2016 has been an unforgettable year, not least because Leicester City won the English Premier League despite beginning with odds of 5,000-1 against them. Rather, because the citizenry of two nations, which have undoubtedly been the champions of globalisation and trade in the world for the last three centuries, voted for protectionism.
As a result, market headlines were dominated almost entirely by politics rather than economics while it became very difficult to accurately forecast the course of currency prices.
In all likelihood, this difficulty is going to remain with us in 2017, as the uncertainty around the policies of the Trump administration on trade and immigration, UK government’s Brexit proceedings and elections in France and Germany unfold.
The usual aphorism about how forecasting maybe a waste of time accepted, what could be the key themes set to influence the prices of the major currencies in 2017? Let’s take a look:
USD: The USD is all set to end the year on the strongest tone in over a decade, with the Dollar Index, at the time of writing, at 103, a level last seen in December 2002. The question is, how near or far are we from the end of this rally, which began with Hillary Clinton’s shock defeat on November 9, fuelled by forecasts of a protectionist regime-driven spike in inflation, which along with higher US yields should strengthen the USD.
|The USD is all set to end the year on the strongest tone in over a decade. (Reuters photo)|
Moreover, according to the latest Federal Open Market Committee (FOMC) statement, the committee’s yet to incorporate the impact of the coming fiscal easing on the GDP, implying an upside risk to the USD, as it leaves room for further tightening.
However, there might be limits to this rally, since historically; higher US yields and a stronger USD have had adverse implications for risk assets and economic activity. Tightening financial conditions are problematic for an economy where the average household debt is $133k, and a crowding-out effect from an imminent fiscal easing is around the corner. Besides, a stronger USD is also usually detrimental for the American corporations, which lose out on competitiveness to European and Emerging Markets (EMs) firms.
Also, USD returns can usually be categorised as either driven by policy (fiscal easing or monetary tightening) or uncertainty.
With a fair amount of tax-cuts and infrastructure spending, and two rate hikes already priced in, a policy driven rally in the USD depends on the economy outperforming current expectations significantly, which seems unlikely. The predicament is made worse by the fact that around the same time last year, the Fed’s Dot Plot indicated four rate hikes for 2016, and we all know how that panned out.
Also, unless inflation rises very rapidly next year, a third rate hike may in fact appear to be a little disinflationary, and although Federal Reserve Board chair Janet Yellen has saidthat the FOMC doesn’t believe in a ‘high-pressure’ economy, whether or not the committee really wants to be ahead of the curve remains to be seen.
EUR: The EUR was having a surprisingly decent year, considering the political turmoil around Brexit, the Italian referendum and the general rise of Euro-skepticism. The party, however, came to an end after Donald Trump won the US elections, post which the EUR has sold off 6 per cent against the USD, driven by the rising uncertainty around the future of the Euro area.
The EUR slipped below 1.04 against the USD after the horrific attack in Berlin on the December 20, the lowest in more than a decade, since the event roused fears of growing anti-Merkel sentiment in Germany.
The exceptionally long impasse in which the Euro has been snaking sideways is now increasingly likely to end, with growing expectations of a sharp breakout. However, economists are split on the direction of the breakout. On one hand, there is a renewed interest in the EUR/USD parity theory, driven by expectations of rising interest rate differentials and the looming uncertainty in Europe around the elections in France and Germany.
Some market participants on the other hand, are expecting the Euro to appreciate to 1.15 over the next two quarters. Underlying this school of thought is the economic recovery in the Euro area.
The historic agreement between OPEC and non-OPEC countries to cut crude output has also strengthened the case for a revival in inflation, which should keep the ECB on its path to a gradual tightening in monetary policy.
Lastly, any further depreciation in an already undervalued EUR (as per purchasing power parity) could lead to a revival in buying interests, limiting its weakness against the USD.
GBP: A sparsely populated economic calendar and elevated European political risks, along with GBP’s relative undervaluation could prepare the ground for moderate sterling appreciation versus the EUR. Buoyed by the spike in inflation expectations, and the post-Brexit resilience in data, the Bank of England has practically ruled out any further intervention (at least in the short-term), which takes out monetary policy as a potential source of weakness for the GBP. Unfortunately, however, 2017 will not be all roses and sunshine for the GBP.
The most immediate threat to the UK’s outlook is political and not economic, and we get the first coup d’oeil of that risk in January 2017, when the UK Supreme Court is expected to rule on whether or not the government is in its rights use the royal prerogative to trigger Article 50.
Although Parliament has recently voted in favour of the government’s plans of starting the divorce negotiations by April 2017, the vote is not legally binding, which may create difficultiesfor the government if the Supreme Court upholds the High Court’s decision.
A new study, arguing that only triggering Article 50 may not suffice for the UK to leave theEuropean Economic Area -- which may require Article 127 to be triggered separately, has convoluted matters further.
Investors bullish on the GBP have found solace in the fact that if thisdoes turn out to be the case, a good number of MPs would be willing to throw their weight behinda treaty which allows Article 50 to be triggered, while blocking Article 127. Add to that ScottishFirst Minister Nicola Sturgeon’s latest proposal “Scotland’s Place in the Europe”, wherein the Scots seek a deal which allows them to retain the access to EU’s single market in exchange of free movement of EU citizens in Scotland, and we get higgledy-piggledy Brexit bomb, ready to explode, threatening to engulf the markets in a cloud of uncertainty.
JPY: The Japanese Yen is the oriental counterpart of the US Dollar, in the sense that like thegreenback, the Yen also enjoys a safe haven status, a distinction which becomes especially important in times of acute market stress. The explanation behind Yen’s elite status is two-fold:
1. Japan holds the largest net international investment position, which means the Japanese are net creditors to the rest of the world, for the goods and services exported by them. Japan’s tradingpartners finance this position by debt, which Japan owns in the form of bonds, of variouscurrencies. Accordingly, in times of heightened volatility, the holders of these bonds enter intohedging transactions by selling the indigenous currencies of the bonds held, and buying the JPY, thereby pushing the Yen up.
2. The Bank of Japan (BoJ) has been very creative in their battle against deflation and thestagnation in growth. Most recently, the BoJ adopted ‘yield-targeting’, wherein the central bank would interfere in the markets every time the yield on the 10-year Japanese government bonds deviates from zero per cent.
Such a policy encourages ‘carry-trades’, a strategy where market participantsborrow in the low-yielding currency to invest in a high-yielding currency. However, when pessimism increases in the markets, traders hurry to unwind their positions, causing anappreciation in the JPY.
However, during a risk-on mode, as witnessed since Donald Trump’s victory in the US elections, carry trades can weigh heavily on the JPY, as investors borrow frantically in Yen to invest inhigher-yielding bonds in the West. The global bond rout made matters worse as the interest rate differentials between the USTs and JGBs widened to 250 basis points, which resulted in USDJPYreaching a fresh near term high of 118.18 on December 15.
While there are limits to JPY’s weakness, solid US data and expectations around Trump policies are likely to keep USDJPY supported at least into early next year. However, the rise in globalyields and improving inflation dynamics may prompt the BoJ to raise its 10 yield target from zero per cent next year, which along with the net short speculative positioning, could come to JPY’s rescue.
INR: The likelihood of restrictive trade policies in the US, along with higher US yields may weighon the INR. However, the INR is likely to continue to be one of the most resilient EM currencies, ledby India’s relatively lower dependence on external trade, improved policy and macro fundamentals. Besides, a favorable FX carry-to-volatility ratio and the possibility of rising foreigndemand for INR debt (helped by prospects of a rally in government bonds) should also limit the rupee’s downslide.
Having said that, the resurgence in commodity prices and sluggish industrial production are risks worth monitoring. Moreover, RBI’s take on Modi government’s surprise decision to demonetise86 per cent of India’s currency in circulation in November 2016, which is widely expected to have a sharp negative impact on economic activity in the short term, also remains to be seen.
Should the Central bank, which has come under severe criticism for being behind the curve on demonetisation,find it necessary to reduce lending rates to flush out the liquidity and support output, it could thwart the carry-driven consolidation in USDINR.
Clearly, the FX markets in 2017 look like a confusing maze, where uncertainty is the only certainty in the FX markets. For all those whose prosperity depends on being on the right side of currency fluctuations:
“The game's afoot: Follow your spirit, and upon this charge Cry 'God for Harry, England, and Saint George!'”