposited at the Fed. This is contracting at its worst pace in over 40 years. Every time this measure has severely contracted in the past, the shortage of dollars has triggered a blowup somewhere, typically among countries running twin deficits. Chart 5A Liquidity Squeeze Of Dollars To cap it off, last year’s change in the U.S. tax code to allow for repatriation of offshore cash helped the dollar, but not to the extent that might have been expected. On a rolling 12-month basis, the U.S. has repatriated back a net of about $US400 billion in assets, or close to 2% of GDP. Historically, this is a very huge sum that would have had the potential to set the greenback on fire – circa 10% higher (Chart 6). Chart 6USD Should Be Higher On Repatriation Flows Dollar liquidity shortages tend to be vicious due to their ability to trigger negative feedback loops. As the velocity of international U.S. dollars rises, offshore dollar rates begin to rise, lifting the cost of capital for borrowing countries. Debt repayment replaces capital spending and consumption once this reaches a critical threshold. The drop in output, prices, or a combination of the two, only exacerbates the debt-deflation problem.  The bottom line is that looking at historical trends, the dollar should be much higher than current levels. Practical investors recognize the need to pay heed to correlation shifts. Either our favorite liquidity indicators have stopped working outright or more realistically other forces are at play, explaining the relative stability in the greenback. A Counter-Cyclical Currency The first possibility is that the recent stability in the U.S. dollar has been in anticipation of better economic data in the second half of this year. We have shown many times in the past that the greenback is a countercyclical currency that tends to do poorly when global economic momentum picks up. Many investors are now fixated on China – specifically, whether the latest credit injection will be sufficient to turn around the Chinese economy, let alone the rest of the world. Meanwhile, as the U.S.-China trade talks progress, it will likely include a currency clause to prevent depreciation of the RMB versus the dollar. In reality, there is still scant evidence to support a bottoming in global growth, making it difficult to loop this back to dollar stability.  In reality, there is still scant evidence to support a bottoming in global growth, making it difficult to loop this back to dollar stability. Typical reflation indicators such as commodity prices, emerging market currencies and industrial share prices are off their lows but rolling over. March export data remained weak globally, even though compositionally there were some green shoots. Exports to China from Singapore jumped by 34% year-on-year, and those to emerging markets by 22% year-on-year. Japanese machine tool orders from China also showed some stabilization. Historically, these are necessary but not sufficient conditions to gauge whether we are entering a bottoming process (Chart 7). Another contradiction is at play: If the dollar rally is being held back by prospects of improvement in global growth, then gold should fare poorly and most currencies should be outperforming both gold and the greenback. Until yesterday’s sell off in gold, this was not the case. Suggesting some other explanation might be tempering the U.S. dollar’s rise. Chart 7Tentative Green Shoots In Global Trade?   Regime Shift? While U.S. residents have been repatriating capital domestically, foreign investors have been fleeing U.S. capital markets at among the fastest pace in recent years. On a rolling 12-month total basis, the U.S. saw an exodus of about US$200 billion in equity from foreigners, the largest on record (Chart 8). In aggregate, both foreign official and private long-term portfolio investment into the U.S. has been rolling over, with investor interest limited only to agency and corporate bonds. Foreigners are still net buyers of about $450 billion in U.S. securities, but the downtrend in purchases in recent years is evident. Interestingly, gold has also outperformed Treasurys over this period. The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges. Vis-à-vis official flows, China has risen within the ranks to be the number one contributor to the U.S. trade deficit. At the same time, Beijing has been destocking its holding of Treasurys, if only as retaliation against past U.S. policies, or perhaps to make room for the internationalization of the RMB (Chart 9). In a broader sense, the fall in dollar deposits at the Fed might just represent an underlying shift in the global economy away from dollars and towards a more diversified basket of currencies. This makes sense, given a growing proportion of trading – be it in crude, natural gas, bulk commodities or even softs – is being done outside U.S. exchanges. Chart 8Foreigners Are Dumping U.S. Equities   Chart 9China Has Stopped Recycling Surpluses Into Treasurys   Data from the International Monetary Fund (IMF) shows that the global allocation of foreign exchange reserves towards the U.S. dollar peaked at about 72% in the early 2000s and has been in a downtrend since. Meanwhile, allocation to other currencies, notably the British pound, Swiss franc and the yen have been surging (Chart 10). At the same time, foreign central banks have been amassing tremendous gold reserves, notably Russia and China, almost to the tune of the total annual output of the yellow metal (Chart 11). This further helps explain why the dollar may not be as strong as it should be. It also explains the stability of these currency pairs relative to the price of gold. Chart 10The World Is Diversifying Away From Dollars Chart 11Central Banks Are Absorbing Most Gold Production The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the U.S. Congressional Budget Office (CBO) estimates that the U.S. budget deficit will swell to 4.5% of GDP. Assuming the current account deficit widens a bit then stabilizes, this will pin the twin deficits at 8.1% of GDP. This assumes no recession, which would have the potential to swell the deficit even further (Chart 12). Chart 12A Twin Deficit Cliff For The Dollar The U.S. saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the U.S. trade deficit. Shale productivity remains robust and U.S. output will continue to rise, but the low-hanging fruit has already been plucked. For one reason or another, foreign central banks are diversifying out of dollars. If due to the changing landscape in trade, this is set to continue. If it is an excuse to shy away from the rapidly rising U.S. twin deficits, this will continue as well. And if the U.S. dollar cannot sufficiently rally on “good news,” expect it to sink when the bad news eventually starts rolling in. That said, the timing remains uncertain.   Private Capital Flows Foreign official flows might have been fleeing the U.S. dollar because it has lost some luster as a reserve currency, but private capital will begin stampeding toward the exits when the return on invested capital (ROIC) for U.S. assets falls below their cost of capital. For investors with a long horizon, this may already be happening. Take 10-year government bonds for example. For the Japanese or German investor, borrowing in local currency and investing in the U.S. might seem like the logical course of action given negative domestic rates and a 10-year Treasury yield of 2.4%. However, this positive carry suddenly evaporates when one factors in hedging costs (Chart 13). Chart 13JGBs More Attractive Than Hedged Treasuries During bull markets, countries that have negative interest rates are subject to powerful outflows from carry trades. The impact of these are difficult to measure, but it is fair to assume that periods of low hedging costs (which tend to correspond to periods of lower volatility) can be powerful catalysts. As markets get volatile and these trades get unwound, unhedged trades become victim to short-covering flows. With many yield curves around the world inverting, the danger is that the frequency of this short-covering implicitly rises, since long-bond returns are falling short of spot rates. One winner as volatility starts to rise is the yen. Investors should consider initiating short USD/JPY positions today as a hedge. Outside the fixed-income space, what matters is that relative ROICs are higher than the cost of capital. Both are difficult to measure for many emerging or even developed economies across asset classes. However, for the equity market, a good starting point has always been valuations as exchange rates tend to move to equalize returns across countries. The forward P/E on the MSCI U.S., Europe and Japan indexes is 16.5x, 12.6x and 12.3x. The skew towards the U.S. is because market participants expect U.S. profits to keep outperforming, the U.S. currency to keep appreciating, or a combination of the two. However, empirically, current U.S. valuations suggest future earning streams have already been fully capitalized today (Chart 14). Chart 14AReturn On Capital Could Be Lowest In The U.S. (1) Chart 14BReturn On Capital Could Be Lowest In The U.S. (2) Chart 14CReturn On Capital Could Be Lowest In The U.S. (3) The expected 10-year annualized return for MSCI U.S. is 3.1%, versus 5.5% for MSCI Europe and 9.6% for MSCI Japan. If we assume the U.S. dollar is overvalued, as some models suggest, this will further erode future U.S. returns. Net equity portfolio flows into the U.S. are already negative, as shown in a previous chart. This means the day of reckoning for the U.S. dollar may not be far off when current tailwinds eventually fade.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades