After a steady decline since January, the dollar hit a low in early September. From that low, the USD has subsequently staged a bit of a rally as there has been an improvement across the factors that previously pulled the USD down.
While the dollar is currently stronger than it was in September, its performance since November shows a renewed bout of dollar weakness as the US inflation picture remains unclear; as such, the dollar remains under pressure. Additionally, it should be noted that despite the dollar’s decline over the past year, it could still be argued that the dollar is overvalued when measured on a purchasing power parity basis.
With regards to monetary policy, a more hawkish Fed is a possible source of support for the dollar, but under the current market conditions, any repricing is likely to lead to a muted response. Case in point, the incremental pricing of further hikes in 2017 and favorable increase in front-end interest rate differentials resulted in an overall yearly decline in the dollar. One possible explanation for this is the flat US yield curve with long term rates in line with the Fed’s terminal rate which should serve to limit the impact of further rate hikes.
As a result, we continue to hold the view that it will take a material and sustained acceleration of the US economy and resulting rise in equilibrium real rates on the far end of the yield curve to power the dollar higher. As a result, the ultimate impact of the new tax code, as well as a potential infrastructure spending program, will play a key role in the dollar’s direction.
Also, keep an eye on domestic politics, specifically the Russian investigation, as domestic uncertainty could weigh on the dollar’s performance.
As touched upon in our last forecast, euro strength has been one of the strongest themes of the year as a reduction in political risk premia and improved growth prospects drove the euro’s appreciation. Notably, despite the rise this year, it could still be argued that the euro is still cheap on a purchasing power parity basis. Looking towards 2018, 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. Her initial attempts to form a coalition failed, but another round of coalition talks is scheduled and 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 the euro most likely will react to political developments, we still maintain that ECB policy, 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 reserves the right 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. 2017 represented a year of growth in the eurozone and another year of solid and widening cyclical growth should further ease concerns over debt sustainability and balance sheet pressures, further supporting the euro. Furthermore, investment intentions have improved and net trade is now positively contributing to growth. All of this should support the ECB’s ability to normalize policy which in turn should allow European yields to also normalize and match the relative improvements in the labor market versus the US.
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. Case in point, after the EU agreed that “significant progress” has been made and negotiations were able to move on to phase 2, the GBP fell; the difficulties the UK government faced trying to enter phase 2 illustrates the complexity and magnitude of tasks needed to complete negotiations as well as the ever-present risks to domestic politics.
Moreover, we continue to see asymmetric risks surrounding the negotiation process. Many businesses have warned that they are near the tipping point regarding their contingency planning. Because of this, the movement towards phase 2 is just the next stage of negotiations whereas failure could wrong-foot the market and result in a relatively large move down. Even a transitional deal may only provide temporary relief because the medium term outlook remains cloudy as the “cliff-edge” risk doesn’t dissipate but is rather pushed out. It would take an actual Brexit deal for this risk to be resolved.
Additionally, the Bank of England’s “hawkish” turn shouldn’t be able to support further GBP strength on its own. When the Bank of England (BoE) hiked in November, it signaled a gradual and shallow hiking forecast. Furthermore, persistently weak fundamentals and Brexit uncertainty represent sources of uncertainty for the BoE to even deliver on its modest rate path.
Lastly, the UK’s current account deficit, while reduced, remains wider than historical norms implying that the UK economy, and by extension the GBP, remains venerable to a downturn in the global cycle as macro imbalances remain. Keep an eye on current account data to gauge the pace of the deficit adjustment as well as growth and inflation releases as they influence the BoE’s policy stance. Finally, the path of Brexit negotiations is a critical issue to follow. However, due to the complexity of the remaining issues, we expect uncertainty to remain elevated and the GBP to remain under pressure.
Over the past month, the CAD has treaded water 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. Looking forward, the CAD should be expected to receive limited support from the BoC as a substantial amount of tightening has been priced in. Risks also exist towards growth as past fiscal stimulus fades.
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. Against a backdrop of moderating growth and inflation dynamics--core inflation continues to run 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. All of this sets up for a weaker-than-expected inflation outlook against elevated tightening expectations.
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.
We acknowledge that the domestic Japanese economy is showing signs of improvement. Following a strong Q2 GDP growth of 2.9% SAAR, the Japanese economy responded with a 2.5% SAAR in Q3 as exports drove the economy. Moreover, business sentiment is strong, capex spending appears to be gaining momentum and private consumption is on the rise with the improvement in the labor markets.
Despite all of the above, there remains much work to be done before we see the BoJ changing its stance and that is the crux of our theory for a rise in USDJPY. The Bank of Japan (BoJ) remains committed to anchoring nominal rates around 0% until realized inflation is above 2%. What this implies is a widening of real rate differentials versus the US and continued upward pressure on USDJPY.
Further strengthening this view is the super-majority won by PM Abe which allows for maximum policy continuity, including the BoJ’s current leadership and accommodative polices with the BoJ’s yield curve control policy described as “highly sustainable” and the “core” mechanism of monetary policy.
Outside of monetary policy, we note that PM Abe’s significant majority gives him the votes needed to revise Japan’s constitution, which raising the risk that the government will prioritize constitutional 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 rates 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. However, as discussed in our USD section, absent a material uptick in US growth rates, any USD benefit from Fed repricing has the potential to be muted; so while our directional bias may be correct, the timing of the move remains uncertain. Furthermore, economists expect housing prices to moderate, drawing down the wealth effect created by the housing boom and slowing consumption.
The risk to our view comes via the cyclical uptick in commodity prices and an increase in public and private capex spending.
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