Our euro forecast has materially changed to reflect the dollar’s strength on the back of hopes of asymmetric U.S. growth driven by tax cuts, fiscal spending and regulatory easing. The widening spread between U.S. and German 10-year yields reflects the expectations for asymmetrical U.S. growth. As of right now, the above spread has grown to over 200 bps and is at its highest level since ~1990. Looking specifically at the euro, 2017 is shaping to be a tale of two halves. Political risk, specifically the resulting reactions to the Italian referendum on December 4th and the French/Dutch election early next year, will drive H1. Market focus then shifts to the ECB as tapering comes into play in H2. Interest will be directed towards the ECB’s December 8th meeting for more color around the ECB’s plan for QE.
Economic performance post-Brexit continues to be more resilient than expected, but it is important to note that the U.K. has yet to actually exit the E.U. If the government is able to stick to its timeline—the U.K. Supreme Court is scheduled to hear arguments on Article 50 starting December 5th—then the E.U. will be officially notified of the U.K.’s exit during the scope of this forecast. So far, all indications are that the U.K. is committed to Brexit, and as such, that is our base case. This is significant as it brings the prospect of a hard Brexit and the U.K.’s very large (over 5% of GDP) current account deficit to the forefront. A normalization of this deficit is a negative for the GBP. Data shows little evidence that the current account has adjusted significantly, meaning that the risks for a lower GBP are still intact. With Brexit as our base case, risk for GBP strength comes via a transitional deal and a move towards a softer Brexit. However, on balance, risk still skews for GBP weakness.
The CAD, post U.S. election, has been impacted by perceptions on how much Canada will benefit from the following: higher U.S. growth/fiscal expansion, expectations that the Keystone XL pipeline will be approved, possible trade tensions, and the possibility of rate divergence with inflation expectations picking up in the U.S. The Keystone pipeline most likely will help Canada, but the Bank of Canada (BoC) has been consistently disappointed with export growth compared to U.S. growth, implying less of a tailwind from U.S. fiscal expansion. While trade rhetoric hasn’t been directed at Canada, U.S. protectionism will still adversely impact the CAD. Moreover, rising U.S. inflation expectations juxtaposed with a dovish BoC adds further pressure to the CAD. Lastly, the recent OPEC production cut deal provides support to oil prices, and non-OPEC members, specifically Russia, have indicated willingness to participate. However, details and compliance matter, and OPEC’s meeting with non-members will not occur until December 9th.
Higher U.S. interest rates and the possibility of additional USD strength as a result of a second Homeland Investment Act (HIA2) position the JPY as one of the currencies most vulnerable to weakness in 2017. Of all the G10 currencies, the JPY exhibits the most sensitivity to interest rate differentials and the shape of the yield curve. The shift from loose monetary policy/tight fiscal policy to tight monetary policy/loose fiscal policy supports a steepening of the yield curve. Moreover, with the Bank of Japan anchoring its 10-year yield at 0%, the impact of rising U.S. rates will have a greater impact than it otherwise would have had. Lastly, a Republican sweep of Congress raises the likelihood of HIA2. In 2005, following HIA1, the yen weakened from 102 to 117, implying yen weakness in the event of HIA2.
AUD movement has been driven by a stronger USD, deteriorating carry trade and higher commodity prices. On the commodity front, demand for coal and iron ore from Australia is closely correlated to Chinese steel production, as much of these exports go toward steel production. Steel is a key part of property construction which is expected to soften due to tightened Chinese property restrictions in Q3; this implies softer commodity demand in the medium to long term. With regards to monetary policy, Fed policy will be a key driver. Market implied data shows the Royal Bank of Australia on hold through 2017. Given the higher inflation expectations in the U.S., the AUD’s role as a high yielding carry trade currency should deteriorate.
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