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Shaun Osborne: Hi, I’m Shaun Osborne, Chief FX Strategist at Scotiabank.
Brendan Stark: And I’m Brendan Stark, Managing Director, Short Term Interest Rate and FX, Scotiabank.
SO: All right, Brendan, thanks for coming along today. We’re here to talk about FX. We’re going to be talking about the FX outlook, the FX forecast as Scotiabank sees it.
We’re going to be talking about the risks around that outlook, some pretty lumpy risks coming up for markets particularly, on the political front. We’re going to be talking about other issues that may be driving or an important factor for markets going forward and particularly looking at the low level of volatility across asset markets at the moment.
BS: Yeah. Thanks for that, Shaun. It’s great to be here. And it’s definitely an interesting time to be talking about foreign exchange, really look forward to reviewing some of the forecast, looking at some of the bigger themes in the market regarding volatility and some of the exogenous factors such as the election and potentially, discussing things like de-dollarization.
SO: So, I thought maybe a good starting point for us today is just to run through the kind of house forecast as we see them. I think in terms of the major currencies, the views that Scotia have are fairly mainstream, we think for the U.S. dollar, it’s a case of a bit more range trading through the first half of the year.
But then as we move into the second half of this year and into 2025, maybe a bit more U.S. dollar softness. That’s really predicated on the idea that as the Fed starts to move to lower interest rates, the dollar becomes less attractive for international investors. We expect also some convergence in global growth trends.
The dollar has done particularly well over the past couple of years because interest rates have been somewhat higher than the rest of the world. Growth rates have been higher than much of the rest of the world, certainly in the developed market space. So, there is this idea of U.S. exceptionalism that has supported the U.S. dollar. We do think we’re moving towards an era of probably more convergence in interest rates and certainly more convergence in growth, which we do expect to weaken the U.S. dollar.
So, in terms of hard numbers over the course of this year, we expect dollar Canada to move back towards the 133 point. Euro dollar to push up towards 112. Sterling to end the year around about 130, and dollar Yen to end the year around about the 140 point. So, a generalized weakening in the U.S. dollar. That’s probably not uncommon looking at other bank forecasts. It’s pretty much consensus I would say in terms of our expectations relative to other big banks or bulge bracket banks.
But as the saying goes, I think it was Mike Tyson, “everyone has a plan until they get punched in the face.” And I think the question we often get when we’re talking to clients is the outlook is all well and good, but what could possibly go wrong? And I think we’re looking at a situation where there’s a lot of uncertainty and volatility potentially emerging in markets this year.
BS: We’ve largely been stuck in a range. It’s not been front and center in terms of trading opportunities. Some of the, traditional, say, more active hedge fund clients, I really don’t see them being tremendously focused on foreign exchange opportunities. A little bit more on the front-end rate. Even if you were to look back and think of how FX would typically be used to express a very short-term trade based on economic surprises.
It seems like there’s much more follow through in the rates market. Most of the things that I think that we would have pointed to outside of the carry dynamics of rate differential is on the political side. And I personally would have gone back over the last several years and thought to myself that this was really a big moment in time because we’re going to get a shift in political leadership in the U.S. potentially.
Trump’s policies and expectations around his policies, I think those generally feed into a lower dollar perspective. I think people think that it's a more protectionist, probably more focused policy regarding the dollar, but I’m not sure that I totally believe that that’s what's going to happen. I’m not sure what stops the exceptionalism at this point. They have great growth. They’ve got strong support from a labour perspective. They still have relatively high inflation, there’s still a decent growth profile. I really want to see what policies are this time next year, when either the current administration is setting forth their next four years or Donald Trump is stepping in with whatever direction he may take us.
SO: Right, it’s interesting you say that you think the dollar may soften. I mean, we’re starting to see a lot of banks now put together some ideas about where they think things might shift or move in terms of the political developments that we see. We don’t factor into the forecast, the election at this point, but clearly we’re starting to think about what a Trump win might mean, because that probably implies more volatility, relative to the status quo that would be a Biden win, for example.
The consensus there seems to be shifting towards the idea that a Trump win would be actually dollar positive, at least in the early years of a Trump win. And I think that really relates to, or goes back to the idea that he’s gonna be pretty heavy on tariff action at least initially in the administration, although there will be a lot of focus or expectation that tariffs are gonna be a big part of his trade picture.
But I tend to agree, I think the issue about the dollar direction is generally not clear at this point. I think we will probably, from a macro point of view, come down to the idea that if we’re simply talking about tariffs, that would be dollar supportive.
We’ve seen that happen before, but if you look back at the last Trump administration, it wasn’t generally dollar positive. In fact, the dollar weakened in the early stages quite significantly. It was down about 10% roughly in the early years of the first Trump administration.
We did rally a little bit in towards the middle of that administration. Then we had another big sell-off in towards the tail end of that administration. So net-net, the dollar actually ended up about 10% down through the Trump administration last time around. So it’s not obvious that this is going to be dollar supportive, and I think beyond tariffs, the issues that probably people are going to be focusing on is, the second round effects of tariff action. Tariff action is going to be inflationary, it’s going to slow growth. It could disenchant some of the U.S.’s major trading partners who also happen to be major holders of U.S. Treasury debt. There’s a lot of complicating factors that could emerge here.
BS: What I find kind of interesting and, of course when we look at FX in Canada, we are mostly focused on dollar Canada. We can get a lot of information based on what the Aussie dollar is doing, or basket of commodity currencies, or we can look at carry currencies or funding currencies, but I think in Canada’s case, given the importance of the U.S. influence, I look at Canada/MEX is kind of an interesting pair. MEX is appreciated I think beyond almost any anyone’s expectations.
So maybe there’s an opportunity where Canada becomes, a story for the U.S. I don't think that the Bank of Canada story on Canada really matters. I don’t think like, certainly Mexico isn’t looking at the CAD MEX exchange rate and saying anything about it, but I think if the U.S. were to start to focus on that, that could be one of the catalysts for appreciation for the Canadian dollar.
SO: Generally, a lot of currencies are looking relatively cheap when we look at 10-year history, 20-year history of currencies. The yen obviously sticks out at the moment as a very weak currency. The Canadian dollar in real effective terms is also a relatively weak currency. But, I think from when I’m talking to clients at the moment, one of the issues that comes up is, you know, what is going to drive the Canadian dollar higher if we’re talking about the potential for some strength.
We think there’s a case for some moderate appreciation just from growth convergence and interest rates maybe not falling quite as quickly in Canada or quite sharply certainly this year. There’s some potential for the CAD to pick up a bit of ground there.
BS: When I’m thinking about the Canadian dollar and I'm thinking about its typical relationship with the S&P, which is a good broad measure of just risk, we’ve kind of broken that relationship down. It used to be a very sort of positive correlation – S&P up, and the Canadian dollar appreciates.
SO: Yeah, I think, you know, it’s interesting you bring up correlations. I mean, we generally have seen, I think, a weakening in most of the, what I would call, traditional correlations between the Canadian dollar and variables that are normally driven currency movement in my lifetime in Canada.
When I’m engaging with clients, I used to say, you know, look at interest rate differentials, interest rate spreads between the U.S. and Canada, and oil prices, and that's probably going to tell you an awful lot about what the Canadian dollar should be doing at any given point in time. We’ve seen a clear breakdown in the CAD’s correlation with oil prices. We’ve got oil prices around 80 bucks a barrel. It’s been a lot higher than that.
Ordinarily, we’d be associating those kind of levels with a significantly higher Canadian dollar than, than we’re seeing, or have been seeing in, recent history. So, there is a bit of a breakdown between, or appears to be a bit of a dislocation between the Canadian dollar and, and oil prices. I’d say generally the correlation between the CAD and commodity prices more broadly is, has held up a little bit better.
But commodity prices have been quite soft, so it's probably not surprising that the Canadian dollar, Australian dollar, New Zealand dollar, the high beta currencies, currencies that do correlate with global growth, typically have underperformed.
Until we see a material improvement, I think, in commodity prices, it’s hard seeing that situation change. So from my point of view when I look at these variables that drive the Canadian dollar, we’re not correlating particularly well with the risk at the moment.
We’re not correlating particularly well with commodity prices. We’re seeing a little bit of correlation with interest rate differentials, but we’ve been stuck in a bit of a range there as well. So interest rate spreads have moved effectively in a range as well. And that's contributing to this, low volatility, low conviction, environment that we see persisting at the moment is driving volatility significantly low, not just in FX, but in a lot of other asset classes.
BS: Yeah. I think it’s a slow adaptation to the normal behavior for, say, our customer base would be to be net selling vol, analogous to a farmer, like the, it’s like they just constantly sell. But the crop is, is at the sort of record low levels which you would expect that then somebody would want to consume that vol, but we just don't see it.
We just don't really see any significant interest to be long, certainly FX vol it’s all, I think, at the levels that would traditionally indicate a very, almost perfect scenario, like they’re incredibly liquid markets and very tight but yeah, from a vol perspective the things that should be impacting, there’s a very small blip in FX vol in and around the election time, that initial blip was a little bigger than we had seen for a while and sort of is intuitively accurate. But a lot of that’s disappeared. It seems like we’re just very comfortable with just about any scenario.
SO: Right. And that makes me uncomfortable.
BS: Agreed.
SO: So, and I have some ideas or I have some thoughts on why we’re seeing low volatility persist. I think from a kind of macroeconomic point of view, when I look at our forecast in particular, we’re looking at a number of central banks in the developed market space that we expect to do more or less the same thing over more or less the same time frame.
So when we look at our interest rate forecast, for example, when we look at the Fed, the Bank of Canada, the European Central Bank, the Bank of England, very generally, we’re all looking over the course of the next sort of 6 to 12 months for rates to fall by somewhere between 75 to 100 basis points over around about the same time frame.
So, particularly in the second half of the year, so it strikes me that one of the reasons that we’re seeing low volatility is that there’s a highly synchronized global economy at the moment where there’s not a lot of differentiation on the macroeconomic front. We don’t have cases where one continent is growing and other continents in recession and another continent is doing something else entirely that we used to have back in the good old days of sort of desynchronized global economy. So, the high degree of synchronicity across monetary policy, across global growth trends, I think, contributes to this decrease in volatility that we've seen.
I think from my point of view, talking to our sort of corporate commercial clients, I look at the kind of range trade environment that we've been in, the low volatility, and it does leave me a little unsettled. For clients in our corporate and commercial space who obviously are interested in following the exchange rate to an extent because it's an important aspect of their business profitability, that can lull some people into a sort of false insecurity that the Canadian dollar hasn’t moved that much over the past year, so therefore it’s not going to move that much over the coming year. But we know that that’s generally not the case, that we do see these periods of heightened or extreme volatility, sort of interjecting themselves into the market.
So, our messaging to clients, particularly in the corporate and commercial space, is to look at U.S. dollar spikes as an opportunity to hedge receivables. I think we’ve seen a very consistent flow of business from our corporate and commercial space over the last few months. Looking at dollar Canada levels closer to 136, is a great opportunity to hedge near term receivables. But beyond that, the message is that, you know, we have to be conscious of the fact that even though we have a fairly orderly outlook in terms of what we expect to unfold over the next 12 to 18 months, there are a lot of risks out there. Some of the risks that we can identify at the moment as being potentially an issue for markets, don’t have very good consequences for Canada or potentially even the Canadian dollar.
BS: I think, and that, that segues nicely into, I think, what’s happening on the institutional side. The large Canadian pension plans, it’s hard, it’s impossible to look at the Canadian landscape and not talk about eight pension plans that are largely invested globally and have, I think, taken a longer term view on their risk. Some of that risk, whether it’s rates risk, or beta, or FX, or inflation, all of those things are really important, but there's one thing that’s common to all of them, which is that they’re I think to a large degree invested outside of Canada. Partly, because there isn’t an investment subset here that’s big enough to attract or keep that capital in Canada at this stage. I think that they would have, I think longer term allocation where they would like to be hedged against U.S. dollar weakness. I think one of the things we had mentioned in our conversation, you know, earlier about this was, I was talking about just de-dollarization in general. Is that a real risk? If you're a pension plan and you're managing assets for a hundred years, those are things that you have to factor into your hedging. I certainly don't think it's a near term risk. But, when you see things like this Ukraine bond, that’s backed by Russian assets in dollars, those are kind of interesting things. I mean, we haven't really thought about confiscation and appropriation in a long time at a national level.
SO: That's another subject that comes up quite often talking to clients. What are the alternatives to the dollar? We’re talking about the BRICs or the BRICs plus six now as the sort of new entrant invited into that BRICs group. I think from my point of view, it’s just very difficult to see an alternative to the U.S. dollar over a timeframe that's kind of relevant for most people at this point. But certainly a shift to, you know a bipolar or tripolar world, where you have eventually currencies like the euro potentially, or maybe even the yuan eventually competing with the U.S. dollar in that space. But I think realistically over the next 5 to 10 years, the U.S. dollar is so deeply embedded in the global financial architecture that there is no alternative at this point. I would imagine that the U.S. Treasury, U.S. authorities, have a vested interest in trying to maintain that position because of the benefits in terms of being able to float debt at relatively cheap yields. A tremendous benefit that, obviously other countries are quite jealous of, but it is a tremendous benefit for the U.S. in terms of fiscal management.
Brendan, we’ve covered a lot of ground there. I think in terms of you know, the, I think my main takeaways from the conversation certainly from my point of view, the door is opening to a somewhat softer U.S. dollar. Reflecting our forecast, I think at Scotia, in line with pretty much the market consensus that we are going to be able to see some weakening in the U.S. dollar generally in the next few quarters. But clearly there’s a lot of uncertainty in markets and that uncertainty is looming up pretty quickly as we look towards November in the U.S. and what that may mean for markets. But I really enjoyed our conversation.
BS: Absolutely, it was great to be here. I think we have a tough time talking about the sort of basic mechanics of foreign exchange, the things that have been reliable correlations are a little bit askew at the moment. So, we are looking for other factors that are driving what we’re doing.
But the election, I think, remains sort of the most important driver and it may not be the election that does it, but it could be the first sort of few months in office where we get real clear policy directive from the either existing or new administration.
SO: All right. That was a great conversation. Thanks very much.
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