The foreign exchange forecasting dilemma

By Simson Sanaphay

Economies don’t always operate as forecast due to the shifting dynamics of both a local economy and the impacts it faces from regional and global events. And that constant state of change makes foreign exchange forecasting problematic, as the outlook for an economy is the primary input for FX forecasts.

And it gets harder as the correlations some forecasters rely on grow and shrink in importance. Take for example the well-worn Australian terms of trade that’s often guided where the AUD will likely be. It’s a good source for determining FX direction as a country’s exports relative to its imports justifies the demand or supply for its currency. Yet if this were the case the AUD should be trading above 80US cents, but it isn’t.

And that’s because there a lot of other variables, including current issues like “trade wars” and a range of flexible parameters around central bank thinking, political decisions and agendas, corporate and consumer sentiment and a wide range of economic data that is impacted by seasonal influences.

So instead of observing the cacophony from the gallery we think that investors should at least consider using an FX framework. It must be a framework that is grounded in historical observations of the ups and downs of the undisputed global reserve currency (and barometer) for the global economy for the past several decades – the USD.

At Citi we call it the “USD smile”. It tells us when the USD will likely show its strong hand, but not how high it will go, and it tells us when USD will be a weak hand, but not how low it will go. How high or low the USD will go is mostly circumstantial and often swayed by difficult-to-model unintended consequences.

Source: Citi

However, if one were to pin-point where we are on the USD smile its surely leaning to the right, and this is because of US cyclical outperformance and a hiking Federal Reserve while the rest-of-world’s central banks are on hold.

Add the risk of an asset market sell-off that could arise from US muscling of global trade partners and it all supports the USD as a safe-haven and a currency of strength. There’s evidence that investor positions are generally net long USD, nearly as high as when markets embraced the newly minted US administration in 2016.

More importantly, current prospects imply ongoing USD strength at least for the next few quarters in Citi’s view, as the factors driving USD strength precipitates weakness in other currencies.

In other words, a zero-sum game in foreign exchange markets with the USD is a winner and other currencies such as the AUD, EUR and CNY trailing behind.

It’s clearly evident from released data out of the US that’s its economy is outperforming. The US Federal Reserve Board remains the only central bank authority with the ability to guide rates higher due to full employment in the US, stronger corporate investment spending and robust consumer spending. First half GDP was an outstanding 4.1 per cent and we think the significant US corporate tax cuts will continue to extend the prosperous US growth narrative and emphasise the “mighty” in the greenback.

Global ‘trade war’ risks and the negative impact it has on US trade partners also encourages safe haven seeking investors as they pile into USD denominated government bonds, in turn agitating the resilience and robust global economic growth outlook and eroding what’s left of “synchronised” global growth.

And despite widespread condemnation, global trade risks are not likely to go away soon, because if the US Administration’s objective is to reduce the US trade deficits so as to achieve US trade ascendency it will hit a roadblock when domestic growth spills over to increased imports, thus vexing its ability to strike down its trade deficit.

One things for sure, we think USD strength should be a realisation for investors that the AUD will remain under pressure at least in the short to medium term.

FX Stocktake

• Citi's forecast for AUD-USD shows 73US cents in 3 months and 69US cents in 12 months.
• Citi expects the USD to potentially weaken in the longer term, (that could see the positioning on the “USD smile” move to the vertex) but delays the turn to sometime around H2’2019 when the point of inflection in growth differentials between the US (currently outperforming) and the rest of the world likely occurs. Upcoming US Mid-term elections presents a risk to USD strength, especially if there’s a shift in House of Representative majority away from the incumbents
• Current AUD weakness is driven by the following factors:
  • RBA unlikely to lift the cash rate until 2020 as its challenged by low inflation versus the US Feds, which has signaled rate hikes through 2018 - 2019
  • 2 year AU-US Government Bond yield differentials have shrunk reducing income from carry.
  • China growth moderation.
  • Trade tensions negative spill-over affecting an open Australian economy.
  • Lack of Euro strength which had previously counteracted the USD, unwound on a dovish ECB earlier this year.
• Catalysts for further downside AUD risk
  • US-China trade tensions will continue to remain in focus.
  • Citi Economics remain concerned over China risks but expect these to be contained as growth slows only modestly, barring additional adverse developments on trade tensions.
• Catalysts for upside AUD risk
  • Progressive negotiations in US-China trade will be a strong positive for AUD.
  • Resumption of USD weakness based on twin deficits. This is a medium to long-term construct as the US needs to offer higher yields and/or a weaker USD to attract deficit funding.
  • Sentiment re-adjusts to better reflect the “undervalued” nature of the AUD when compared to its terms of trade.
  • Positive trading on a return of EUR strength as ECB tapers reducing investment outflows.

Simson is a strategist for Citi’s wealth business