After hitting a low in early September, the USD has staged a bit of a rally, moving back up to a level last seen in July 2017. Earlier in the year, the USD dollar’s weakness was driven by a combination of factors. In the same vein, this recent round of USD strength has been driven by an improvement across the factors that previously pulled the USD down.
Specifically, the US inflation picture has improved with core inflation not only ending its multi-month slide but also rebounding 0.1% in its latest print. Accordingly, market pricing for future rate hikes have increased based on inflation data as well as more hawkish Fed speak. Moreover, incremental progress on tax reform, while not yet a catalyst for a move higher has helped to reduce dollar pressure.
Beyond domestic issues, the dollar’s recovery has also been aided by the repricing of monetary expectations around the world as some countries (AUD, CAD) have pushed back on the market’s hawkish narrative and there has been a reemergence of political risk in Europe.
While the factors above have indeed helped the dollar, we find it difficult to buy into a sustain rally narrative. Market pricing already broadly reflects the stabilizing inflation data so it will take multiple quarters of upside surprises for further inflation related strength. Further, continued growth around the world supports a continuation of global policy normalization over the medium term. With regards to Europe, the political risk referenced above is not enough to derail the ECB’s normalization path, which we see as the dominate euro driver.
End of the day, the USD’s fate will be determined by progress and impact of fiscal stimulus/tax reform. As touched upon in our other commentaries, tax progress has been slow. Beyond this, it remains difficult to assess the ultimate impact of a passed tax bill as many variables remain around what the final bill could look like. As a result we see odds of any tax related boost by year end as small.
Also, keeps an eye on domestic politics, specifically the Russian investigation as it has been reported that Michael Flynn will testify that Trump directed him to contact the Russians.
As touched upon in our last forecast, euro strength has been one of the strongest themes of the year. Looking towards the end of 2017, we continue to see monetary policy and politics as the two main drivers of euro directionality.
On the political front, German Chancellor Merkel won a 4th term. However given the losses suffered by her party, Chancellor Merkel will be forced to put together a ruling coalition. On this front, Merkel’s attempt to create what the Germans refer to as a “Jamaica” coalition—the colors of the three parties are also the colors of the Jamaican flag—has initially failed. After the failed talks, it has been reported that Chancellor Merkel would prefer to hold new elections than lead a minority government, raising the possibility that Europe could be facing another round of election uncertainty. While this is certainly a possibility, we are not yet ready to give up on a coalition being formed.
While any election/negotiation to form a coalition does raise uncertainty and while the euro most likely will react to political developments, we still maintain that ECB policy and not politics will be the most durable driver of the euro.
On this front we would like to remind you that while the ECB did reduce its monthly bond purchase amounts, it was a dovish recalibration. ECB President Draghi reserved to increase and extend the program as needed. Moreover, the ECB has reiterated its forward rate guidance for rate hikes to come “well past” the end of QE, and Draghi reiterated that the ECB needs to tread carefully as long as inflation remains below target. All this has led the markets to conclude that the ECB decision was dovish; however a progressively less dovish ECB over the medium to long term remains our base case.
At the risk of repeating the same theme multiple times, Brexit negotiations have been and should continue to be a primary driver of the GBP. With regards to this, all eyes will be focused squarely on the EU summit scheduled for the middle of December 2017 to determine whether “sufficient progress” has been made. With market sentiment moving towards expectations for progress, we see asymmetric risks surrounding the outcome of the December meeting. Many businesses have warned that they are near the tipping point regarding their contingency planning. Because of this, any further progress would just lead to the next stage of negotiations whereas failure could wrong foot the market and result in a relatively large move down.
To this end, a failure to meet the “significant progress” goal could trigger business to move forward with their worst-case contingency plans and move the U.K. closer to a “hard” Brexit. We acknowledge that under this scenario, the impact on the wider economy may not be visible initially but remain confident that business uncertainty would be magnified and ultimately weaken economic trends.
The latest negotiation development has been the announcement, via media sources, that the EU and the UK have reached an agreement on the divorce bill, strengthening the GBP. This agreement should clear the way for a larger withdraw discussion and raises prospect that the EU will determine that “sufficient progress” has been made, clearing the way for negotiations on trade to begin early next year.
End of the day, the recent developments are clearly a positive for the GBP. However we believe that caution should be heavily used as the fundamental issues still remain. Agreeing on the divorce bill marks the start of the next stage of negotiations, not the completion of them. With regards to moving onto the next stage of negotiations, three main sticking points still remain—EU-UK citizen rights, the financial settlement and the Irish border. We do note that progress has been made across all three of these dimensions and there is certainly upside risk to our GBP forecast if progress is made with talks. However due to the complexity of the remaining issues, we expect uncertainty to remain elevated and GBP to remain under pressure.
Over the past month, the CAD has been fairly range bound after a big strengthening move that started around the beginning of May. Frankly this is to be expected after a multi-month long monetary policy repricing recalibration. The key catalyst for CAD strength this year was the hawkish pivot from the Bank of Canada (BoC) that has ultimately led to two rate hikes. However, over the past month, the CAD has consolidated due to improving hopes for a Fed rate hike.
Looking forward, the BoC has indicated that it expects the output gap to close imminently, which, on balance, is a hawkish statement and implies a continuation of policy normalization. However, a substantial degree of BoC tightening has already been priced in despite the BoC indicating it is monitoring currency strength, stating that it is not on a predetermined tightening path and indicating that it will be cautious on future rate increases.
Moreover, it could be argued that the two hikes delivered this year were actually the removal of the 50 bps emergency cuts in 2015, making growth the key decision factor. As the emergency cuts have been removed, inflation should play a larger role in the BoC’s reaction function going forward.
To this end, Canadian inflation remains below target. We would argue that the bar to raise rates in the near future is high. As the USD has illustrated, monetary tightening without an uptick in inflation doesn’t always strengthen the currency. Even with the output gap closing along the lines with what the BoC has forecasted, inflation has the potential to remain sluggish as there is a time lag between the absorption of the slack and buildup of price pressure.
Lastly, NAFTA re-negotiations are ongoing. While the near term impact has been minimalized with the initial December deadline extended to March 2018, it is worth noting the uncertainty surrounding the ongoing negotiations.
On November 6th, the JPY reached ~114.80 in the interbank market, the highest level since March 2017, but has trended down since as US yields have dropped.
PM Abe’s snap election paid off in a big way for him as his coalition was able to maintain its 2/3rds majority. This result should clear the way for the continuation of ultra-accommodative monetary policy, the reappointment of Bank of Japan (BoJ) Gov. Kuroda, should Abe desire, and the continuation of Abenomics. As noted in last month’s commentary, we noted that the continuity in accommodative Japanese monetary policy makes US yields a primary driver of the currency and our view has not changed.
While we acknowledge that the domestic Japanese economy is showing signs of improvement with business sentiment strong, capex spending appearing to be gaining momentum and private consumption on the rise, there remains much work to be done before we see the BoJ changing its stance.
As touched on above, Abe’s victory bolsters support for the Bank of Japan’s current leadership and its accommodative polices implying that the BoJ will continue to push for higher inflation until it is able to sustain a 2% overshoot.
Outside of monetary policy, we note that PM Abe’s significant majority gives him the votes needed to revise Japan’s constitution, which raises the risk that the government will prioritize constitution reform over economic reforms.
Lastly, developments on the Korean peninsula warrant close monitoring. The JPY is traditionally viewed as a safe haven currency, so any escalation in tensions would imply yen strength. However, given Japan’s close proximity to North Korea, it is possible that significantly heightened tensions—i.e. physical conflict--could result in yen weakening.
While solid Chinese growth and improving domestic economic performance may have removed a bias of the Reserve Bank of Australia (RBA) to ease rate in 2018, Australia still remains a genuine “low for long” country as inflation remains below target. To this end, the RBA has worked to create distance between itself and more hawkish central banks, which makes sense given the structural differences between Australia and more hawkish countries. Specifically, the RBA has stated that “…an appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast.”
Because of this monetary policy dynamic, we continue to believe that the AUD will remain under pressure due to widening interest rate differentials as the Fed hikes and the RBA remains on hold. In fact, US 2-year yields recently rose above Australian 2-year yields for the first time since 2000. However, the timing of this move is complicated by volatile Chinese data and an uncertain level of conviction surrounding the U.S. wage and inflation outlook. Currently, odds for a Fed hike are at ~93%, up from ~35% three months earlier. So while a Fed rate hike in December is likely, it is already fully priced in and it will take a couple months of upward inflation surprises before the markets begin to price in a sustained hiking path.
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