Mysteries Pile Up in FX Market, From Fed's Path to China Growth

(Bloomberg) -- Investors in the $5.1 trillion-a-day currency market have some big questions hanging over their heads as they chart a road map for the year ahead.

Among the major themes they must tackle: a potential end to the Federal Reserve’s tightening cycle, a Chinese economic slowdown exacerbated by trade friction, and the outlook for global growth after the International Monetary Fund just downgraded its forecast for the second time in three months.

Predicting how these closely intertwined forces play out in 2019 will be crucial for divining the dollar’s path after its surprising surge last year. While most of Wall Street expects the U.S. currency to falter, a weakening global economy and the threat of a stepped-up trade war could upend those wagers as foreigners seek safety in U.S. assets.

Nailing the dollar’s direction is key for money managers. For those based in the U.S., a weakening greenback can juice returns on unhedged overseas holdings, while a strengthening dollar can crimp returns.

Here’s how a few investors rank the biggest currency-market mysteries for this year and how they’re wagering events will unfold:

Pause or press on?

For Paresh Upadhyaya at Amundi Pioneer Asset Management, whether the Fed has reached the end of its hiking cycle is the key to 2019.

Chairman Jerome Powell said this month that the central bank can be “patient and flexible,” a dovish tilt from December, when policy makers projected two 2019 hikes. Futures show that traders are pricing in just a few basis points of tightening over the course of 2019.

Mysteries Pile Up in FX Market, From Fed's Path to China Growth

“Even if they communicate that they’re essentially on a long-term pause -- barring any unforeseen events overseas -- that will start to get interest-rate differentials really moving against the dollar, and you’ll see non-dollar currencies start to rally,” said the portfolio manager. “To me, that is by far the most important question mark.”

And that’s the scenario he anticipates: Tighter financial conditions, a flat yield curve and growth headwinds should lead the Fed to pause, providing a “green light for risk to rally,” he said. For those reasons, Upadhyaya expects high-yielding emerging-market currencies such as the Colombian peso to outperform the dollar.

Can China shore up growth?

As the world’s second-largest economy hits a soft patch amid a standoff with the U.S. over trade, the most important question for Invesco’s Noelle Corum is whether stimulus measures by Chinese officials, including at the People’s Bank of China, will suffice to turn things around.

“The major question, at least for credit markets and risk assets, is whether or not Chinese growth and the subsequent policy tools that the PBOC is using are going to be effective enough,’’ Corum said. “Three of the big questions would be growth, trade and the Fed, naturally, but it comes down to growth because of that Chinese effectiveness.’’

As the impasse over trade continues -- Commerce Secretary Wilbur Ross said Thursday a resolution is “miles and miles” away -- the economic backdrop in China has global markets worried that the nation’s slowdown could undermine developing economies.

Corum predicts China’s efforts will succeed, supporting both emerging markets and Europe. Given that she expects U.S. growth to moderate, she’s “tactically short’’ the dollar -- a position she’ll look to augment as China’s data show its economy bottoming.

“They’ve shown us they’re very willing to react to global growth conditions as things worsen,’’ she said. “So while we don’t think there’s going to be this huge rebound in growth in China, we think it’s going to stabilize and we think that’s enough.’’

She sees the euro climbing to $1.20 by year-end, from about $1.13 currently.

Mysteries Pile Up in FX Market, From Fed's Path to China Growth

Global growth rebound?

Beyond China’s borders, the health of the global economy is a crucial topic of debate among FX investors. The IMF sees the world economy expanding 3.5 percent in 2019, the weakest pace in three years. The lender blamed Europe, citing softening demand across the region. European Central Bank President Mario Draghi on Thursday said risks to growth “have moved to the downside.”

Given disappointing euro-zone data, many analysts’ strong bias against the dollar doesn’t make sense, says Stephen Jen, chief executive officer of Eurizon SLJ Capital.

“People are so confident about the euro, but the economy is slowing,” he said. “Inflation is falling again. And they haven’t even had an opportunity to normalize policy. In the event that the global economy slows further, their capacity to support the economy is much less than the U.S.”

Combined with China’s slowdown, Jen says that backdrop should benefit the dollar, at least in the first half of 2019. China’s stimulus should kick in after that, boosting emerging economies as well as Europe, he said.

“I just don’t see how the dollar can perform poorly when the levels of interest rates in the U.S. are still so attractive,” said Jen, who views two Fed hikes this year as likely.

Political crisis?

There’s another big item on the list of known-unknowns: U.S. political dysfunction. Even if the government re-opens one day soon, that still leaves investors waiting for the outcome of Special Counsel Robert Mueller’s investigation into Russian interference in the 2016 presidential election.

Upadhyaya at Amundi sees the risk of a domestic crisis should President Donald Trump try to block any release of the probe’s findings. While investors have confidence in U.S. institutions, Upadhyaya expects haven assets -- the yen, the Swiss franc, Treasuries, and perhaps gold -- to benefit in that situation.

“There will be genuine questions about could this lead to a constitutional crisis,” he said. “All of that is bound to increase uncertainty in the market.”

©2019 Bloomberg L.P.