USD RALLY EXPECTED TO EXTEND INTO 2017
We remain constructive on the U.S. dollar (USD) outlook moving into the end of the year and into 2017. We expect a 25bps Fed tightening in December to support the USD and a further increase in U.S. rates to underpin broad gains well into 2017. We anticipate another three ¼ point hikes in 2017 whereas the short end of the yield curve has barely priced in one 25bps tightening over the coming 12 months. The U.S. presidential election is liable to sustain market volatility through early November but, assuming a likely win for Hillary Clinton, as current polling suggests, we expect the USD to strengthen on the expectation that the election result will not deflect the Fed from its tightening path. Widening short-term rate spreads will support the USD moving into next year versus its major currency peers. In the longer-term, we expect the USD’s mature-looking secular bull trend to moderate in late 2017 as the Fed policy rate nears neutral and other central banks tilt away from accommodative policy settings.
The pound (GBP) remains a clear concern for FX investors. The GBP underperformed in Q2 on the Brexit referendum outcome and was the weakest G-10 currency in Q3 as investors considered the implications of the decision. Q4 has started inauspiciously for the GBP, with U.K. government adopting an aggressive position on Brexit negotiations and the GBPUSD suffering a “flash crash” early in October as the market broke under 1.25 in thin, Asian trading, driving the pound more than 6% lower in a matter of minutes before it stabilized. Extended weakness reflects the GBP pattern of adjustment to previous domestic shocks (down 25% following the 2008 financial crisis and down 20% following its Exchange Rate Mechanism exit in 1992). More losses look likely as investors consider the risks and consequences of a no-compromise, so-called “hard Brexit” on the economy. The Bank of England, meanwhile, does not appear overly concerned by the GBP’s plight and may only attempt to stabilize the exchange rate in the event of markets turning disorderly (for more than a few minutes) or if domestic inflationary pressures rise as a result of the weak exchange rate. We have lowered our GBPUSD target to 1.20 for early 2017 but feel “overshoot” risks remain significant as investors await the UK government’s decision to formally start the EU exit process.
The euro (EUR) will weaken versus the USD in response to rising U.S. yields and widening rate differentials. Eurozone-US 2-year bond yield spreads have moved out to a little over 150bps, the largest yield advantage for the USD over the single currency at the short end of the yield curve in ten years and spreads should continue to pressure EURUSD lower towards our 1.05 target through year-end. We see no chance of the European Central Bank reducing stimulus before the planned end to the current asset purchase programme of EUR80bn/month in March 2017. Neither inflationary pressures nor inflation expectations have increased significantly since the ECB programme began. Actually, under these circumstances, an extension of quantitative easing, but incorporating a lower total of monthly asset purchases, seems more likely.
We expect the Canadian dollar (CAD) to retain a soft undertone versus the USD in the coming months. Crude oil prices have recovered in response to hopes that OPEC and other oil producers may instill some discipline in output and boost prices. We do not expect a significant extension of crude oil gains in the coming 12 months but prices holding near $50bbl will help mitigate the impact of rising U.S. interest rates on the CAD to some extent. The CAD retains a fairly consistent, positively correlated relationship with crude oil prices in the longer run. Domestic growth trends remain subdued but we expect the Bank of Canada to remain sidelined until late next year when we anticipate economic momentum, supported by fiscal policy steps, will be sufficient to trigger a 25bps increase in the overnight rate.
The yen (JPY) will under-perform in the longer run. Subdued domestic growth, super-loose monetary policy and poor fiscal dynamics will ensure the JPY remains under pressure in the medium term and suggests that the JPY will not be able to take advantage of an over-extended USD bull run to stabilize or improve in the longer-term. Rising, real long-term yields will help support USDJPY and drive the USD towards the 120 mark through 2018.
For Asian EM FX, global risk sentiment, geopolitical tensions and domestic issues will be the primary drivers of performance in near-term. EM Asian currencies will 1) trade in a range on a combination of local political, economic and financial uncertainties and global excess liquidity prior to the U.S. presidential election 2) decline in general versus the dollar in the period between the election and the FOMC meeting scheduled for 13-14 December and 3) rebound broadly following the Fed decision. Geopolitical tensions escalating intermittently on the Korean Peninsula and in Kashmir could undermine the Korean won (KRW) and Indian rupee (INR) respectively.
The KRW, Malaysian ringgit (MYR) and the Singapore dollar (SGD) are the most vulnerable currencies to a Fed rate hike in December. Meanwhile, the high-yielding Indian rupee and the Indonesian rupiah will advance over the medium-term, supported by capital inflows. The death of Thailand’s 88-year-old King may cast a shadow over the nation’s political and economic outlook and exert downward pressure on the Thai baht (THB).
The USD broke above 6.70 versus the yuan (CNY) in the first session following the CNY joining the IMF’s Special Drawing Right basket. While the depreciation pressure on the CNY is likely to intensify in the months ahead, we believe the People’s Bank of China will step up efforts to avoid self-reinforcing expectations of CNY depreciation and avert further pressure for competitive devaluations. A relatively stable CNY will be critical in allowing the Fed to raise its benchmark rate in December. Tighter rules on home purchases risks slowing the economy next year and weighing on the CNY value afterwards, however.
With stronger U.S. growth and tighter Fed policy extending into 2017 and 2018, export-driven EM Asian economies will benefit. Meanwhile, global excess liquidity may continue to chase regional assets for higher returns, although possibly to a lesser extent. EM Asian currencies may decline slightly or remain flat in 2017 and post modest gains in 2018.
This has been a volatile few weeks in Latam FX, with a number of country-specific themes playing out. In Colombia, the tone soured following the surprise referendum vote that torpedoed the peace deal, but with a combination of firmer oil prices and a quick response by the government to formulate a “Plan B”, the peso (COP) looks like its finding its footing. Another factor that could support the COP is fiscal reform, which is expected shortly.
In Mexico, the apparent sudden and sharp fall in support for Donald Trump in the opinion polls has driven a strong move up in the peso (MXN), driving USDMXN back to below 18.0, as perceived risks to NAFTA and other capital flow distortions fade along with the Republican Party’s hopes. However, this rebound in the MXN is also likely to affect Banxico monetary policy. The central bank had signaled that the most likely trigger for any additional tightening would be a falling MXN. Adding to MXN support should be the timely bounce in oil which could at least help spark a little more interest in the looming oil block sales — although much depends on how durable the bounce is perceived to be by participants.
Peru and Chile continue display some of the more robust regional FX performances, based on relatively stable copper prices as well as the relative safe-haven status of the two economies. Note, however, that in Chile’s case, the loss of net creditor status this year has emerged as a potential source for downward pressure on sovereign ratings.