Trade negotiations between the U.S. and Canada were resolved on September 30. The resolution reduces a major headwind for the Canadian economy. Second quarter GDP growth showed a rebound from first quarter weakness, and the positive outcome on trade should increase future growth estimates at the margin.
Canadian dollar: Neutral
The Canadian dollar moved higher following the positive North American trade agreement news. The currency may continue to see near-term gains, driven by momentum and a likely rate hike by the Bank of Canada at its October meeting, but we believe it is already entering overvalued territory and additional strength in the Canadian dollar will be difficult to sustain.
U.S. dollar: Neutral
In our view, the U.S. dollar remains trapped between two trends. Interest rate hikes (and ongoing balance sheet reduction) by the U.S. Federal Reserve have increased U.S. dollar funding costs and tightened financial conditions, further fueling the U.S. dollar rally. However, while global growth has been strong, it does appear that U.S. economic activity has peaked. This convergence typically causes the U.S. dollar to weaken. If the trade environment stabilizes, this may benefit other currencies versus the U.S. dollar in the near term.
We remain on the sidelines despite the bounce in the euro/U.S. dollar exchange rate from its lows in August. Risk aversion across emerging market currencies (sparked by Turkey) has abated but remains unresolved. While the fundamental economic picture has improved in the euro area, exogenous factors driving sentiment across currency markets remain unpredictable.
The renminbi/U.S. dollar exchange rate traded between 6.80 and 6.90 in September, driven by various headlines related to U.S.-China trade friction.1 The People’s Bank of China (PBOC) daily fixing level has been consistently stronger than market expectations. This has helped stabilize the currency, especially during U.S. dollar-strengthening moves. The planned issuance of PBOC bills in the offshore market may give the central bank another tool to manage renminbi liquidity and exchange rate stability. Capital controls on outflows remain tight, but financial market opening, such as the inclusion of Chinese equities and onshore bonds in major global indexes, will likely further increase overseas demand for Chinese onshore assets and could help maintain stable capital flows. We expect the exchange rate to hover around 6.80 to 6.90 in the near term.
Japanese yen: Overweight
The yen remains dependent on yield differentials, in our view. The recent rise in U.S. Treasury and German bund yields pushed the yen weaker versus the U.S. dollar and the euro. However, long-term valuations suggest the yen is undervalued, and a reversal of the recent rise in global yields (possibly due to falling growth expectations) should be positive for the currency. Consequently, long yen positions should act as a partial hedge to risk assets.
British pound sterling: Overweight
We recently adopted an overweight position in sterling versus the euro due to our expectation of a more favorable outcome to the Brexit negotiation than is currently anticipated by the markets. Economic data in the U.K. have also begun to show signs of recovery after a weak first half of the year, and inflation remains well above the Bank of England’s 2% target.2 These dynamics suggest that a positive Brexit outcome could spur a strong sterling performance.