Foreign Exchange Volatile Month

We expect some level of volatility in the month of June. Focus will be on the US Fed policy meeting which we expect a 25bps rate hike. More importantly, will be on the Fed’s tone that will suggest whether there will be a total of three or four rate hikes in 2018. Besides, the noises coming from trade war as well as the outcome from US-North Korean meeting will influence the level of volatility.

Meanwhile, on the euro end will be the policy meeting by the ECB. We feel this meeting is crucial as it should on the ending of the QE program which we believe will be by end of 2018. We expect the ECB to reduce the current size of its bond-buying programme of €30bil to €15bil from October and end in December 2018.

Other key events will be on the policy rate meeting by several central banks. BoE is expected to hold rates unchanged at 0.50%. Meanwhile, the RBA as expected left the policy rate unchanged at 1.50% while RBI brought forward its rate hike to June to by 25bps to 6.25%. We foresee BoT to leave rates unchanged at 1.50%, while the central bank of Philippines and BI has room to raise rates by 25bps from the current 3.25% and 4.75% respectively

A. May Recap

• DXY: The dollar index (DXY) appreciated by 1.7% to 93.979 during the month due to expectations of aggressive rate hikes from the US Fed Reserve. The trend reversal in DXY occurred due to stoking fears over higher inflation expectations amid higher crude oil price and robust macro-fundamental data in the US economy which was later reflected in the US 10-year Treasury yields hitting 3.11% levels. Hence, the conundrum supported the surge in the DXY. However, we noticed the gains were capped after: (1) the release of FOMC minutes in which the market’s view of the overall tone was dovish as the Fed highlighted that it would tolerate the overshooting of inflation, fuelling expectations that the Fed would drop the aggressive rate hike approach; and (2) trade war concerns escalated as US President Trump’s administration slapped tariffs on China and imposed tariffs on aluminum (10%) and steel (25%) on Canada, Mexico and the European Union.

• EUR: The euro fell 2.5% to 1.1693 at the expense of political jitters in Italy as policies proposed by the populist parties could hurt Italy’s fiscal health. Though the uncertainty has eased in the Italy, the market remained cautious due to the anti-Euro government. Besides, the overall subdued economic release has kept the euro weak. Against the MYR, the euro has depreciated by 1.25% to 4.6624, suggesting the stronger crude oil is supporting the currency despite domestic noises.

• GBP: The pound took a beating, down 2.3% to 1.3298 in May on the back of: (1) a delayed rate hike prospect from the Bank of England (BOE); (2) unsettling Brexit noises as there wasn’t a guidance for the UK and the bloc striking a deal; (3) spillover effects from the political noise in Italy; and (4) less exciting macro data release. Against the ringgit, the pound has slipped by 1.2% to 5.3054 as the general weakness in the pound and firmer crude oil upheld the MYR’s performance.

• JPY: The appetite for the safe haven currency returned in May with the yen gaining 0.9% to close at 108.8 during the month due to the resurgence of geopolitical tension between the US and North Korea. The spark started after both nations exchanged several provocative statements which led to Trump’s U-turn on the Singapore summit. However, the summit is now back on track and is scheduled to take place on 12 June. While the US-North Korea uncertainties were easing, tensions switched to the EU over the Italian populist coalition, and with looming fears on the escalating trade war, these caused investors to flock safe haven assets. The yen climbed against the MYR by 2.4% to 3.6573, triggered by the risk-off sentiment, hence the attractiveness in the safe haven assets.

• AUD: The Aussie dollar rebounded in May by 1.0% to 0.7568 in May, largely supported by a surge in commodity prices as reflected in the Bloomberg Commodity Index, which rose 1.5%. However, the Aussie dollar’s gain was capped by subdued macro data, added with a dovish tilt in the Reserve Bank of Australia which fuelled expectations of no rate hike in 2018. Against the MYR, the Aussie dollar gained by 2.5% to 3.019 largely due to properties linked to commodity-based currency.

• SGD: The Singapore dollar weakened by 0.3% to 1.3376 during the month on the back of the stronger US dollar as the yields differential largely influenced the SGD’s performance. At the same time, we believe the climbing foreign reserves, which stood at S$381 billion in April from S$ 376.5 billion in March, has kept the Singapore dollar steady amidst noises in from the external factor. The economic data release includes: (1) April CPI rising 0.1% y/y from 0.2% y/y in March; (2) 1Q2018 business confidence hitting a multi-year high at 13 points compared to 1 point in 4Q2017; (3) April trade surplus expanding further to S$6.0bil from S$5.5bil in March; and (4) industrial production accelerating to 9.1% y/y in April versus 6.1% y/y in March. Against the MYR, the currency was up by 0.95% to 2.9766 as domestic noises post-GE14 in Malaysia weighed down on the MYR, added with Singapore’s growth deviating higher as compared to the Malaysian economy.

• Asia Ex-Japan: The majority of Asia ex-Japan currencies depreciated against the dollar in May, save for the Indonesian rupiah. The rising yields in the US economy and the sustainability of the emerging market (EM) debt left the currencies vulnerable to the dollar. Leading the pack, the Philippines peso weakened by 1.5% despite the Philippines central bank raising 25bps to 3.25% in May. We believe the twin deficit problem and the central bank’s policy to stay behind the curve added pressure to the peso to depreciate significantly. Similarly, the Thai baht fell by 1.2% amid the Bank of Thailand (BoT) leaving interest rate unchanged while the Indian rupee shed 1.1% as the rising yields and stronger crude oil price overshadowed the news of the accelerating GDP growth of 7.7% in 1Q18 from 7.0% in 4Q17. The Chinese renminbi lost ground, tumbling by 1.2% to 6.4106 following the Trump administration’s U-turn on the trade deal and move to slap the initially planned US$50bil tariffs on China’s imports. The Indonesian rupiah was able to recoup losses, clawing back 0.1% after the pre-emptive move by Bank Indonesia (BI) to raise 50bps in May to combat the capital flight and falling rupiah.

• MYR: The Malaysian ringgit (MYR) dropped by 1.4% to 3.9798 in May as the MYR was vulnerable to volatility emanating from both domestic and external factors. The surprise outcome of 14th general election and rapid changes in domestic policies have partly induced volatility while the dollar added further deterioration in the MYR. The volatility in the domestic market was reflected in the: (1) net foreign outflow of RM5.6bil in May in the local bourse; (2) the 3-, 5-, 7- & 10-year MGS rising by 7.7bps to 3.722%, 3.1bps to 3.807%, 6.5bps to 4.019% and 6.3bps to 4.187% respectively; (3) the 5-year CDS rising and hovering between 71.8 and 93.7 in May (70.4 and 73.9 in Apr).

B. June Highlights

1. US Fed’s tone

• A key focus in will be on the 13-14 June FOMC meeting. The market is pricing in an 86% chance of the Fed raising rates during the FOMC meeting, while we maintain our 90% possibility of a rate hike by 25bps.

• In this FOMC meeting, our focus will be on the tone of the Fed Chair in relation to the direction and aggressiveness of the policy going forward. We maintain our view of a total of three rate hikes in 2018, with the remaining two hikes to be in June and September after the March hike.

• We feel wages and inflation are rising at a gradual pace, suggesting there is less urgency for the Fed to embark on aggressive rate hikes in 2018 (see Chart 1). Should the Fed move too aggressively on the rate hike, we fear the yield curve will be inverted in 2018, a sign indicating an impending economic downturn. At the moment, we are expecting the yield curve to invert in 2019 as the Fed reaches its neutral rate of 2.75% – 3.00%.

• On the possibility of a fourth rate hike in 2018, it can happen if the expectations on inflation become louder than the 2% target and wages are growing faster. For now, the market is looking at around a 29% chance of a rate hike in December while we have placed a 40% chance.

• Meanwhile, should the Fed institute four rate hikes in 2018, we then foresee a total of two rate hikes in 2019 to reach the neutral rate of 2.75% – 3.00%.

2. US Trade War (Tariffs)

• President Trump imposed a 25% and 10% tariffs on steel and aluminum respectively on Canada, Mexico and the EU. In March, the US imposed those same tariffs on Japan. Now, every country that has been subjected to the US steel and aluminum tariffs is making plans to potentially retaliate with tariffs of their own.

• Meanwhile, the US and China seem to be playing a risky game. The US is hoping to reach an agreement with China in which China agrees to buy more goods from the US while dropping some of its unfair trade practices, such as forcing US companies in China to hand over their technology to Chinese companies. With no new grounds so far, it opens the door for a trade war.

• The US has a final list of US$50bil worth of Chinese goods that will be subject to tariffs. It will be announced on June 15 and the measures will go into effect shortly thereafter. China plans to retaliate with tariffs on US$50bil worth of US goods, which could deal serious damage to the US agricultural industry.

• If we recall, former US President Bush slapped tariffs between 8% and 30% on imported steel in an attempt to revive the industry. It was implemented on March 20, 2002 and ended on December 3, 2003. Canada was exempted but not the European Union (EU), which lashed back at the US with tariffs of its own after the World Trade Organization (WTO) deemed the US tariffs a violation of global trade agreements.

• Consequently, the Bush tariffs saw about 49% of steel-consuming firms in US experience difficulties in obtaining steel; 32% of manufacturers, including automakers and canneries, reported delays in production; while 19% of firms passed through price increases to customers. Employment in the sector generally was weak. The USD plunged around 15% although the sharp fall was not entirely due to the tariffs as there were other factors that undermined the currency during this period.

• We believe the current tariffs on steel and aluminium of 25% and 10% respectively will have some knock-on effects. Industries to be affected are in the manufacturing sector like fabricated metal products, machinery and equipment, transportation equipment and parts; chemical manufacturers; petroleum refiners and their contractors; tyre manufacturers; and non-residential construction companies. Small businesses who are price takers with little or no influence on the prices will be the hardest hit.

• We expect the USD to weaken following the tariff imposition and this will worsen the trade balance. The reason being import demand, which is less price sensitive in the short term or from the first-round effect of the tariffs, will remain the same or drop marginally while prices paid for imports rise, thus hurting trade balance.

• For instance, in 1983 President Reagan imposed tariffs on Japanese motorcycles which subsequently saw the USD dropping 0.5% after 1 month and 1.00% after 3 months against the yen. In 1985, he slapped tariffs on Japanese semiconductors that saw the USD plunge 4.7% after 1 month and 8.5% after 3 months against the yen.

• In the mid-1990s, President Clinton threatened to impose tariffs on Japanese luxury cars. The USD fell 2.3% after 1 month against the yen but gained 5.6% after 3 months when the tariffs were not introduced. In 2002, President Bush slapped tariffs on EU steel that saw the USD depreciating 1% against the euro after 1 month and 6.4% after 3 months. In mid-2016, President Obama imposed restrictions on Chinese steel imports that resulted in the USD shedding 3.8% against the yen after 1 month and 8.1% after 3 months.

• Hence, the net effect from past experience is that we can expect the USD to weaken by 1%-2% against the euro in the near term and probably as much as 5% -6% in 3 months.

3. US–North Korea meeting

• The US reveals the historic first meeting between President Trump and North Korean leader Kim Jong-un, tentatively scheduled at 9am Singapore time on 12 June.

• The US is unlikely to remove current sanctions imposed on North Korea unless Pyongyang, which is being viewed as increasingly powerful with nuclear tests and ballistic missiles, agree to denuclearisation. That would mean the US will continue to maximise its pressure campaign against North Korea.

• A possible outcome from this meeting could be the official ending of the Korean War, which sputtered to a close in 1953 with a ceasefire. We think the North Koreans will denuclearize in phases as Pyongyang would want to ensure that there are no further threats from the US. So it can be a long-term process. However, should there be an accelerated nuclear disarmament, it may not be in China’s strategic interests.

• There is a risk that the US-North Korea summit could end with no significant outcome or a last-minute cancellation. A failure could raise the possibility of a preemptive US military strike on North Korea’s nuclear facilities.

4. ECB policy meeting

• Expectations of the ECB embarking on policy normalization have somewhat waned largely due to the euro zone data that proved sluggish. The current low inflation has been pushing back expectations on when the ECB will begin rolling back its quantitative-easing programme.

• Harmonized eurozone inflation stood at 1.2% y/y in April, while core inflation came at 0.9% y/y. It has raised concerns on whether the European growth story has come to an end. Meanwhile in the US, the Fed has room to raise interest rates and data remained supportive, making for the return of a US-centric interest rate differential theme.

• But we feel a long running rise for oil could push inflation higher and allow the ECB to spring into action faster. Should oil prices continue to stay at current levels, there is room for inflation to come close to the 2% target set by the ECB in June or July. We expect May inflation to be around 1.6% y/y while the ECB is looking at 1.9% y/y based on the oil price average of US$77.01 and US$69.98 per barrel for Brent and WTI respectively.

• Besides, the loss of some economic momentum in 1Q2018 was partly due to weather and strikes which are being viewed as temporary. With global growth staying positive and supportive of trade in the euro area, it should potentially support the data to settle and boost confidence. But the concern is on the political noise.

• Hence, we feel the 14 June ECB meeting is crucial. We expect the policymakers to most likely communicate on whether to end its €2.55 trillion asset purchase by end-2018 or earlier even if inflation falls short of the 2% target.

• Our view has been that the ECB would maintain its purchases in 2018. However, we expect the ECB to reduce the current size of its bond-buying programme of €30bil to €15bil from October and end in December 2018.

• Meanwhile, we expect inflation to ease in 2019 to around 1.3% y/y despite expecting some second-round effects from the higher oil prices. Being a net importer of oil with higher cost, it is expected to eat into the consumers’ wallet and in turn weigh on businesses as well as the economic growth. The ECB could become dovish, especially if growth is further limited with a less supportive external demand in the medium term.

5. Other key events

• Nonetheless we believe market also would focus on the Bank of England’s (BOE) monetary policy meeting which is scheduled on 21 June. With lack of clarity on the Brexit deal, the outlook on the UK economy remained uncertain as macro data and business confidence remained subdued. We hold the view that the BOE would keep the rate unchanged at 0.5% and pricing in a rate hike in November 2018. Meanwhile, we are watching the EU-UK Article 50 negotiations 5-8 June as well as the EU Summit 28-29 June should both sides come to an agreement.

• Meanwhile, our other focus for the month will be the policy meetings of several central banks in the Asian region. For instance, the Reserve Bank of Australia’s June 5 policy meeting left the policy rate of 1.50% unchanged as expected owing to sluggish wage growth and inflation at the lower end of the target range of 2% to 3%.

• With the Bank of Japan (BoJ) having removed any reference to a time frame for hitting its 2% inflation target and unveiling its new inflation target, which is 1.8% in fiscal 2019 and 2020, this implies inflation would fall short of the target for another three years. It supports our view that the BoJ would maintain its current policy on June 15 and may hold rates for a prolonged period if inflation remains elusive.

• Room for the Reserve Bank of India (RBI) to raise interest rates in June is in the cards following an unexpected surge in inflation and GDP. But we are still looking at an August rate hike by 25bps to 6.25% with the June meeting used to shift its policy communication to an explicit tightening bias from the neutral bias since February 2017.

• We expect the Bank of Thailand (BoT) on June 20 to maintain its current 1.50% policy rate. We believe the policy normalization is unavoidable in the long term. For now, the weak recovery in rural areas justifies the need for a continued accommodative policy stance. The widening interest rate gap between Thailand and the US would slow down capital inflows and weaken the baht.

• The Philippine’s central bank in its June 21 policy meeting is more likely to keep rates unchanged after raising rates by 25bps in May to 3.25% for the first time in more than three years to tame price pressures and manage inflation expectations. We believe there is some room for another rate hike in 2H2018.

• Bank Indonesia (BI) is expected to continue focusing on the weakening of rupiah as opposed to inflation during June 28 policy meeting. Following the two rate hikes in May, each by 25bps to now at 4.75%, we have pencilled for another 25bps rate hike on 28 June and stay neutral thereafter to keep the rupiah in a consolidated mode though there is some room for BI to take a breather due to slower inflation and the steady rupiah.

Source: AmInvest Research - 7 Jun 2018