The foreign exchange forecasting dilemma
Economies don’t always operate as forecast due to the shifting dynamics of both a local economy and the impact it faces from regional and global events. And that constant state of change makes foreign exchange forecasting problematic, as the outlook for an economy is the primary input for FX forecasts.
And it gets harder as the correlations some forecasters rely on grow and shrink in importance. Take for example the well-worn Australian terms of trade that’s often guided where the AUD will likely be. It’s a good source for determining FX direction as a country’s exports relative to its imports justifies the demand or supply for its currency. Yet if this were the case the AUD should be trading above 80 US cents, but it isn’t.
So instead of observing the cacophony from the gallery we think that investors should at least use an FX framework. It must be a framework that is grounded in historical observations of the ups and downs of the undisputed global reserve currency (and barometer) for the global economy for the past several decades – the USD.
At Citi we call it the ‘USD smile’. It tells us when the USD will likely show its strong hand, but not how high it will go, and it tells us when USD will be a weak hand, but not how low it will go. How high or low the USD will go is mostly circumstantial and often swayed by difficult-to-model unintended consequences.
However, if one were to pinpoint where we are on the USD smile its surely leaning to the right, and this is because of US cyclical outperformance and a hiking Federal Reserve while the rest-of-world’s central banks are on hold.
Add the risk of an asset market sell-off that could arise from US muscling of global trade partners and it all supports the USD as a safe-haven and a currency of strength. There’s evidence that investor positions are generally net long USD, nearly as high as when markets embraced the newly minted US administration in 2016.
More importantly, current prospects imply ongoing USD strength at least for the short to medium term in Citi’s view, as the factors driving USD strength precipitates weakness in other currencies.
In other words, a zero-sum game in foreign exchange markets with the USD is a winner and other currencies such as the AUD, EUR and CNY are trailing behind.
It’s clear from released data out of the US that its economy is outperforming. The US Federal Reserve Board remains the only central bank authority with the ability to guide rates higher due to full employment in the US, stronger corporate investment spending and robust consumer spending. First half GDP was an outstanding 4.1 per cent and we think the significant US corporate tax cuts will continue to extend the prosperous US growth narrative and emphasise the ‘mighty’ in the greenback.
Global ‘trade war’ risks and the negative impact it has on US trade partners also encourages safe haven-seeking investors as they pile into USD-denominated government bonds, in turn agitating the resilience and robust global economic growth outlook and eroding what’s left of ‘synchronised’ global growth.
And despite widespread condemnation, global trade risks are not likely to go away soon, because if the US Administration’s objective is to reduce the US trade deficits so as to achieve US trade ascendency, it will hit a roadblock when domestic growth spills over to increased imports, thus vexing its ability to strike down its trade deficit.
One thing is for sure; we think USD strength should be a realisation for investors that the AUD will remain under pressure at least in the short to medium term.
Simson Sanaphay is a strategist for Citi's wealth business.
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