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Currency Market Commentary - July

Detailed Currency Views

Macro Environment
Macro forces were the primary driver of currency moves during the month while country specific data and news played a secondary role. Global rates fell steadily during the month primarily due to a drop in real rates while inflation expectations remained elevated. The proximate cause for this drop was a downgrade in the expected pace of recovery as the rapid spread of the Covid Delta variant threatened demand growth. The United States experienced a 502% increase in the 7-day average of new Covid cases during July, while Spain experienced a 352% increase, according to data from the Worldometer website. Indonesia, South Korea, and Malaysia experienced increases of 95%, 149%, and 185%, respectively. The modest slowing in the pace of recent economic recovery in the context of this Covid surge likely weighed on expectations of growth and pace of central bank tightening over the next 12–18 months.

In addition to a modest re-rating of near-term growth we also saw a flattening of curves in developed markets, a trend that began shortly after the June Federal Reserve (Fed) meeting. That flattening appears less related to the near-term impacts of Covid and more a reflection of the expectation that short-term rates will remain lower over the long run than previously expected. There are a few likely reasons for this behavior, though it is difficult to attribute the degree to which each of those reasons contributed to falling real yields. Firstly, curve flattening implies that an earlier tightening by central banks is likely to result in lower terminal rates at the peak of this economic cycle. By taking a more proactive stance the degree of overheating and overshooting of inflation is likely to be limited. In addition, it is possible that investors expect central bank tightening to be more effective at slowing growth and inflation than in prior cycles due to factors such as the high level of global debt. Secondly, rates markets are clearly pricing in a return to lackluster global growth rates after the initial Covid recovery in 2021–2022. Many of the structural factors such as high debt levels and demographics that resulted in poor growth rates for the decade prior to the pandemic are still in place. In fact, given the surge in debt and potential for misallocation of capital in this negative yield world, these factors may have further damaged potential growth. Finally, investors may be pricing a greater gap between equilibrium real rates and real growth given the adoption of average inflation targeting, high global debt levels, and possibly the difficulty in sustaining inflation at or above target during the past 10 to 20 years. This is far from an exhaustive explanation of the drop in real rates, but it covers some key potential causes that are consistent with observable fundamental developments and help shed light on recent FX behavior.

FX markets largely followed rates markets. This is partly because lower rates and flatter curves directly caused moves in FX, namely the unwind of yield seeking carry trades as current and expected yield differentials compress. Cross currency carry positions, buying high yield versus low yield currencies, is a risky business because it seeks to gain from relatively small interest rate differentials relative to higher levels of spot FX rate volatility. A compression in yields due to Covid concerns and the expectation that yield dispersion would remain depressed in the long run (that is, flatter curves in the higher yielding countries) make cross currency carry trades less attractive. As a result, the Norwegian Krone and Canadian Dollar sold off despite resilient local fundamentals while the low yielding Swiss Franc and Japanese Yen were the top two performers in G10. This is almost the exact opposite of the price action when yields rose and curves steepened in February and March.

Unwinds of currency carry trades are often associated with severe drawdowns and volatility. Such drawdowns are generally caused by a sharp spike in global risk aversion and risk premiums; the denominator of the carry/risk relationship becomes unhinged. That was not the case in July. Instead we saw an orderly unwind of carry positions driven by a re-rating of the numerator, the expected interest rate differentials across countries, while risk sentiment

remained well supported. This more orderly behavior was clear in the healthier behavior of equity markets and credit spreads. A slower than previously expected recovery is still a recovery and leaves 2022–2023 growth expectation less affected which in turn helps support the medium-term earnings outlook; great Q2 earnings reports were also a clear help. At the same time, lower rates support equity valuations and reduce future expected interest costs to the benefit of both equity markets and credit spreads. For this reason, we saw a July re-rating of future expected growth and real yields without a concurrent spike in equity and credit risk premiums. This calmed the unwind in currency carry trades and prevented the US Dollar from spiking higher as it usually does during global risk events.

Going forward we must be wary of greater volatility across markets. For now, the surge in Covid is seen as temporary and having a negative but limited impact. Should cases continue to escalate prompting undervaccinated regions to implement ever stricter lockdowns, the hit to growth and earnings expectations could outpace, at least temporarily, the benefits of lower yields. A global correction in risky assets would likely force a less orderly unwind of positions in cyclical, higher yielding currencies and generally increase currency market volatility. Asia, a hub of the global supply chain, uses lockdowns as a primary tool to control Covid outbreaks. Such lockdowns, in response to the current outbreak, could therefore lead to sustained supply side inflationary pressures. Those would be somewhat offset by slowing demand growth in a sustained Covid wave, but we think it is appropriate to be on watch for a stagflationary impulse which would be quite negative for risky assets.

US Dollar (USD)
The US Dollar was up slightly for the month, +0.3% versus the G10 average. The uptrend in USD after the Fed pulled forward rate hike expectations at its meeting in June carried over through the first half of July. A strong June employment report, +850k new jobs compared to +720k expected, helped sustain the optimistic trend. Strong PMI data, a large surprise in June core inflation of +0.9% MoM versus expectations of +0.4%, and better-than-expected June retail sales all helped to push USD higher by validating a more hawkish Fed policy outlook. Falling interest rates and initial fears from the sharp acceleration in Covid cases caused a short-lived equity market correction from June 14th to 19th. The rise in risk aversion pushed USD even higher to its peak on the 20th. From that point USD trended lower as equity markets pushed to new highs and yields to new post March lows. The Fed meeting on the 28th brought little relief. The Fed maintained a cautiously optimistic tone and pointed to continued progress; they clearly indicated there was still a way to go before the recovery progressed enough to begin to taper the QE program. As a result, USD fell almost 0.8% in the day following the meeting.

Increased Covid uncertainty and the potential for a more material correction in equity markets, which have not seen a 7+% correction since October 2020, could provide support for USD over the coming months. A pickup in employment growth would also favor an earlier start to QE tapering and stronger USD. However, beyond those near-term USD supports we maintain a bearish view and increased our tactical short position into the mid-July rally. USD remains overvalued, more than 9% above fair value versus an MSCI World xUS basket of currencies. That suggests much of the US future growth and yield advantage is already priced. While recent trends in US relative growth and inflation favor US assets and USD over the near-term, the rest of the world is likely to catch up later this year and especially in 2022 as global vaccination rates improve and the current Covid surge winds down. If that happens as we expect, then it should favor a weaker dollar as USD tends to suffer during broad global recoveries. US capital flows are also a risk as US equities remain historically expensive relative to foreign equities. Our expected shift in growth leadership increases potential for relative upside surprises in earnings growth outside the US. Greater risk of higher corporate taxes in the US later this year further increase the chance for equity market outflows which tend to weigh on the dollar.

This negative dollar view does not mean that we reject the thesis of US exceptionalism that many investors see as a basis for longer-term USD strength. It is hard to deny the pillars of the US exceptionalism thesis. Many factors support a structurally stronger USD over the next several years. The US potential growth and monetary policy/interest rate outlooks remain attractive relative to much of the world. US demographics are healthier than in most developed countries and China while friendlier immigration policies under the Biden administration could also help labor force growth. The US remains well-positioned to lead in a global economy driven by innovation and the development of intellectual property while we may see some technology enabled re-shoring of manufacturing. We respect these positive long run factors and think that they result in the mildest USD bear market since currencies were floated in the early 1970’s. Whereas the USD typically moves 15–20% below fair value at the trough of a bear market we think USD only falls back to and maybe slightly through fair value in this cycle. However, that still implies a broad 8–10% fall in USD.

Euro (EUR)
Euro was almost unchanged versus the USD and up 0.2% versus the G10 average on mixed economic data and a dovish tilt from the ECB. The month began on a soft note with the ZEW expectations survey plummeting from 81.3 in June to 61.2 in July. The PMI overshadowed a positive surprise in May retail sales released on the same day, July 6th. A couple of days later the ECB announced a symmetric 2% inflation target which replaced their prior target of near 2%. With YoY core inflation below 1% and headline still slightly below 2% despite this period of surging global inflation, the adoption of a symmetric 2% mandate translates into an outlook of negative rates for a very long time. However, this was only marginally negative EUR because the market was already pricing negative policy rates out many years. Perhaps the most important defining characteristic of EUR during the month was its orthogonality to major FX market drivers. It simply wasn’t as exposed to the unwind of the cross-currency carry trade or spike in Covid cases as other G10 currencies. EUR is not as popular a carry funding currency or haven as the Swiss Franc or Japanese Yen and the increase in its Covid case count was not as dramatic. France and Spain struggled with sharply rising cases while German cases remained low and Italy was somewhere in between.

Looking ahead, we are bearish EUR over both the tactical and strategic horizon. All three of our long-term signals, valuation, interest rate carry, and long-term growth, suggest a short EUR position. EUR is quite expensive compared to GBP, NOK, SEK, CAD, and JPY and only fairly valued versus USD, AUD, and NZD. The EU is trapped in a negative interest rate regime and hindered by an anemic potential growth outlook which is a function of low productivity growth and poor demographics. That is not a good backdrop for currency strength. More importantly, we do not have high hopes for change because of high debt levels, persistently high levels of regulation, resistance to reform, and potential misallocation of capital due to the ECB’s negative rates and large QE program. As a result, our long-term potential growth model ranks the EUR at the bottom of the G10 universe.

While our central case is negative EUR against the G10, we recognize the risk that EUR could surge versus the US Dollar as its economy reopens and US relative growth peaks. The EU vaccination program has mostly caught up to the US and UK. Growth may slow alongside global growth for now due to the recent Covid surge but should continue to find support from a return of the consumer backed by historically high household savings rates over the past year. The EU is now disbursing fiscal support from the Next Generation EU fund, which will provide additional tailwinds and may help to raise longer-term potential growth depending on the effectiveness of the investment programs. At very least the EU appears unlikely to repeat its mistake of forcing excessive fiscal contraction after the 2008–2009 global financial crisis which should help it achieve a much more robust cyclical recovery. Low interest rates are a drag, but we expect that as the recovery reasserts itself after the current Covid surge, we are more likely to see a steadier rotation toward cyclical and higher yielding sectors of the equity market. This favors some rotation out of US equities into European equities. Such a rotation would help to push EUR higher versus USD. We saw this during late 2020 and think it may well resume as we get closer to a sustained post-pandemic recovery. To put a number to it, we could see EUR/USD up toward 1.25 at some point in late this year or in 2022.

British Pound (GBP)
The Pound enjoyed a strong 0.9% gain versus the G10 average thanks to a late month rally alongside an unexpected fall in new daily Covid cases. UK growth continues to moderate while inflation tracks higher. July PMI data moved lower from June but remained well above 50 signifying a positive growth trajectory. June employment came in at 25k 3M/3M, well below expectations of 91k. Some of the recent deceleration is simply a return to normalcy after the initial surge in consumer activity as the economy reopened in April–May. However, some of the slowdown is likely from the increased drag of rising Covid cases which rose from less than 3,000 new cases per day in May to a peak near 50,000 new cases per day by mid-July. Still, low fatality rates and moderate hospitalization rates allowed the government to lift all Covid restrictions on July 19th. Volatility around that reopening decision on the 19th drove much of the behavior in GBP during the month. GBP was near flat versus EUR and USD early in the month. As Covid case growth peaked mid-month investors began to worry that PM Johnson would delay the lifting of remaining restrictions. Once it became clear that the government would go ahead with their plans to fully reopen GBP stabilized. Many predicted that fully reopening at a time of peak virus transmission would be disastrous. Instead, the number of cases unexpectedly fell later in the month from that peak near 50,000 per day to near 30,000. GBP responded positively.

We shifted to a cautious near-term stance on GBP in July versus more pro-cyclical and commodity sensitive G10 currencies. We closed our tactical long position and moved to a slight short bias. Just as the UK and GBP benefitted from its rapid vaccination program and earlier re-opening it is now on the leading edge of the deceleration back to longer-term sustainable growth levels. The high levels of Covid cases thanks to the Delta variant also introduce additional uncertainty despite the welcome, but unexplained, drop in case counts over the past two weeks. It is important to note that the negative shift in our GBP positions was versus the G10 average; we retain a strong GBP view versus EUR, USD, and CHF.

For strategic investors/hedgers we also encourage long GBP positions and/or higher than average hedge ratios on most foreign currencies. The long-term GBP story is positive in our view. The currency is cheap to fair value and now that Covid and Brexit stresses are receding there is plenty of upside in terms of growth, inflation, and monetary policy expectations. In addition, we see the potential for capital flows into the lagging UK equity market to further accelerate GBP gains. With a long horizon it is better to ensure that you are in the market with a positive GBP position once the recovery takes hold and GBP reverts to fair value. The pound’s gains Q1 were a good example of the need for long-term investors to look through short-term uncertainty.

Japanese Yen (JPY)
The Yen gained 1.4% against the G10 average in July following its 1.1% gain in June. JPY continues to be driven by external factors. This month the continued fall in US and other developed market yields encouraged an unwind of cross currency carry trades. This favored JPY against higher yielding currencies including USD. The mid-month equity market correction was shallow and short lived but pushed JPY to an intramonth high up over 1.5% versus the G10 on the 19th. The subsequent recovery in equity markets brought a concurrent reversal of nearly half of JPY’s peak intramonth gain.

The Japanese economy continues to improve slowly with May core machine orders of 7.8% MoM and June retail sales of 3.1% MoM. Even as growth picks up, we expect little impact on the Yen because with core CPI still in deflationary territory, -0.2% YoY, there is a long way to go before the BOJ will react. Thus, as we’ve seen over recent quarters JPY will be driven more by expectations of central bank behavior and yields outside of Japan. Recently, the surge in Covid and falling global real rates have pushed Yen higher. As vaccine distribution continues and the current virus surge peaks it will be difficult for JPY to hold those gains. That said, we remain long Yen over the tactical and strategic horizons. Why?

Over the tactical horizon the long position is attributable to two factors. First, and most importantly, JPY provides diversification against adverse events as it tends to rise during global shocks, lower yields, and equity market corrections. We may lose on the long JPY position during this recovery, but using long Yen as a hedge allows us to take even more aggressive long positions in higher beta currencies such as NOK, SEK, and NZD which we think are likely to more than offset any losses on long Yen. Secondly, Japanese yields are higher than EUR and CHF yields across the curve and short end yields are historically high versus most of the rest of G10. This implies that Yen weakness is likely be milder compared to prior global recovery periods in which JPY was the clear low yielding currency used to fund interest rate carry trades. The yield gap is even more attractive in real terms because of the very low Japanese inflation rate. Thus, over the tactical horizon we may lose money in absolute terms on a long JPY position during this recovery, but the diversification and likely limits to those losses versus other low yielding currencies make it a worthwhile position.

Over the longer-term horizon, we have a more explicitly positive Yen view. The Yen is quite cheap to long run fair value relative to most G10 currencies except for NOK, SEK, and GBP. This suggests that long run forces are tilted toward a stronger JPY. Projecting ahead into late 2022 and 2023 the business cycle is more likely to support gains in JPY. We may be in the early stages of a dramatic global recovery, but by mid-2022, or earlier, investors will turn their attention to the reversion of growth back to sub-par long run averages. In fact, depending on the drag from high global debt levels, the potential misallocation of capital due to ultra-easy policy, and the degree to which governments efficiently allocate fiscal spending, global long run potential growth may even be lower than the already weak level prior to the pandemic. That future period of a mature and decelerating expansion is more consistent with outright Yen appreciation given its lofty valuation. The major risk to this view is a longer recovery period and greater than expected productivity gains outside Japan on the back of government financed development programs and higher levels of private investment.

Canadian Dollar (CAD)
The Canadian Dollar struggled during the first half of July losing nearly 2% versus the G10 average by the 19th before it bounced back to finish the month down only 0.5%. CAD entered July up over 5% YTD, the best performance in G10. This strength was well deserved. Strong commodity prices led by oil pushed Canadian terms of trade to near 25-year highs. After lagging significantly, the pace of vaccinations rose and the percentage of the population with at least one shot topped 70% by mid-July, the highest in the industrialized world. The lifting of restrictions and strong terms of trade paved the way for a steady rebound in economic activity which saw the Bank of Canada begin to taper its QE program earlier this year and signal that a rate hike may in in the cards during H2 2022. These strong circumstances sensibly made long CAD a very popular position with strong performance.

CAD’s popularity led to rather crowded positions by late June which introduced greater risk of a correction lower in the exchange rate should we see any rise in uncertainty regarding the growth and/or interest rate outlook. As Covid surged, mostly outside of Canada, and rates fell those crowded CAD long positions were squeezed out in early July. This caused a steady fall in CAD despite continued positive surprises in employment and other activity data. The mid-month oil and equity market corrections further accelerated the drop in the currency. After that initial adjustment and sharp fall in CAD, the long CAD positions were less crowded and the market once again focused on the relative strength in Canadian fundamentals and monetary policy outlook. That outlook that was reiterated by the BoC at its July 14th meeting. At that meeting they further tapered bond purchases from CAD $3bn per week to CAD $2bn and raised the growth forecasts for both 2022 and 2023. The Canadian dollar rebounded into month end.

The pickup in economic activity and strong interest rate outlook prompted us to take advantage of the July sell off to add a tactical long CAD position. From a longer-term hedging perspective, the story is mixed. CAD is slightly expensive versus the G10 average but that average valuation measure masks major differences across currencies. CAD is cheap versus USD, AUD, and EUR and extremely cheap vs. CHF while it is expensive vs. JPY, GBP, NOK, and SEK. Therefore, we recommend that Canadian based currency hedgers adopt above-average hedge ratios on USD, AUD, CHF, and EUR and lower than average hedge ratios on JPY, GBP, NOK, and SEK.

Swiss Franc (CHF)
The Franc was the strongest currency in the G10 for the month, +2.2% versus the average. CHF behavior in July was a mirror image of its behavior in March. During the March run up in US and global yields CHF suffered as investors favored the yield pickup from selling CHF and buying higher yielding and more pro-cyclical currencies. The more recent fall in yields reversed that move and pushed CHF higher. Its best period during the month was July 5th–9th as US 10 year yields broke support at 1.40% and fell to 1.29% while the weak equity market performance on July 8th added an extra surge of Franc buying from defensive investors. The currency added to gains, albeit at a slower pace, through the remainder of the month due to continued downward pressure on global yields and the rapid rise in global Covid cases.

The local economy is recovering after the removal of Covid restrictions but a drop in May retail sales to 2.8% MoM from 35.7% MoM in April signifies that the initial post Covid surge is over. More importantly, even with that dramatic post lockdown surge in demand and global inflation pressures, Swiss core CPI only managed to reach 0.3% YoY for June. The SNB’s negative rate and currency intervention policy is not under pressure to change with inflation at those low levels. As a result, we expect CHF to continue to be driven by external growth, inflation, and central bank expectations like JPY.

We continue to hold a large short CHF position over both tactical and strategic horizons. Our strategic negative view is driven almost entirely by the Franc’s extreme overvaluation and ultra-low yields. By our estimates, after the recent rally CHF is more than 23% expensive to its long run fair value vs. an MSCI World currency basket. Over the tactical horizon, very low inflation, an overvalued currency, and weak growth point to continued currency intervention and negative interest rates. As domestic and EU growth pick up capital outflows are likely to accelerate (eventually) as investors look for growth and higher yield opportunities, much like they did during the 2017 EU growth spurt. We expect low global yields and the surge in the Delta variant to delay the recovery process and CHF weakness. However, once we get through this surge, or at least gain confidence that its end is in sight, the net result will likely be pressure for a weak CHF during the subsequent recovery.

Norwegian Krone (NOK)
The Krone lost 2.3% versus the G10 average in July. As we outlined in the macro section and again in the detailed discussion of nearly every G10 currency, the macro forces of falling yields, occasional small equity market corrections, and the rapid increase in the spread of the Covid Delta variant have driven currency markets in July. Local economic conditions have mattered, but far less than one would assume given the powerful global forces. For the past couple of years NOK has been the most sensitive currency in the G10 to macro concerns. Since it’s the central bank is the most likely to raise rates first in this recovery cycle, it is at the center of the long carry, yield capture trade that was unwound in July. Against this backdrop it is no surprise that NOK was the worst performer in July and reached its low on July 20th coinciding with the lows in US yields and the trough of the mid-month corrections in both oil and equity markets. At its worst NOK underperformed the G10 by nearly 3.5%. The late month rebound back to a loss of only 2.3% tracked the rebound in oil and equity markets but unlike those markets NOK failed to reach its prior highs, or even retrace half of its intra-month loss, as yields remained depressed and Covid cases continued to rise.

Local economic data was mixed but consistent with a resilient recovery. Core CPI remains elevated at 0.4% MoM for June though that was lower than expectations of a 0.5% increase. The case for a rate increase from the Norges Bank in H2 remains intact. June retail sales slowed to -0.1% MoM after the initial reopening surge of +5.8% in May. And, unemployment is a healthy 2.9% which is only slightly worse than the 2.1% pre-Covid level. Macro forces may be driving recent returns in currency and NOK, but once investors adjust their macro view and we get through the current surge in Covid cases, NOK is well positioned for recovery. We retain a long tactical position.

As we point out each month a long NOK position is not without interim volatility risk, risks we experienced in July. We cannot ignore the Krone’s extreme volatility during 2020 and its frequent hypersensitivity to equity market corrections, as we recently witnessed in late February and again since mid-June. Norway’s underlying fundamentals and the Krone’s cheap valuation may portend strong returns, but they do come at a greater level of risk. And, even if the vaccination process continues to accelerate globally, equity markets at or near all-time highs are likely to experience a correction or two along the way. This higher volatility and the Krone’s high beta to global risk sentiment limits the size of our position. Over the strategic horizon, we can look through the short-term risks and are more positive in our view. We recommend Norwegian based investors set strategic hedge ratios on foreign currency at a high level while most foreign investors leave NOK almost completely unhedged.

Swedish Krona (SEK)
The Krona lost 0.4% relative to the G10 average in relatively muted trade. SEK is not as sensitive to the big macro drivers that dominated July. It is a high current account surplus, low yielding currency but is not traditionally a defensive funding currency similar to JPY and CHF. Partly this is due to lower liquidity but also the greater cyclical sensitivity of the Swedish economy to the global business cycle. Local economic and policy conditions were not enough to cause a major move in the currency either. The central bank, the Riksbank, met on July 1st and reiterated their expectation that policy rates would remain at zero through at least the end of 2023. However, they also raised their 2021 growth forecast from 3.7% to 4.2% and underlined the health of the current recovery. June composite PMI fell back from 70.2 in May to 66.9 but that is extremely strong relative to history. June retail sales also fell back in June to -0.3% MoM from an elevated +2.3% in May. The trailing three-month growth in retail sales remains comfortably above 1%, or 4% on an annualized basis. Moderating, but still strong, growth and increased global fears regarding the latest Covid surge justify the limited SEK weakness we saw in July.

Despite recent softness we retain a significant long SEK position over the tactical and strategic horizons. Starting from a stronger base compared to its regional neighbors (apart from NOK) we are seeing a solid economic recovery as Covid recedes. This will benefit SEK over time and is likely to put upward pressure on inflation later this year and into 2022. The Riksbank outlook to keep rates at zero through 2023 is likely to limit SEK gains against higher yielding, equally cyclical G10 currencies. But our positive tactical SEK view is strongest versus EUR and CHF; both are backed by even more dovish central banks. Also, long SEK versus EUR and CHF also provides 50–70 basis points of positive interest rate carry even if the Riksbank holds rates at zero. Over the strategic horizon, we focus on SEK’s extreme undervaluation as the primary driver. We recommend that long-term global investors significantly reduce SEK hedge ratios while Swedish investors adopt high hedge ratios on foreign currency.

Australian Dollar (AUD)
AUD trended steadily lower in July and finished the month down 1.8% versus the G10 average. Lower global yields and jitters over the global spread of Covid weighed on AUD as it did most higher yielding, cyclically sensitive currencies as investors stepped back from the pro-recovery cross currency carry trade. Australia and AUD’s woes were amplified by the widespread lockdowns to battle the recent local surge in cases. The country still relies primarily on lockdown measures because vaccination rates remain quite low. That approach proved successful last year, but in the face of the much more transmissible Delta variant it may prove problematic going forward. Delta spreads so rapidly that it must be almost eradicated via lockdowns to prevent it from surging right back as soon as restrictions are lifted. This increases the risk of serial lockdowns until vaccination rates reach a much higher level later this year and into 2023. Retail sales, PMI, inflation, employment, and growth data were strong during the month, but all the data released pre-dates the introduction of lockdowns late last month and is therefore not particularly useful for understanding AUD’s recent behavior.

One small positive was the RBA meeting on July 6th. The RBA stuck to its forecast of tapering QE in Q4 of this year despite lockdowns, a positive for AUD. However, they continue to forecast the first policy rate hike in 2024, well after other central banks begin to raise rates. RBA Governor Lowe pointed out that for inflation to reach a sustained level of 2%–3% wage inflation will likely have to run sustainably above 3% and that is unlikely prior to 2024. We can see potential for that to be pulled forward if the Covid surge passes and borders reopen in early 2022. But even then, it may take some time for the RBA to gain confidence that any pickup in inflation will prove itself sustainable.

We are slightly positive on AUD over the tactical horizon, a small upgrade from last month. While economic data remains strong in absolute terms, the pace of recovery is likely to decelerate sharply over the next couple of months due to recent Covid restrictions. It is hard to see Australian growth re-accelerating meaningfully until the current Covid surge is over and global travel and immigration resume. Easing of China’s restrictions on Australian imports such as coal, wine, and barley would also be helpful, but that doesn’t appear likely in the near-term. Local Covid lockdowns in China are also increasing and may threaten growth which would also have an additional negative spill over impact on Australian exports. These negative factors in addition to the lower for longer rate outlook have already driven AUD lower from its early year highs of 0.80 versus USD. Thus, with pessimism already priced in AUD appears stuck near current levels.

Our strategic view is mixed. By our estimates, AUD is now about 3.6% cheap to fair value relative to an MSCI World xAU basket of currencies, a massive recovery compared to March 2020’s 16.9% undervaluation. This average measure of valuation differs quite a lot across individual currencies. We still recommend that Australian investors maintain higher than average hedge ratios on foreign investments against the USD and fully hedge CHF positions. We estimate an AUD/USD long-term fair value of 0.770, nearly 5% above current levels. More broadly we recommend Australian investors leave positions in the cheaper GBP, CAD, JPY, and the Scandinavian currencies mostly unhedged; AUD is rather expensive relative to these currencies.

New Zealand Dollar (NZD)
NZD gained 0.2% versus the G10 average, a sharp divergence relative to neighboring Australia. The macro forces favoring a rotation out of cyclical/commodity currencies in favor of low yielding defensive currencies was an important headwind for NZD. Strong local economic conditions, an increasingly hawkish central bank, and low Covid cases more than offset those macro forces to keep NZD on the positive side for the month. Q2 CPI surprised on the upside at 1.3% QoQ relative to only 0.7% expected. June manufacturing PMI also continued to rise reaching 60.7 from 58.6 in May. Covid lockdowns and restrictions are not an issue at this time because New Zealand finished the month with a seven-day average of only three new cases per day. The positive inflation and activity data alongside the low number of Covid cases prompted the central bank, the RBNZ, to adopt a more hawkish stance shift at the July 14th meeting. The RBNZ kept rates unchanged but announced an end to their large-scale asset purchase program for July 23rd, much earlier than expected. That move along with their positive growth outlook and concerns over unsustainably high home price inflation materially increased the chance of a rate hike later this year or in early 2022.

We remain close to neutral NZD over the tactical horizon with a small positive bias. This is a change from the small negative bias we have held over the past few months. New Zealand and the NZD enjoy robust local economic conditions which will only improve once we see a broader global recovery from the pandemic and nations reopen to international travel. The greater likelihood of a monetary policy tightening and the recent QE tapering are clearly positive. We see strong upside potential against the currencies with more dovish central banks, EUR, CHF, JPY, and USD. For long-term strategic hedgers, we suggest a maximum hedge ratio on CHF and slightly higher than average USD hedge ratio. Oppositely, NZD remains quite expensive versus NOK, SEK, GBP, and JPY based on our estimates of fair value. We recommend New Zealand based currency hedgers maintain very low hedge ratios against NOK, SEK, GBP, and JPY. We are near neutral versus AUD and EUR.