Invisor Economic Update Image June.jpg

Economic Update June 2017: Hawkish Central Banks Take a Bite Out of the USD

by Josh Miszk Last updated on July 07, 2017 Tags: Market & News Updates

In their local currencies, global equity markets were relatively flat in June (see Canada below). However, a devaluing US dollar and a stronger Canadian dollar were reflected in negative returns for Canadian portfolios. In this market update, we'll look at the cause of the devaluing US dollar, and what it could mean going forward. 

Index Performance June 2017USD

First, we’ll look at what has changed in the US. Along with the popularity of the US president, expectations of his promised changes to the economy have subsided. Earlier in the year, the market priced in promises of infrastructure spending and tax cuts, thus pushing the value of US equities to record-setting levels. In addition, continuing positive fundamental data in the US propelled a US rate-hike program, while the rest of its peer G20 countries remained in low-rate programs designed to keep the gas pedal down and stimulate their respective economies. 

However, given the weakness shown by the president in implementing his agenda, the market has largely discounted the chance of his proposed stimulants to the economy. The market has taken this ‘weakness’ as a sign that the Fed is less likely to keep the same pace for increasing rates.

Global Fundamental Strength

While campaign promises seem less likely to stimulate the US economy, it doesn’t change the fact that global market fundamentals are still solid; so solid, in fact, that it looks as if central banks from several developed economies are acting in unison to start increasing their respective rates back to comfortable levels. The Bank of Canada, for example, said in June that nearly all economic indicators are picking up, including intentions for demand, employment, and investment. While we believe the fundamentals in the rest of the developed world support this rising rate program, we still feel that in Canada these indicators are weighed down by larger risks of default on an over-leveraged consumer base.  As a result, expectations of a rate increase may be overstated.

Rate-hike odds for December meetings, BloombergWhat is a rate hike and what does it do?

Monetary policy works by influencing the value of assets in an economy. When the economy is weak, like in 2008, central banks reduce interest rates to decrease the cost of borrowing, and incentivize investment. When the economy is over-heated, higher rates prevent prices from getting carried away. 

This practice can trigger another effect: when one economy has higher interest rates than another, money saved in that currency is expected to grow faster, therefore increasing the value of that currency. We saw this in the CAD/USD rate; when the improving US economy drew the Fed to increase rates, the Canadian economy remained weaker and kept rates low. From the start of 2014 to its peak in 2016, the USD climbed from 1.06 CAD to 1.45 CAD.

What happened in June?

In the last few days of June, several central banks indicated that they might kick-start their increasing rate program, causing the USD to fall by over 2% against the CAD, EUR, and GBP in just a few days.

Major currencies vs. U.S. dollar, Bloomberg

The US Fed is already well into their program and has room to go, while the new entrants will likely tread lightly, especially in Canada. Given this pressure, we believe the drop in the USD is an exaggeration that will stabilize when the dust settles.

What does this mean for investors?

When the shifts between markets are large enough, we buy the underweighted securities and sell the funds that are overweight. This method of rebalancing benefits accounts significantly when markets move back into their broader trends. Maintaining this plan enables us to stick to the course and keep our eyes on the horizon.

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