The USD is strengthening broadly amid rising expectations that the Fed will tighten monetary policy sooner rather than later. With the Bank of Canada resolutely on hold, policy divergence is weighing on the CAD. The MXN has steadied after the US Presidential election shock but internal (elections) and external (NAFTA renegotiation) risks remain.
The EUR is poised to soften as subdued core inflation and political risks ensure the ECB will remain in easing mode this year. The GBP remains depressed as the UK’s formal exit from the EU nears. The RUB will benefit from improving fundamentals.
Rising US yields will bolster USDJPY in the medium-term. We expect the CNY to remain stable through March as the National Congress of the Communist Party of China convenes. Positive fundamentals will underpin the PEN while the COP risks stalling if crude oil prices stabilize.
The early days of President Trump’s administration have brought mixed fortunes for the markets. US equities have risen broadly amid optimism that the newly elected President will introduce a growth-inducing mix of tax cuts, fiscal spending and deregulation. The US dollar’s (USD) performance has been uneven, however. Uncertainty about how quickly the Fed would raise rates and worries about the new administration’s policy on the USD weighed on the currency in the early part of the year. But a more pragmatic approach on the USD from Treasury Secretary Mnuchin (a strong USD reflects strong US growth) and a sudden strengthening in market conviction that the Fed could tighten monetary policy as soon as the March 15th FOMC meeting have renewed gains in the USD. We continue to view the USD as likely to appreciate further in the medium-term; superior economic growth and the anticipated rise in US interest rates will underpin the USD broadly though mid-to-late 2017.
The Canadian dollar (CAD) improved in the early part of the year but we expect the recent reversal to extend (we target 1.40 for USDCAD through mid-year). Canadian employment data were strong through the turn of the year but the combined gains of around 95k jobs for the December/January period perhaps overstate the real strength of the domestic economy (given that 214k jobs were created through the whole of 2016) where significant excess capacity continues to bear down on core inflation. We expect the Bank of Canada (BoC) to remain on hold over the balance of this year and well into 2018. OPEC production discipline has served to lift crude oil prices, providing some underpinning for the CAD, but we think relative policy considerations, i.e. tighter Fed/loose BoC expectations which have driven short-term spreads back out towards recent (USD-supportive) highs, are liable to overshadow commodity price gains and pressure the CAD.
We remain euro (EUR) bearish and continue to expect EURUSD to reach 1.02 in the next few months. However, the EUR rallied through the start of the year on short-covering. Higher inflation, driven in part by rising fuel costs, prompted market expectations that the European Central Bank (ECB) may start to taper its asset purchase programme later this year. Core Eurozone 10-year bond yields rose to 0.5% through the end of January and short-term yield spreads versus the USD compressed, driving EURUSD to the 1.08 area. We think the central bank will maintain its current policy stance through the end of the year. Core yields have eased again and short-term rates have declined significantly in the past few weeks as investors have moved out of weaker, peripheral bond markets as well are larger, core markets (France) amid rising investor worries that the results of key elections (The Netherlands, France and Germany) over the course of the next few months could further destabilize the EUR project. Two-year Eurozone-US rate spreads have widened to more than 200bps, the largest yield advantage for the USD in the EUR’s lifetime.
Sterling (GBP) remains weak as investors continue to focus on the UK government’s Brexit negotiations and the potential economic (the risk of a large “divorce bill” from the EU) and political (the risk of another Scottish independence referendum) consequences of the UK’s exit from the EU. These uncertainties (as well as the broader strength in the USD) still risk pushing GBPUSD back to the 1.20 area in the coming weeks but we think the GBP is starting to look attractive from a longer-term valuation perspective, particularly on some of the more beaten down crosses (such as the EUR and CAD). We think bargain hunters may start to look more favourably on the GBP in the medium-term, once some of the above-noted risks have been fully factored in.
Other major currencies have fared quite well since the start of the year. The Australian dollar and New Zealand dollar have strengthened on relatively higher yields although weakness in the broader commodity complex through February has served to temper gains somewhat. The Japanese yen (JPY) has been a relatively strong performer since the start of the year as US yields retreated. We think rising US rates will lift USDJPY to 117 this year but the JPY remains prone to sporadic bouts of “safe-haven” related demand in periods of risk-aversion.
Beyond the G-10 space, the combination of favourable domestic and external factors led to a sustained appreciation of the Brazilian currency which gained 28% against the USD over the past 12 months even though the administered policy rate has been reduced by 200 bps to 12.25% over the past four months. The Mexican peso (MXN) experienced a rapid recovery from the elevated stress (and associated overshooting) that occurred in response to the US election. Gains are partially supported by aggressive interest rate hikes (up 325 bps to 6.25% over the past 14 months). We think the MXN looks fundamentally undervalued but it is too early to dismiss the risk of renewed volatility in response to US policy initiatives.
Similarly, reduced trade war fears have allowed the Korean won to become the top-performing major currency since January. The South African Rand (ZAR) remains aligned to the bullish trend present in emerging-market currencies; however, the South African sovereign debt quality has been steadily deteriorating, prompting all international credit agencies to place the country’s sovereign debt ratings on “negative outlook” watch. Rising copper prices (highest since mid-2015) have supported the Chilean peso while the Colombian peso is lagging modestly despite firm oil prices after the central bank made a surprise reduction in its benchmark rate to 7.25% in response to weak inflation and a drop in consumer confidence to a 16-year low.