The GBP has been in limbo as the currency has been pulled in different directions. Resilient economic data, combined with rising inflation, raised hopes that the Bank of England’s (BOE) next rate move would be a rate hike, strengthening the GBP. However, these hopes were dash once the BOE lowered its employment driven inflation assumptions, allowing the BOE to simultaneously raise its GDP forecast and lower its inflation estimates. The counter to the previously mentioned driver of GBP strength has been the concerns surrounding Brexit. As it stands, it appears that it will be a hard Brexit with Europe unwilling to compromise on its principle freedoms and the U.K. unwilling to cede control of migration. Notably, the U.K. maintains that it will prioritize sovereignty above economics. The danger to downplaying a transitional deal is that the U.K. might have to trade on WTO rules—the most disruptive scenario--if it fails to agree on a new agreement. With the government clearing most of the legal and procedural hurdles, the government remains on schedule to start the two year countdown by the end of Q1, firmly establishing Brexit as the most important driver of the currency.
In last month’s forecast, we outlined our expectations for AUD to weaken over the course of 2017 as narrowing U.S./Australian rate differentials and falling commodity prices put downward pressure on the currency. Specifically we see the narrowing rate differential driven by both rate tightening in the U.S. as well as the possibility for further easing in Australia. Since our last update, there has been an uptick in global growth prospects as well as further increases in iron ore prices. Both of these factors have provided support for near-term AUD strength. However, a pullback in commodity prices, as more supply comes online, should weigh on the AUD through the balance of the year. Furthermore, while positive global factors have provided near term support, domestic inflation remains low. If inflation remains low, it opens up the possibility for further easing in the second half of the year, providing further pressure on the AUD. Finally, Australia is an economy dependent on global trade and should be adversely affected should global trade tension rise.
In a similar vein to the GBP, the EUR has exhibited price action that is more tied to political factors than economic ones. As such, we maintain our stance that political uncertainty will drive euro weakness in the first half of the year. Specifically, focus will be on France with a La Pen Presidency the market’s main concern. Recent polling shows that Marine Le Pen, the far-right, anti-euro candidate leading in the first round of polling. While Le Pen is still widely expected to lose in the second round, assuming she makes it through the first round, the markets still remember that the Brexit and U.S. Presidential outcomes were different than what polls indicated. To this end, French-German interest rate yield spreads have widened significantly as there is real concern in the market that a core member of the Eurozone will elect someone who favors leaving the EU and the euro. Elections are also scheduled to be held in the Netherlands and Germany; however these are not seen as euro negative events. In the second half of the year, focus should shift from politics to economics as the prospect of ECB tapering and strengthening fundamentals moves to the front and may push the euro higher.
The JPY has weakened since the Bank of Japan (BoJ) introduced its “QQE with yield curve control” (YCC) in which the BoJ committed to holding its 10-year JGB rate close to 0%. With Japanese rates held static, the rise in U.S. rates has increased the rate divergence which in turn weakened the yen. Even though the weaker yen has provided a tailwind to the BoJ’s goal of increasing inflation, there is little reason to expect a shift away from current policy in the short term. Additionally it is the shape of the yield curve, which has been addressed with YCC, more than the negative rates that troubled the finance industry so the threshold for BoJ action is high. Because of this, U.S. yields should continue to be the main influence on yen movement as shown by the increased correlation, versus historical average, between the USDJPY and changes in 10-year U.S. yield. Looking forward, the extent to which the new U.S. administration is able to deliver on its promise for substantial growth-enhancing policies is key to the trajectory of U.S. 10-year rates and, in turn, the yen.
While economic data out of Canada has been mixed, with positive surprises with trade, GDP and manufacturing indices over the past month, the data points most relevant to the Bank of Canada’s (BoC) monetary policy continue to be soft. Specifically, core inflation has remained below the bank’s 2% target, reinforcing the view that the BoC will remain dovish. Moreover, the BoC has indicated that it sees a divergence between the U.S. and Canadian economies, implying that the bank does not want Canadian rates to be pulled higher by rising U.S. rates. The counter to CAD weakness has been the constructive, and not confrontational, approach to the U.S.-Canadian relationship from the Trump administration, which has provided support to the CAD. However, despite the lack of confrontational rhetoric, Canada sends over 70% of its exports to the U.S.; therefore even a marginal shift in trade relationships—via a NAFTA renegotiation--carries large disruption risk. Ultimately, the BoC has keyed in on the role of the currency in the recent decline in core inflation, indicating its desire for a weaker CAD as well as increasing the probability that the bank would take some sort of action to weaken the currency should it strengthen further.
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