In our last monthly commentary, we noted how the USD has staged a bit of a rally since September as there has been an improvement in the factors previously pulling down the dollar. With the benefit of hindsight, the above rally has fizzled out and we currently find the dollar index lower than it was in September.
Global growth is being upgraded at its quickest pace in six years. Taking a step back, currencies with the most improved growth prospects have outperformed at the expense of the dollar, implying that growth has become a key driver of the currency market.
Specifically to the USD, the passage of the US Tax Cuts and Jobs Act has not helped to push the dollar stronger. Two of the more persuasive reasons for this are as follows: (1) the markets are still maintaining a pessimistic view of the economy as reflected in the flattening of the US rate curve indicating that the terminal rate remains unchanged at not much more than 2%, and (2) the continuation of global growth upside surprises more concentrated outside the US has made the US less exceptional than previously thought.
Additionally, relatively speaking, the US is in a late-cycle rate normalization stage versus the rest of the world that is in an early to mid-cycle normalization stage. This difference in stages implies different reactions to upside/downside surprises. Moreover, uncertainty in Washington, including government funding issues, shutdown risks, debt ceiling and technical default risks, as well as the Russian investigation and trade protection risks, continue to pressure the USD.
However, there are some factors that should provide a tailwind for the USD, namely corporate repatriation and foreign direct investment/equity inflows. While both of these have the potential to be meaningful and worth monitoring, balance of probability suggest that dollar weakness factors should prevail.
As we have touched on in previous commentaries, the euro was the top performing currency last year as a combination of an uptick in business measure and a reduction in political risk pushed the euro higher. This has improved the investment profile to the extent that the region's inflow of long term investment capital lifted its basic balance surplus to its highest level ever (500 bn euros) and has helped the euro close the valuation gap built in due to political risk and ECB policy.
Looking ahead at 2018, we anticipate this trend to continue. The eurozone is set to outperform the US for the third consecutive year as the eurozone remains in the lead group of economic performers with strong data improving further from already strong levels. Moreover, all indications are that the ECB exits QE this year as a precursor to rate hikes at some point in 2019.
As an illustration of the divergence in central bank minutes, the minutes from the ECB's December meeting indicated that the central bank was considering when it would revise its forward guidance to avoid more abrupt changes later on. In contrast, the Fed dots remained unchanged in December. As a result, interest rate spreads have tightened in the euro's favor. Moreover, with polls indicating that Italy will elect a mainstream government, political risk in the eurozone should remain muted this year.
In total, we agree that there is a long list of reasons why the euro should strengthen; there is caution as to how much upside is left. The markets are forward looking and much of this bullishness has already been priced in. Looking at the historical relationship between EURUSD and interest rates, the euro is currently materially overshooting. Additionally, a more assertive Fed remains a possibility and it remains to be seen how much foreign profits will be repatriated by US companies.
More than any other currency, the GBP appears to be coated in Teflon as it has continued to rise despite the continued overhang of Brexit uncertainty. There appears to be two main themes influencing the movement of the GBP—economic underperformance and improved sentiment around the expected Brexit outcome. Given the price action surrounding the pound, it appears that the markets are giving more credence to favorable Brexit progress.
With regards to Brexit, the UK and EU have agreed to move on to phase 2 of negotiations. The markets have gained some reassurance, driving GBP strength, from an apparent commitment from both sides to hammer out a transitional deal. As it stands, the framework appears to be a 2 year standstill period once the UK officially exits the EU next March. Another factor supporting the GBP has been the apparent unification behind PM May, which is a welcome turn of events for GBP bulls following a period of uncertainty surrounding her leadership abilities. However, this unification is possibly due not to actual support of the PM but to fear that any challenge to PM May could destabilize the Conservative government, lead to new elections and result in a Labor government.
The bear case for the pound revolves around the details of what remains. For starters, the details surrounding the trade deal still need to be worked out and ratified by both the EU and UK, leaving headline risk alive to both the upside and downside. Moreover, upcoming talks will involve trade, arguably the most important, complex and contentious topic to be negotiated. If the EU doesn't soften its stance towards services and manufacturing, the Eurosceptic members of the Conservative party may not remain so quiescent. Because of this, there remains a material chance that the whole negotiation process could still fall apart.
Lastly, with regards to economic performance, the UK has slowed especially when juxtaposed to the growth experienced by the rest of the world, i.e. the eurozone is set to outgrow the UK for three consecutive years. The impact of this economic underperformance has been muted by the BoE's rate hikes, but given that the current hiking cycle is driven by high inflation (currency depreciation) and low growth, we don't believe the GBP will benefit from the appreciation normally associated with a hiking cycle.
As we head into 2018, there are two themes that should be key drivers for the CAD--the pace of Bank oif Canada (BoC) normalization and NAFTA negotiation risks at least for the early part of 2018.
With regards to the BoC and its normalization path, a strong run of economic data has caused the markets to pull forward its rate hiking expectations. To this point, key economic measures have returned to the highs seen last summer when the BoC delivered back to back hikes. Specifically, the unemployment rate currently sits at 5.7% below the prior cycle low of 5.8%. However, it should be noted that last summer the BoC was working on removing its emergency cuts so its reaction function then and now are likely different. Reaction function notwithstanding, strong oil price performance has also been supportive of the CAD but WTI crude above $60/bbl risks a renewed investment interest in energy.
The main caveat to CAD bullishness is the uncertainty surrounding the NAFTA negotiations with the possibility of a disorderly result weighing on the CAD. This risk was illustrated with the CAD spiking weaker on reports that Canadian officials believed the US would move on a NAFTA withdrawal notice. This uncertainty plays into monetary policy via the BoC's de-emphasis of “data dependency,” i.e. recent history has shown an elevated sensitivity towards risks and uncertainty with NAFTA—see the BoC's November policy statement. With the latest round of NAFTA negotiations leading to both bullish and bearish news, the BoC's past comments advising caution on the pace of hikes appears to be a material consideration for the markets. Moreover, with a significant amount of hikes already priced into the market, the bar for additional tailwinds vis-à-vis rate hikes remains elevated.
Through a combination of US and JPY underperformance, the Japanese yen has stayed within a 3 yen range since the end of November through the middle/end of January 2018, at which point USDJPY broke to the downside.
In prior monthly forecasts, a key theme for the JPY has been the direction of US yields as the Bank of Japan's (BoJ) YCC program in place kept Japanese 10-year yields near 0%. However, the markets were woken up by the BoJ's announcement to decrease its month purchase amount of super-long dated bonds, leading to a sharp appreciation of the yen.
However, in my opinion, the change in super-long bonds isn't a game changer for the JPY and the price action is more reflective of a knee-jerk reaction and position management. Mid to long term purchases have been trending down for a while now and, maybe more significantly, purchase amounts are no longer the main components of the BoJ's monetary policy.
With regards to monetary policy, the BoJ left all three of its policy targets unchanged at its latest meeting. While it did raise its inflation forecast to flat from “weakening,” there remains a skew towards the downside and we ultimately expect the JPY to weaken against the USD.
Looking ahead, bank personnel should be a focus in February as Governor Kuroda's term ends in April and Deputy Governors Iwata and Nakaso will end their terms in March. Market consensus is for Kuroda to be reappointed but if names such as Takatoshi or Watanabe, both of whom have suggested normalization, emerge as candidates then the announcement could be JPY bullish. Lastly, we would like to note the breakdown in correlation between the JPYUSD and rate differentials so keep an eye on whether this recovers against a backdrop of future Fed hikes.
For 2017, the AUD finished as the 5th best G10 performer against the USD despite Australia remaining desynchronized from the global upswing in growth and having a central bank that is firmly on hold with rates around historic lows.
Interest rate differentials were a key theme for the AUD in 2017 and we continue to believe this to be true, albeit to a greater extent in 2018. With the Fed expected to raise rates ~3 times and the RBA (Reserve Bank of Australia) expected to remain on hold for 2018, it is very possible that there will be a negative
policy rate spread between Australia and the US. While we acknowledge that interest rate spreads have lost some of their influence in the FX world, interest rates still matter.
Evidence of our belief that the RBA will remain on hold can be found in the RBA's own communication. In its December statement, the RBA indicated that “… an appreciating exchange rate would be expected to result in a slower pick-up in economic activity and inflation than currently forecast.” Put another way, the RBA is concerned that a strong Aussie dollar will push inflation and economic activity down, and as such, it would not be expected to tolerate a strong AUD, let alone raise rates.
While we have confidence in the future direction of the AUD, there remains uncertainty around the timing of the move. The Australian economy is greatly influenced by the Chinese economy, and with Chinese growth solid, the pace of the AUD's decline may be initially slow.
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