2016 has been full of shocks and surprises. Around mid-year, financial markets were rattled by Britain’s shock decision to vote in favour of leaving the European Union in June, which sent Sterling crashing to its weakest position against the US Dollar since 1985. The Pound has since stabilised somewhat, although remains just above its 31 year lows.
Just five months later, Republican Donald Trump stunned Democrat Hillary Clinton by winning the race to the White House. This caught currency markets completely off guard sending the US Dollar and risk assets sharply lower. However, the US Dollar’s turn right around and rallied against almost every major currency in the days following the election, as investors poured into the Dollar on expectations for higher spending and tax cuts in the US under a Donald Trump presidency next year as well as higher interest rates. In trade-weighted terms, the US Dollar is currently trading around its highest level in 14 years.
The divergence in monetary policy stances between the world’s two main central banks, the Federal Reserve in the US and the European Central Bank in the Eurozone, has also widened rather sharply this year. We think that this divergence between the Federal Reserve and the other main central bank’s, notably the ECB and Bank of Japan, will remain one of the key drivers in the currency markets in 2017.
On the political front, Italy voted resoundingly to reject proposed constitutional reforms at its referendum in December. We think that Trump’s election and the Brexit vote have increased the probability that populist parties could rise to power within Europe next year ahead of a number of crucial general and presidential elections. France, Germany, the Netherlands and possibly Italy will all go to the polls in 2017. Every one of these elections will have the potential to create a similarly uncertain and volatile trading environment.
Sterling plunges to 31 year low after shock Brexit vote
Financial markets were rocked in June by Britain’s shock decision to vote in favour of leaving the European Union. Contrary to a string of opinion polls in the lead up to the referendum which showed the ‘remain’ camp marginally ahead, the vote to ‘leave’ defied all the odds to triumph by 52% to 48%. The result came as a major shock to the markets which, as the polls closed at 10pm on polling night, had all but fully priced in the possibility that the ‘remain’ vote would prevail.
The Pound went into free fall overnight in one of the most dramatic major currency movements in recent history. As the results in favour of the leave vote began filtering through during the early hours Sterling crashed in value, falling from near 1.50 to as low as 1.33 to the US Dollar. This marked a massive 10% decline in a matter of hours, sending the currency plunging to its weakest position against the Greenback since 1985 (Figure 1). The Pound also dropped in value against every other major currency, including an 8% depreciation versus the Euro and a massive 15% drop versus the Japanese Yen.
Figure 1: GBP/USD (January ’16 - December ’16)
Source: Thomson Reuters Datastream Date: 21/12/2016
Since the referendum the Pound has remained susceptible to violent and unpredictable swings. The current extreme levels of volatility in the currency were exacerbated by a mystery ‘flash crash’ overnight on 7 October, which saw Sterling nosedive by over 6% in a matter of minutes before recovering most of its losses. This was not triggered by additional news, rather by automated trading programs operating in an environment of low liquidity.
Sterling has been driven almost exclusively by political news since the referendum, particularly expectations for both the timing of the triggering of Article 50, and the terms of the UK’s departure from the EU. There was heavy selling pressure on the currency followed comments from Prime Minister Theresa May that suggested restrictions on immigration were coming. This would increase the likelihood of a ‘hard Brexit’ in which the UK’s access to the European common market is significantly restricted. However, the High Court ruling in November, which ensures parliament must vote on the triggering of Article 50 and thus start the formal two year process on Britain’s exit from the European Union, has provided a significant boost to the Pound. We think this reduces the risk of a ‘hard Brexit’ and is likely to delay the timing of when Prime Minister Theresa May can trigger Article 50. She had previously stated this would take place no later than March 2017, but this deadline is looking increasingly improbable.
Trump stuns market with US election triumph
Financial markets worldwide were caught completely wrong-footed by Donald Trump’s election victory in early November, particularly given a Hillary Clinton victory was heavily priced in as the early exit polls began filtering through. Betting odds had given Trump less than a 10% chance of victory at around midnight UK time on election night.
The immediate market reaction was very negative. The Mexican Peso, which was viewed as a proxy to the US election throughout the last few months of the campaign, suffered the most, plunging over 10% in a little over three hours against the Dollar. The Euro rallied sharply against the US Dollar, while Sterling similarly jumped overnight as investors fled to the safe-haven Japanese Yen and Swiss Franc.
However, since the immediate dramatic panic moves, we’ve seen investors flocking to the US Dollar, with the currency rallying to its strongest position in 14 years (Figure 2).
Figure 2: US Dollar Index (January ’16 – December ’16)
Source: Thomson Reuters Datastream Date: 21/12/2016
Trump’s economic policies have never been fully clear during his election campaign and he has a knack for changing his mind. However, a few consistent themes have emerged. Firstly, one of Trump’s pledges is likely to see a significant increase in fiscal stimulus in the US next year. This could see as much as $1 trillion spent on infrastructure and ramped up defence spending, a sharp contrast from the fiscally conservative policies historically favoured by Republicans. He has also promised to introduce a series of large scale tax cuts, possibly the most drastic in over 30 years, in a bid to foster faster economic growth.
While plans to cut taxes and increase spending could significantly increase the government deficit in the next eighteen months, the short term effect on growth is likely to be positive, and should negate much of the downside effects of his proposed trade restrictions on US exports, of which accounts for less than 15% of US GDP. It is also likely that these restrictions will be somewhat muffled by the free-trade leaning (though Republican controlled) Congress.
Trump’s expansionary fiscal plans mean growth may now surprise to the upside next year, and while his spending plans could take a while to filter through to the real economy, it will inevitably improve growth in the medium run. Historically, high growth leads to high interest rates. The Fed already hinted in December that it expects to hike more aggressively in 2017 than originally anticipated back in September.
Trump fiercely criticised the Fed during his election campaign for delaying the process of raising rates. Once in office, Trump will have to option to fill two vacancies on the FOMC’s seven member strong board and could opt for more hawkish successors to both Chair Janet Yellen and Vice Chairman Stanley Fischer when their terms ends in 2018.
Euro heads for parity on diverging Fed & ECB
The divergence in monetary policy stances between the European Central Bank in the Eurozone and the Federal Reserve in the US has grown in the past twelve months, validating our bearish view towards the single currency.
The European Central Bank (ECB) stepped up its efforts to boost both growth and inflation in the Eurozone on Thursday. Nearly two years after the launch of quantitative easing back in January 2015, the ECB announced it would be extending its horizon beyond the previous March 2017 end date. The ECB will now continue its asset purchases until the end of December next year or beyond, if necessary.
The Governing Council will continue purchasing 80 billion Euros a month up until the end of March, though announced it will be lowering the monthly purchases to 60 billion Euros for the remainder of 2017. This increase in the ECB’s QE programme is significant and we will now see an extra 540 billion Euros pumped into the Eurozone economy.
The magnitude of the extension in the QE programme took the market by surprise, given it had priced in only a six month extension. We think President Mario Draghi’s press conference was also very dovish. Draghi insisted that the recalibration of the asset purchases did not constitute tapering. Further, he stated that “tapering”, defined as a slowdown on the pace of purchases towards zero, was not even discussed by the Council.
The ECB’s general outlook was even more pessimistic. The statement suggested the size of the asset purchases could be ramped up should “the outlook become less favourable or if financial conditions became inconsistent with further progress toward a sustained adjustment of the path of inflation”. We ourselves were surprised that updated forecasts for both growth and inflation were little changed, with the ECB not expecting headline inflation to return to target until 2020 at the earliest. The ECB is discounting almost entirely the inflationary impact of rebounding commodity prices.
The single currency has already slumped to its lowest level against the Dollar since 2002 following Draghi’s dovish comments. We believe the ECB’s surprisingly large extension of its QE programme bodes ill for the Euro in 2017, and should help drive the currency towards parity with the Dollar early in 2017.
Federal Reserve hikes rates for first time in a year
In sharp contrast to the ECB, the Federal Reserve hiked its benchmark interest rate for only the second time since the financial crisis in December.
The Fed funds rate was raised by 25 basis points to a range between 0.5% and 0.75%, having spent a full year unchanged following the previous rate hike in December 2015. All ten voting members of the committee threw their support behind an immediate rate increase.
While a rate hike in December was fully priced in by the market, the Fed’s stance towards future rate increases was less clear. Policymakers in the US also validated our expectations for a hawkish turn by ramping up the path of future interest rates in 2017 and beyond, sending the US Dollar soaring against major currencies.
The FOMC’s ‘dot plot’, which outlines where each member of the committee expects rates to be at the end of each year, shows that the committee now expects on average three rate hikes in 2017, compared to just two outlined in September. Overall 11 of the 17 members thought that the Fed would hike on three occasions next year, quite a bit more hawkish than the market had anticipated.
Figure 3: FOMC December ‘dot plot’
Source: Federal Reserve Date: 14/12/2016
Chair Janet Yellen’s press conference remained fairly cautious, downplaying the change in the projected path of future rates as only a modest shift in the thinking of several committee members. She did, however, acknowledge the “considerable” progress the US economy has made, indicating an improvement in the labour market and inflation. The statement made no explicit mention of the effect of Donald Trump’s plans to increase spending and cut taxes next year. There’s little chance the Fed will comment on such changes until Trump’s plans become clearer after his presidency begins in January.
Moreover, the Federal Reserve updated its growth forecast for next year, albeit only modestly. GDP Growth for next year is now expected to reach 2.1% compared to the previous 2.0% estimate, with the 2018 growth forecast unrevised at 2.0%.
We think that the risks to a faster than expected pace of interest rate hikes by the Federal Reserve remain tilted to the upside following the election victory of Donald Trump in November. Trump’s pledges during his election campaign have never been fully clear, however, his promises to increase spending could see as much as $1 trillion spent on infrastructure, combined with a series of tax cuts. While these plans could significantly increase the government deficit over the long term, the short term effect on growth is likely to be positive, and could encourage the Fed to be even more aggressive in its approach to tightening monetary policy. We think there remains a strong chance that we’ll see hikes on roughly a quarterly basis in 2017.
Emerging market currencies rally on oil rebound
Emerging market currencies reacted badly to Donald Trump’s surprise US election victory in November, with many selling off sharply in the immediate aftermath of the announcement. The President-elect’s proposed protectionist policies could also severely restrict US trade with emerging markets countries, many of which (in particular Mexico) rely heavily on export demand from the States. The Mexican Peso and Turkish Lira have been two of the currencies most severely affected by the rout, the former plunging by more than 10% against the Dollar on election night. The Turkish lira, however, suffers from some idiosyncratic problems of its own, most notably the aggressive interference in monetary policy by the Government, which demands lower rates in no uncertain terms.
2016 on the whole has, however, been a relatively good one for emerging market currencies in general, barring a few exceptions. We’ve seen strong rebounds in the currencies of many of the more developed countries, led by the BRICS currencies in Brazil, Russia and South Africa. A sharp depreciation of almost every emerging market currency in 2015 in anticipation of higher rates in the US and falling commodity prices had left them at very cheap levels, and yield-hungry investors were enticed by the high yields they offered.
Commodity prices have also initiated a rebound since the beginning of the year, led by an increase in oil. Crude oil prices have increased by almost 50% since the beginning of 2016, rising back above $50 per barrel in November after OPEC announced its first production cut in 8 years (Figure #). Oil prices are expected to continue increasing gradually next year, which should provide good support for emerging market currencies across the board, particularly those dependent on commodity exports.
Figure 4: Oil Prices vs. Commodity Price Index (2012 – 2016)
Source: Thomson Reuters Datastream Date: 21/12/2016
The MSCI Emerging Market Currency Index, which provides a weighted index of twenty-five emerging market currencies against the US Dollar, has risen off January’s multi-year low. We think in most cases the sell-off in the currencies of emerging markets has gone too far, and expect most to hold their own against the Dollar next year even in the face of gradually increasing interest rates by the Federal Reserve in the US in 2017.
We think that the backdrop of still extraordinarily stimulative policy from many of the world’s major central banks, most notably the European Central Bank and Bank of Japan, is also generally positive for emerging market currencies in general.
However, Trump’s victory introduces an element of uncertainty. The prospects for each particular emerging market currency will be highly dependent on two factors:
- The country’s position as a commodity exporter or importer, as exporters will benefit from our expectations for worldwide reflation.
- The impact of potential restrictions on trade passed by the Trump administration on trade flows.
What to expect in 2017?
Following the Brexit vote in June and Donald Trump’s shock US election victory, financial markets are concerned about a rise in support for anti-establishment movements across Europe.
We had the Italian constitutional referendum in the first week of December. The referendum, aimed at slimming down the country’s legislature and speeding up lawmaking, yielded a resounding “No” vote, with around 60% of voters rejecting the proposals. Renzi’s defeat is likely to set a negative tone ahead of a crucial few months of high profile elections in Europe. France will go to the polls for its Presidential election in May. Germany will also hold a federal election in the third quarter of 2017, while the Netherlands has its own general election in March.
The unreliability of the opinion polls for both the UK’s EU referendum and the US Presidential election has made investors increasingly nervous about the risk of contagion in Europe.
Netherlands (15th March 2017)
An election that could prove a major event risk in Europe next year is that in the Netherlands in March. Geert Wilders, the leader of anti-EU, anti-immigration Party for Freedom is comfortably ahead in the polls and looks likely to receive the most votes in next year’s general election. However, support for Wilders is currently nowhere near enough to form a majority - he is predicted to win around 30 of the 150 seats on offer, although this would be a significant increase on the 15 the party currently holds.
With many of the mainstream parties looking certain to dismiss him as a coalition partner, we could see a scenario where an unprecedented four or five centre-right and centre-left parties come together to form a coalition government. We think the main risk is a stronger-than-predicted showing by Wilders’ party that would make it very difficult to form a coalition that excludes him.
France (7th May 2017)
The possibility of a Presidential election victory for Marine Le Pen in France has gone from unthinkable to plausible. Le Pen, leader of the far-right National Front, looks increasingly likely to make it through as one of the top two candidates in the first round of France’s Presidential election in April. This would likely directly pit her against former French Prime Minister and now surprise clear favourite François Fillon in a second round vote to decide the next President in May.
A victory for the anti-immigration, anti-free trade National Front Party would almost certainly lead to a referendum on France’s future within the European Union. However, opinion polls show France remains firmly in favour of remaining in the EU, and the possibility of a Le Pen win in the second round of the French elections remains very remote.
Germany (Between 27th August & 22nd October 2017)
German Chancellor and leader of the Christian Democratic Union Angela Merkel has announced she will be running for her fourth term in office next year. This could see her extend her run as Chancellor to 16 years since coming to power in November 2005. However, Merkel’s approval rating has fallen over the past twelve months to around 55% from more than 70%, with her CDU Party now polling at around 30% compared to the 41.5% of the vote obtained in the 2013 Federal election. Her decision to let almost one million asylum seekers into Germany last year allowed the populist and anti-immigration Alternative for Germany (AfG) Party to record wins in recent state elections.
While Frauke Petry’s Alternative for Germany Party has received an increase in support of late, it still sits at a modest 10-15%. At present, it looks unlikely to mount a realistic challenge when Germans go the polls in the third quarter of next year. PredictIt has shown Merkel opening up a comfortably advantage over her rivals in the in the past few weeks.