TOTAL FOREX OUTLOOK
The status of the current economic downturn has affected every sector of the capital markets; including the FX markets. This article will explain the biggest factors influencing each currency as well as what to watch for regarding their potential direction.
- The effects of Covid-19 have been widespread and overwhelming for financial markets. The global infrastructure was already crippled as a result of foreing debt defaults, domestic debt crisis, civil revolutions, trade wars, brexit, and late cycle trends. Central banks from some of the largest GDP nations such as: China, Korea, Japan, Euro zone, Federal reserve, and others have pledged to perform “Unlimited QE”, meaning the unlimited supply of currency into the markets as stimulus. The effects of quantitative easing are drastic and can restructure the way that money flows through the credit system.
- Stimulus packes tend to have a negative affect on the domestic currency because of the over-supply of the currency. If, however, the stimulus package is succesful at revitalizing the real economy, then the effects will be postive for the currency in the long term. Stronger economy = more favorable exchage rate for that respective currency.
- It is imperative to understand why currencies and exchange rates change. The value of a currency is dependent on the dynamics of supply and demand. High demand for a central bank currency will have a bullish affect on price. Low demand for a currency will devalue its exchange rate relative to other exchange currencies. Low supply of that currency in the exchange market will cause the value to rise in response. The supply and demand for currencies is a result of their attractiveness as stores of value or investments that provide a predictable yield. The more stable currencies are attractive to investors because they reduce the exchange rate risk (risk of the decrease in the currency you are holding). Currencies are bought and sold by central banks as investments, hedges, and part of the strategic reserves.
- Long story short: More stable currencies will be in high demand during recessionary markets. Look for a rise in the stable/high yielding currencies, look for a decline in the less stable, low yielding currencies.
Frequently Used Language
GDP: Gross Domestic Production- The value of economic activity within that country. Represents the sum of the market values, or prices, of all final goods and services produced in an economy during a period of time.
Manufacturing Index- Index summarizing economic activity in the manufacturing sector in the US.
Q.E.: Quantitative Easing- Form of unconventional monetary policy in which a central bank purchases longer-term securities from the open market in order to increase the money supply.
Fiscal Stimulus: An attempt by governments to stabilize the economy. This occurs in the form of budgets and taxes.
Monetary stimulus: Unlike fiscal stimulus, which is handled by the central government, monetary stimulus is a function of the central bank. In the U.S., the federal reserve is responsible for affecting the money supply through changes in the interest rate, capital reserve requirements on member banks, and open market operations (QE).
Central Bank Divergence: The difference in central bank policies that causes disparity between their respective currencies.
Yield: The return on investment for a particular financial instrument or investment vehicle.
The Petrodollar System- The exchange of oil for U.S. dollars between countries that buy oil and those that produce it. The petrodollar was the result of the oil crisis in the mid-1970s when prices spiked to record levels. It helped increase the stability of oil prices denominated in U.S. dollars.
Top Concerns (Macro)
Oil war stability
China Trade conflict (Phase II)
USMCA agreement (new NAFTA)
Credit Market weakness
Unemployment (All time high)
Bond market failure
Consumer Index slow-down
Domestic debt bubble (Pensions)
Top Concerns (Current)
Testing of population for Covid-19
Stimulating the stock market through unlimited Q.E.
Supplying fiscal stimulus to unemployed/affected businesses
Bailing out the companies that are too big to fail
Private/public partnerships to combat virus
Stabilizing the oil markets
Bullish Scenario (More likely)
The Dollar is the central currency of central currencies. Most central currencies are tied (Pegged) to the value of the dollar. Demand for dollars will be higher than ever if there is a global collapse of credit institutions.If the federal reserve continues its pledge to do “unlimited QE” then there will be an abundance of dollars in the open market. The issue is that the funds will be concentrated among a few member banks who will be expected to make loans and stimulate the economy. The banks will likely not want to take the risk of loaning in a desperate market and will likely reinvest the dollars. This will create a shortage in the supply of dollars in the credit markets (lack of circulation). The increase in demand for the dollars will cause the value to continue rising as central banks look to achieve yield.
If the federal reserve continues the “unlimited QE” process for too long then they will cause deflation in the real economy because of the overabundance of dollars. If, God forbid, the FOMC decides to reduce the interest rates into the negative territory then the value of the dollar will take a dive. Only if all the countries in the global economy agree to reduce their interest rates will this be effective. If the U.S. goes into a recession and there is no activity in the real economy then the demand for dollars will not be as strong. This scenario depends on what other central banks do in comparison to the actions of the federal reserve.
Top Concerns (Macro)
Still recovering from the Eurozone crisis
Sovereign debt defaults
Debt defaults among member nations
Impacts of trade wars
Impact of new Trade agreements
Italy debt collapse
Bond market collapse
Negative yield on debt
Top Concerns (Current)
Containment of spread
Fiscal stimulus to the real economy
Monetary policy changes
Interest Rate changes
Stimulus to member banks
Populist movements due to inefficient government response to crisis
Bullish scenario (Unlikely)
The value of the Euro is already underperforming compared to the rest of the major currencies. The bearish nature of the trend is likely to continue since negative interest rates are still in effect; causing a devaluation of the Euro. If the ECB announces more conservative measures to handle stimulus, raising interest rates, and limiting the money supply then we can see a rally in the value of the Euro.
Bearish scenario (Most Likely)
As explained in our previous “Euro Crisis” article, the value of the Euro is likely to see a drastic drop in this late market cycle. The Euro zone had never fully recovered from the 2008 crisis and the EuroZone crisis that followed. The effects of global slow down, bank defaults (Italy), and riots (France/spain/italy) were already weighing heavy on the fragile European economy. Brexit and the China Trade war were adding serious strains to the Union as well. Covid-19 is the straw that broke the camel's back. If the ECB continues this “Unlimited QE” while they have negative interest rates then they will not be able to sustain their course; and the legitimacy of the Euro will be in question.
Canada's primary export is Oil. It is one of the top 4 largest exporters of OIl globally. Due to the current trade war which crashed the price of Oil, combined with the economic effects of the virus; Canada has no demand for their expensive oil and their GDP will suffer as a result. The majority of Oil exports end up in the United States and are purchased in Dollars. Cheap oil = bullish USD = Bearish CAD
Bullish Scenario (Unlikely)
Canada's main export is Oil. Due to the current trade conflict between Russia, Saudi Arabia, and OPEC, the value of Crude Oil is at the lowest since 1991. Cheap Oil would mean a bullish dollar. Since the oil markets are settled through the Petrodollar system, it will cost more Canadian dollars to purchase the same U.S. goods. In order to counter the effects of a rising dollar, Canada will need to limit their printing of currency and preserve whatever is left of the real economy. If Canada creates an environment that is more favorable to investors than the failing systems of Europe and Asia, then perhaps money can flood to the CAD. If OPEC, Russia, and The U.S. can agree to cut production of oil, and stabilize the oil markets, then the canadian economy can be stable enough to potentially see some investment capital.
Bearish Scenario (Most Likely)
The devaluation of the CAD will come as a likely effect to the current Oil price war. Canada holds significant oil reserves, however, with the economy at a stand-still there will be no market for the oil. Since Oil is Canada's primary export, the economy will suffer greatly. Cheap oil generally means a strong U.S. dollar (because it costs less dollars to buy 1 barrel of oil). Since Canada is a net exporter of oil, the drop in oil prices has more of a direct correlation with the currency since there is less foreign currency income being generated. If the price of oil continues to drop due to low global demand (cruise lines are non-operational, cars are at home, transport is slowing, planes are grounded) then CAD will continue to underperform V.S. the other major currencies.
The value of the Yen is closely related to geoplotical events from neighboring countries (China-U.S. Trade conflict). Since the economic crash of the 1990's the japanese economy has recovered and implemented new forms of economic polocies to stablizie the rising level of deflation. This inlcudes various form of stimulus packages to the real economy. Its important to understand that Japan remains the worlds largest creditor nation. This means that the investments that Japan holds in other countries exceeds the investments of foreign entities into the country. What this means is that when foreign economies struggle, its Japanese money that is backing a lot of that economy, making JPY in high demand.
At the time of this article, Japan had just pledged over $1 trillion in stimulus to combat recessionary fears of CoronaVirus. There is generally a negative effect on currency because of the oversupply. However, due to the fact that Japan is the largest creditor nation there will be an increase in the demand for Yen as the invested economies look for credit.
If the stimulus package is unsuccessful and the economy requires more stimulus then the BOJ (Bank of Japan) will issue further stimulus in the form of QE. If every country is doing the same thing then currencies will all move in tandem, reducing global demand for currency and rising demand for real assets.
After agreeing to leave the EU there was a question about the U.K's ability to establish new trade agreements and get their economy headed in the right direction. Corona virus came at a time where fragility was at an all time high for Europe and the U.K. The real economy (consumer demand/manufacturing exports) were the biggest hope for the stimulation of the U.K economy; become less likely as the effects of CoronaVirus have caused global supply/demand to be at near 0. Can the U.K's stimulus package give life to the U.K economy, or will it prolong the inevitable?
The stimulus plan that was announced by the UK government is one of the top priorities for the government. If the government can keep consumers strong, reduce the bank rates to encourage borrowing, and ease financial obligations (reducing interest payments on consumers) then they have a decent chance of keeping their economy afloat.
Bearish Scenario (unlikely)
If the U.K real economy cannot recover due to the prolonged duration of the economic shut-down, then consumers will be weakly positioned, banks will be overcapitalized, and borrowing will be low. All of these scenarios would lead to a drop in GDP.
Please refer to our article on Gold for more detail on the behavior of commodities, specifically gold, during periods of economic uncertainty. Gold is often seen as a safe haven commodity, a place to park money when economies get uncertain. Gold is usually used as a hedge to currencies because it is used as a store-of-value by central banks. When economies issue more currency, the limited supply of Gold that they hold in reserves becomes more valuable, because it costs more currency units to purchase the same unit of gold.
Gold has recently seen a huge sell off following the equity market collapse. This was due to the fact that institutions needed to offload their winning investments to cover margin calls on their losers. Now that the economy is starting to turn downwards, we can see a bullish rally on the metal as investors turn to safer investments.
Bullish Scenario (Most likely)
If the economy continues to slow down then central banks will have no choice but to print more money, lower interest rates, and or buy back more securities in the open market. All of these actions will result in more cheap currency sloshing around the credit system. When there's an overabundance of currency, especially a systemic increase in supply as there is now, then commodities, real assets, minerals, and other precious metals will see a rise. People want to put their money in places that have value.
If the U.S. dollar remains favorable as the dominant currency and the U.S. equity markets recover then investors will reallocate their money from Gold to better yielding investments. This will cause a sharp decline in the value of Gold as we saw when the equity markets first crashed.
Currencies are an instrument of federal governments to accurately track the performance of their economy. Currency only has value when it is in circulation. If the global economy goes to negative global growth, followed by a prolonged period of no supply/demand then currencies will all see some level of devaluation.
In the FX markets everything is relative. Just because everything is falling doesn't mean that some currencies will not overperform. The key is to find pairs that have one currency with bullish potential and pairing it with a currency that has a likelihood of massive devaluation. Pairs such as AUDUSD, where the AUD currency is likely to see massive sell off and the USD is seeing bullish momentum, then the central bank divergence in policy will result in a bearish outcome for AU.
Pay attention to the strength of the various currencies and look for pairs where the currencies are moving in negative correlation.
*Minor currencies will be covered in the next article.
Disclaimer: This article is the result of the analysis carried out by analysts associated with ChartAddicts. The article does not purport to represent the views or the official policy of ChartAddicts. This is not investment advice.
Investopedia. “How & Why Oil Impacts The Canadian Dollar.” Investopedia, Investopedia, 29 Jan. 2020, www.investopedia.com/articles/investing/021315/how-why-oil-impacts-canadian-dollar-cad.asp.