US DOLLAR STRENGTH TO PERSIST INTO 2017
Good Evening All;
Remain bullish on the US dollar (USD) and expect the greenback’s winning run to extend well into 2017. Much of the USD’s strength in the last few years was predicated on the idea that it represented the “least dirty shirt” among a group of advanced economy currencies that all had their own challenges. However, markets are anticipating that the Trump presidency will be characterised by probusiness, pro-growth policies which deliver above-trend GDP, higher inflation and stronger corporate profitability to the US economy. This will underpin the Federal Reserve’s (Fed) gradual tightening of monetary policy and suggests quite strongly that the USD rally can stand—and extend—on its own merits though H1 2017, at which point we expect gains to moderate.
While it remains too early to know precisely what the incoming administration intends to do—and when it will be able to practically implement policies—there is a clear expectation that tax cuts, fiscal spending and deregulation will form a significant part of the Trump agenda. Moreover, the new administration may implement corporate tax policies which favour exports whilst penalising imports and support a time-limited repatriation of US corporate profits accumulated and held offshore. These initiatives may provide additional support to the USD.
For the moment, the potential positives are overshadowing the potential risks (the adverse impact of protectionism and trade frictions, wider fiscal deficits) that the Trump administration holds for the USD. And if the USD looks strong, it does not appear over-valued. The USD’s recent gains appear well-supported by the US economy’s growth advantage as well as wide (and widening) short-term interest rate differentials versus its major currency peers. Markets are still not quite fully pricing in the three additional rate increases (the Fed) anticipate for the coming year. However, confidence in the US growth outlook will bolster expectations that the Fed will tighten policy, supporting USD gains.
The Canadian dollar (CAD) held up relatively well against the surging USD in Q4 2016 and while we expect it to remain firm versus its G-10 peers in the next few months, we think the CAD will struggle to keep pace with the rising USD, even with commodity prices (and oil in particular) trading on a firmer footing. The problem for the CAD is that the domestic economic outlook remains challenged by soft, non-commodity exports and weak business investment. As Trump’s election campaign focused on trade and border issues, his win appears to have prompted a surge in Canadian worries about the economic (policy) outlook which may hamper a recovery in either exports or capital spending.
The CAD’s relative strength on the crosses has delivered a roughly 4% rise in the CAD’s effective exchange rate over the past year while higher US interest rates are also pulling up longer-term rates in Canada. Both of these factors are delivering an inappropriate tightening in domestic monetary conditions, considering slow growth and declining inflationary pressures. We expect the Bank of Canada to maintain a highly accommodative stance throughout 2017 while the Fed tightens. The wider yield differential between short-term rates in the US and Canada will likely lift USDCAD to 1.40 through mid-year.
European currencies are still dealing with the aftermath of the UK’s Brexit referendum decision last June. The UK government is expected to invoke Article 50, which will formally launch exit proceedings, by the end of March. The UK economy held up remarkably well in H2 2016, prompting the Bank of England to adopt a neutral policy bias. We continue to feel that the pound (GBP) is vulnerable to growth disappointment and uncertainty surrounding the EU exit process, however, and forecast GBPUSD reaching 1.20 in the next few months.
Meanwhile, the strong USD and the European Central Bank’s decision to extend its quantitative easing until September 2017 (albeit at a slightly lower rate of monthly asset purchases) combined to push the euro (EUR) to its lowest level since 2003 in early January. We expect EURUSD to remain under pressure in the months ahead as investors focus on diverging growth and monetary policy trends between the USA and the Eurozone. Political focus suggests that more persistent EUR weakness (or a potential push below par) are non-negligible risks for EURUSD around the French presidential election (first round 23rd April) or the German general election (September). As the risk of UK shocks may recede after March while Eurozone risk may increase, we think EURGBP is liable to ease somewhat in the coming months.
The Japanese yen (JPY) was the worst-performing G-10 currency in Q4, reflecting rising US interest rates and wider US-Japan rate differentials at the long-end of the curve as well as JPY under-performance in a generally pro-risk environment as US equity markets rose following the election. Slowing Chinese growth and the risk of heightened Sino-US tensions have also weighed on regional FX sentiment and risks spilling over into the Australian and New Zealand dollars (AUD and NZD, respectively), given China’s sourcing of commodities from the region. The AUD and NZD are both trading at relatively “rich” levels versus the CAD from an historic perspective and may under-perform moving into 2017.
Regional Asia FX will continue to be primarily driven by US fundamentals, monetary policy prospects and the President-elect’s economic and fiscal policies. Seasonal trends, which typically see the USD advance in Q1 and slide in April may remain intact this year.
The downward pressure on the Chinese yuan (CNY) will extend into 2017. The People’s Bank of China will try and curb escalating one-way expectations of yuan depreciation on the one hand whilst preparing for future yuan depreciation on the other in the months ahead. Offshore yuan liquidity conditions are likely to ease somewhat but remain relatively tight ahead of Chinese New Year to deter speculative pressure on the CNY.