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Market Musings
Global Strategy
5 July 2016 | TD Securities | London
G10 FX Outlook in the Wake of Brexit

We identify a few themes that we think will garner
attention in H2. While the Fed, China, and commodities
will continue to play a role, we think political risks will
become increasingly important for markets.

The second theme focuses on the possible shift to fiscal
policy from monetary policy as a driver for markets. We
think markets will start to reward currencies that rely more
on fiscal and less on monetary policy for stronger growth.

The third theme focuses on the changing nature of risk,
reward, and yield. We suspect the USD and JPY should
benefit the most from the Euro-centric nature of the Brexit
shock, leaving European currencies to underperform
these safe havens but also other currencies with stronger
credit ratings.
Overview
The Fed, China, and commodity rebalancing helped
characterize the price action in G10 FX markets in H1. The
broad USD, for its part, slipped 4% over the first six months,
trailing gains in JPY, CAD, and NOK. Notably, the JPY rallied
17%, outstripping the rest of the G10 by nearly 10% and
marking its best six-month performance since 2008. Positive
real rates helped the antipodeans outperform while European
currencies lagged during the first half of the year.
Looking forward to H2, we see a mix of the old drivers as well
as some new ones that should catalyse markets. Indeed, we
still think the Fed, China, and commodity fundamentals will
drive price action in the second half but at the same time, we
believe political risks will also dominate in the G10 markets in
coming months. The outcome of the UK Referendum will
continue to fester behind the scenes, especially given the lack
of clarity and direction for European politics over the next year.
US politics will also take centre stage in H2, redirecting the
market focus yet again on political, idiosyncratic risks.
We also see two other important themes emerging in H2.
First, we think FX markets will reward currencies where
economic growth has its best potential to accelerate. With
growth still sorely lacking in many major economies, however,
the emphasis looks likely to shift to fiscal stimulus and the
governments most willing—and able—to deploy it.
This comes as conventional monetary policy (and in some
cases, unorthodox policy) has reached its effective limits in
many advanced economies. Even though more extreme
policies are available for policy makers, we suspect the
increasingly difficult political environments will complicate their
implementation anytime soon. The interplay of fiscal policy,
monetary policy, and exchange rates is complex and not
always consistent over time. In this environment, however, we
believe that a shift in the policy mix towards fiscal stimulus
(and away from monetary accommodation) will benefit
currencies backed by governments adopting pro-growth
policies.
Second, risk appetite is likely to remain a key driver in Brexit’s
wake, although the changing nature of risk reward and yield
could shift both the nature and behaviour of safe havens.
Increased focus on political shocks and lingering policy
uncertainty could weigh on FX with large external deficits.
We caution against oversimplifying this factor however, as
ultimately we think the composition of these deficits will matter
as much—if not more so—than their size. Over time this could
benefit currencies with better credit ratings and higher real
rates, but this allocation shift could take time and will be slow.
For now, we think this backdrop favours the traditional safe
havens like the USD and the JPY even with the Fed on hold
for a while longer.
Our views and forecast updates for H2 reflect these shifting
themes. For one, we continue to expect underperformance of
European currencies with GBP likely to languish over the next
six months. We see GBP moving below 1.30 in the near future
and expect it average in the mid-1.20s over the rest of the
year. As it stands, however, the risks appear skewed in favour
of additional weakness for sterling rather than less.
We also see further downside in EUR, NOK, SEK and look for
EUR to test the lower end of its recent 1.05 to 1.15 range in
Q3. And, despite the surge recently, EURGBP still has more
room to run higher we think. By the same token, we are
underweight NOK and SEK given growth links to core Europe.
Market Musings
5 July 2016 | TD Securities | London
Linked to this, we also see CAD outperforming NOK on the
commodity trade. With US real rates likely to remain lower
for longer, we still think JPY is likely to remain one of the top
performers in the G10 but also see the demand for duration
favouring AUD in the dollar bloc.
Theme 1: Political Risks to Remain a Major Challenge
Last week’s vote to Leave is a step into the unknown for the
UK. While the outcome of the referendum continues to echo
across the financial markets, currencies have seen some of
the most violent adjustment across asset classes so far as
investors try to calibrate the risks and opportunities in this
new landscape. The outcome of the Brexit process remains
highly uncertain. The uncertainty currently unfolding in the UK
fits within a broader context of rising political risks in several
advanced economies.
For now, we expect the Brexit fallout to stay relatively
contained regarding its impact on the global economy. There
are certainly risks of escalation, but these are not yet our core
scenario. We expect the aftermath of this event to remain a
slow-burn story, one that plays out over weeks and months
rather than days. Within this, however, it is exceptionally
difficult to gauge how markets may react. FX markets, in
particular, may not be as well confined as the combination of
rapid fluctuations in sentiment and capital flows can result in
noteworthy moves in exchange rates.
These risks are likely to build over the next several months.
The Eurozone has several key political events scheduled in
coming months, culminating with the French and German
elections next year. With the US election also on the more
immediate horizon, political risks may prove to be the single
most important defining feature of FX markets for the
foreseeable future. This may make life difficult for investors.
In our experience, these markets often struggle when the key
drivers transcend the traditional emphasis on economic,
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G10 BBoP vs CAB (% of GDP)
GBP
10
CHF
SEK
0
EUR
USD
CAD
NZD
NOK
-5
JPY
-5
0
Source: Macrobond, TD Securities, Bloomberg
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CAB ( % OF GDP )
10
Theme 2: Currencies in a Post-Monetary Policy World
In most major economies, monetary policy has reached – or
exceeded – its useful limits. Indeed, there has been growing
skepticism over the efficacy and potentially damaging
effectiveness of NIRP. This is a concern we share and one
that Governor Carney even alluded to in his speech last
week. With growth and inflation dynamics still anemic at
best, G10 FX markets should start to rewards currencies of
governments that seek to stimulate both.
This, we think, will lead to the FX market rewarding
currencies that see policy makers rotate to more active fiscal
from monetary policy. Currencies whose economies and
corresponding governments that possess the most fiscal
capacity, willingness to stimulate via pro-growth policies will
outperform in this environment. This favors the dollar bloc
and NOK to some degree.
The outlook for the rest of Europe has become more
complicated. Currently, the UK and Eurozone are set to
tighten fiscal policy further over the coming year. If
implemented, this would naturally increase downside growth
risks but we see scope for a change in tack. In particular, the
UK may need to climb down from its pledges for further
consolidation. Chancellor Osborne has already abandoned
his pledge to restore the government budget to surplus by
2020 while also floating plans to cut the corporate tax rate.
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AUD
financial, and policy analysis and stray into the realm of
politics. Politics (and politicians) tends to operate under a
different set of rules and assumptions. Political calculations
of risks, rewards, costs and benefits can differ dramatically
from what might be expected if maximizing one’s return on
investment was the goal.
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These pressures may heighten twin deficit concerns for
some regions, but we would argue that fiscal austerity is no
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Market Musings
5 July 2016 | TD Securities | London
more than a secondary concern in a world stuck with weak
growth and below average inflation levels. Instead, we would
say that while current account balances (CAB) matter, it is no
longer sufficient to just be long surplus currencies (as few as
there are) while short the deficit countries. Indeed, it is the
composition of the basic balance of payments that matter
more since portfolio and FDI inflows can help plug the
external funding deficit. This is what now makes the UK, and
thus GBP, vulnerable to additional downside with its high
dependence on external financing and particularly with the
government effectively leaderless.
Theme 3: Changing Nature of Risk, Reward, Yield, &
Uncertainty
The nature of safe havens has changed, we think, postBrexit. Indeed, we believe that the basket of currencies
(which is limited in its right) that typically attracts inflows in
times of market turmoil has shrunk. In particular, we think this
applies to the CHF due to the fundamental nature of the
Brexit shock; the Swiss economy is highly levered to the UK
banking system. This magnifies the risks of financial
contagion. Against a backdrop of softening portfolio inflows
and an interventionist central bank, the prospect of investing
in a negative yielding asset (particularly one that is negative
throughout the entire sovereign curve) becomes less
attractive from a capital preservation point of view.
While the USD stands to gain from this process, the JPY may
benefit disproportionately overall. We think the shrinking
basket of ‘safe havens’ will add more downward pressure on
USDJPY and heighten the risk of unilateral intervention,
although we believe this is unlikely to succeed in the end.
Almost without exception, in our view, intervention succeeds
only when it is conducted on a multilateral basis. The problem
is that there is limited to no support from the much of the G7
bodies to support ‘yentervention’.
This leaves the EUR, which is likely to suffer from both
financial and economic contagion risk post-Brexit. Indeed,
Brexit is a deflationary growth shock that has the potential to
spread beyond its borders to neighboring Eurozone. The
economic and financial risks also feed into political risks that
could fester ahead of the crucial elections in France,
Germany, and the Netherlands next year. That said the
impact on the EUR is not clear-cut.
For one thing, German bunds are also quite negative in
nominal terms so unless the ECB aggressively cuts the depo
rate further into negative territory, the scope for real yields to
decline in tandem with falling breakevens is limited. Real
yields, in fact, could rise, and that could provide some
support to the EUR even as adds to its accommodative
stance. For now, we think EURGBP will remain supported,
as idiosyncratic risks are more prominent at this juncture in
the GBP leg.
We think this landscape opens dollar bloc currencies to a
more complicated adjustment process. There will be a much
clearer reach for yield and right now within G10 FX the dollar
bloc currencies offer both positive real yields and solid credit
ratings. This is not necessarily novel but in a world where
capital preservation (from NIRP) and low (and potentially
lower) for longer rate environments will persist, fixed income
managers will increasingly look to FX to generate alpha
strategies. This could lead to a steady inflow into these
currencies (at the expense of those in the epicenter of the
shock), especially as central banks diversify outside of
European currencies. This could, after all, soften the blow to
these currencies as current account deficits remain elevated
and underscore the need for further economic rebalancing.
- Ned Rumpeltin, Mark McCormick, Mazen Issa
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Market Musings
5 July 2016 | TD Securities | London
GLOBAL STRATEGY TEAM
Richard Kelly
Head of Global Strategy
44 20 7786 8448
Global Macro Strategy
David Tulk
Head of Global Macro Strategy
1 416 983 0445
Millan Mulraine
Deputy Chief US Macro Strategist
1 212 827 7186
Annette Beacher
Chief Asia-Pacific Macro Strategist
Jacqui Douglas
Chief European Macro Strategist (On leave)
44 20 7786 8439
James Rossiter
Senior Global Strategist
44 20 7786 8422
Robert Both
Macro Strategist
65 6500 8047
1 416 983 0859
Global Rates Strategy
Priya Misra
Head of Global Rates Strategy
1 212 827 7156
Andrew Kelvin
Senior Rates Strategist
1 416 983 7184
Renuka Fernandez
Senior Rates Strategist
44 20 7786 8408
Gennadiy Goldberg
Rates Strategist
1 212 827 7180
Prash Newnaha
Rates Strategist
65 6500 8047
Cheng Chen
Quantitative Strategist
1 212 827 7183
FX Strategy
Global Strategy
Ned Rumpeltin
European Head of FX Strategy
44 20 7786 8420
Mark McCormick
North American Head of FX Strategy
1 416 982 7784
Mazen Issa
Senior FX Strategist
1 212 827 7182
Emerging Markets Strategy
USA
Cristian Maggio
Head of Emerging Markets Strategy
44 20 7786 8436
Canada
Paul Fage
Senior Emerging Markets Strategist
44 20 7786 8424
Australia
Sacha Tihanyi
Senior Emerging Markets Strategist
1 212 827 7043
New Zealand
UK
Europe
Emerging Markets
Commodities Strategy
Bart Melek
Head of Commodity Strategy
1 416 983 9288
Mike Dragosits
Senior Commodity Strategist
1 416 983 8075
FX & Commodities
Research Home Page: https://www.tdsresearch.com/currency-rates
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Market Musings
5 July 2016 | TD Securities | London
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