Since the FOMC meeting at the beginning of December, the euro has pushed to a ~13-year low. Significantly, this move has been more of a USD strength story, due to the hawkish nature of the Fed’s hike, rather than a euro-related weakness story. Moving into 2017, it is tempting to flag euro-area political risk a driver of the currency given the number of elections on deck. However, the chances of these elections to result in a serious anti-EU move are low. So while political uncertainty should persist through 2017, we don’t envision non-tail election outcomes to push the euro lower, especially with some political risk already priced in. In our view, the pace of growth represents a key area of focus. While U.S. growth outpaced euro area growth from 2011 to mid-2015, euro area growth has outpaced U.S. growth for the last 4 quarters (through Q3 2016). Looking forward, we expect the growth rate to move back in favor of the U.S. Very dovish expectations are priced in for the euro, and as long as inflation remains weak, the ECB will be stuck at or near its zero bound.
The GBP’s outperformance has continued with U.K. data releases since the referendum, painting a picture of short-term economic resilience. The hopes of a favorable trade deal with the U.S., softening the damage to trade as a result of Brexit, and hopes for Parliament’s oversight (which supports a “softer” Brexit) have also provided some support to the currency. However, despite the resilience, we expect economic data to weaken. Forward looking factors, such as investment intentions, remain weak and rising inflation should squeeze real profits and provide a headwind to consumption. Moreover, PM May has indicated that she will trigger Article 50 before the end of Q1 2017, and we hold the view that this act will usher in another wave of pessimism. Most significant is the substantial current account deficit that sits at roughly 5% of GDP and is at its widest level since the 80’s. A normalization of this level will push the GBP weaker, and in our view, the current account adjustment remains the long-term driver of the currency.
Stronger oil prices, via OPEC’s first production cut deal in 8 years, has provided support for the CAD. However, it should be noted that the CAD’s historically close relationship with WTI crude has recently diverged, implying that rate differentials are playing a larger role in explaining the CAD’s recent moves. Case in point, we have seen how a change in monetary policy outlook overshadowed the price movement in oil. Although oil prices have played a lesser role on the CAD, implementation risk to the OPEC deal still remains a real CAD weakness risk. With the trade-weighted CAD appreciating for the first time in 3 years on a YoY basis, the currency should play into generating additional headwinds to already low inflation and reinforce BoC dovishness at a time of increased sensitivity of USDCAD to rate differentials. Finally, trade uncertainty is set to carry over into 2017 as an increasingly protectionist U.S. is set to withdraw from the TPP deal, raising concerns over what will happen to the NAFTA agreement.
Since the Bank of Japan introduced its “QQE with yield curve control” the correlation between USDJPY and changes in U.S. 10-year yields has become stronger than it has been in recent years. By committing to a Japanese 10-year target of ~0%, the BoJ has put U.S. rates in the driver's seat in determining the direction of the yen. Given this, a lot has already been priced in with regards to the reflation potential of the U.S. economy. Case in point, as global yields have risen, Japanese investors have been net sellers of foreign bonds, meaning yen selling pressure is coming from elsewhere, such as from speculative positioning. The extent to which the incoming U.S. administration is able to deliver on material growth enhancing policies will be key to the U.S. 10-year rates and the yen, making high frequency measures of U.S. growth, such as PMIs, important to watch. With regards to monetary policy, the BoJ is currently projected to be on hold through 2017 with subdued inflation expectations keeping the “yield curve control” policy in place for the foreseeable future.
The AUD has weakened ~7% since the U.S. election and accelerated its losses after the December FOMC meeting. AUD spot rates continue to trade at a level higher than where its historical relationship with the Australian-U.S. 2-year yield differential would predict. This relationship breakdown is partially explained by absolute rate levels, with the Australia cash rate of 1.50% being the second highest rate among G10 currencies. Long term, better terms of trade, which have recovered following a recovery in iron ore prices, should provide AUD support from a fund flow perspective. However, on balance, risks remain to the downside. Inflation remains low, as the Q3 YoY CPI reading of 1.6% represents the lowest print ever. Please note that a subdued inflation outlook works to offset the improvement in the terms of trade. Q4 CPI data is due January 25th, and any downside surprise would raise the chances for a rate cut and pressure the AUD lower.
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