After declining for most of the year, the USD has recovered and stabilized during September and October as hopes for a December Fed rate hike have been reignited.
However, as we expressed in our last monthly forecast, we continue to believe that the USD is more likely than not to remain pressured. The markets are currently pricing in a ~80% chance for a December hike, meaning most of the benefits have already been priced in. Moreover, with the Fed set to begin its balance sheet normalization, this move has been well signaled. As such, the market has already priced this in. More broadly, the path of long term rates are mainly determined by expected inflation. For the dollar to strengthen further, there needs to be evidence of stronger growth and higher inflation.
This brings us to the heart of the issue. Inflation in the U.S. has remained persistently soft and wage growth has yet to show sustained signs of growth, both of which reinforce the market’s concerns about the Fed’s ability to enact multiple rate hikes against an increasingly hawkish global backdrop. In our view, it would take material progress on fiscal stimulus/tax reform for a revival in inflation expectations. However, the most recent tax proposal has too many variables to be able to determine what the final version would look like, and thus it is difficult to determine the likely macro impact. Additionally, the odds of a tax bill passing remain unclear given Congress’ recent record and our proximity to the next debt ceiling vote and mid-term elections. As a result, we find it difficult to build a case for a sustained USD rebound.
Finally, it has been widely reported that Jay Powell will be nominated as the next Fed Chairman. Powell is seen as the more dovish of the final candidates and represents a continuation of policies from Yellen’s term. This said, the Fed chair doesn’t operate in a bubble and most likely won’t be able to drastically sway the entire committee one way or another. As a result, fundamentals will still ultimately determine the long term rate path.
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.
With regards to monetary policy, there has been speculation as to when the ECB will start to be concerned with euro strength. So far, the ECB has only flagged its concerns over the euro’s appreciation while stopping short of actively leaning against euro strength implying that we have yet to reach the ECB’s pain point.
However, the markets are mainly concerned with whether or not the ECB will begin to taper and the ECB answered to the affirmative at its October meeting. The ECB announced that it would reduce its monthly bond purchases from €60bn to €30bn starting in January 2018 along with an extension of the program through September 2018.
While the ECB reduced its purchase amount, the move was dovish as the ECB reserved the right to increase purchases as well as extend the duration of the program. Additionally, 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 of this implies that a hike will not come before mid-2019. So while the markets took the ECB decision as dovish, a progressively less dovish ECB over the medium to long term remains our base case.
Beyond the ECB, politics, specifically in Spain and Germany, represent potential risks. However, we view the standoff between the central and Catalan government to be more of a domestic Spanish issue than a euro area issue. Meanwhile in Germany, Merkel won a 4th term but did not win the decisive victory she was hoping for. Over a short term window, the euro may react to political developments but we do not see politics to be a material and sustainable driver of the euro.
Prior to the Bank of England’s (BoE) September meeting, the market had assumed that the BoE would remain on hold well into 2019. However at its September meeting, the BoE signaled the possibility of tightening in the “coming months” as inflation continues to overshoot target in the UK; ultimately, the BoE did raise rates at its November meeting.
The complicating factor to all of this is determining what the BoE’s reaction function will be going forward …is it one and done or the start of something more? While the BoE worked to signal that recalibration to monetary policy either way should be expected as Brexit and the economy unfolds, we continue to believe that the BoE will err on the side of dovishness. To wit, the BoE dropped language that future rates may need to rise faster than markets expect and emphasized any future hikes would be gradual and to a limited extent.
Finally, domestic politics and Brexit remain issues. On the domestic front, PM May’s disastrous speech at the Conservative party conference has reignited questions surrounding her ability to lead the government, further adding to political uncertainty. With regards to Brexit, the GBP has benefited from the UK government’s acknowledgement for a transitional deal; however, the BoE still maintains that Brexit is the biggest economic forecasting variable, and as such, a successful transitional deal is essential for the BoE to turn hawkish. However, the reality is that negotiations have been tough and it is concerning how little progress is being made. The risk is that the longer negotiations drag on without progress, the more likely that UK businesses will enact their hard Brexit contingency plans which would diminish the benefits from a transitional period.
In summary, the BoE’s hike warrants attention and an adjustment to our 3-month GBP forecast. However, over the medium to long term, we still remain skeptical on the BoE’s ability maintain a hiking path as the UK government’s objectives for Brexit—exiting the single market and customs union—are still disruptive and biases our belief that the UK should underperform its European peers.
Over the past month, the CAD has been fairly range bound after a big strengthening move that started around the beginning of May. 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.
The main event last month for the JPY was the snap election held on October 22. Even though Abe was polling well, calling the election was a gamble for PM Abe and it paid off in a big way as his ruling coalition was able to maintain its two-thirds majority in the 465 seat lower house. This opens up the possibility of PM Abe leading Japan through 2021.
Moreover, PM Abe’s decisive victory clears the path for a continuation of ultra-accommodative monetary policy and a continuation of Abenomics. Additionally, PM Abe’s path to reappoint Bank of Japan (BoJ) Gov. Kuroda when his term ends in April 2018 should be available should PM Abe desire as such.
The Japanese economy has shown signs of recovery, and inflation remains below target. With PM Abe holding a more than two-thirds majority, BoJ policy—specifically holding Japanese 10-year rates at 0%-- appear to remain unchanged for the near future. As such, we reiterate our view that U.S. rates should remain the key driver for JPY direction, i.e. as U.S. rates rise, the JPY should weaken.
While there appears to be continuity with monetary policy, fiscal policy remains in flux. PM Abe has indicated that he intends to move forward with an increase in the consumption tax, which could stall economic growth just as it is picking up. Additionally, 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.
The AUD remains near multiyear highs due to improved economic data and positive sentiment both domestically and in China. While this improved economic backdrop might have removed the easing bias from the Reserve Bank of Australia (RBA), Australia still remains a genuine “low for long” country with inflation and unemployment both missing the central bank’s targets. 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 such as Canada. 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, we continue to think that the AUD will remain under pressure due to widening interest rate differentials as the Fed hikes and the RBA remains on hold. However, the timing of this move is complicated by improving sentiment in Chinese growth and an uncertain level of conviction surrounding the U.S. wage and inflation outlook. Currently, odds for a Fed hike are at ~81%, up from ~35% two months earlier. So while a Fed rate hike in December is likely, 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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