G4 forecast revision - January 2017

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US Dollar (USD)

News out of the United States has been dominated by the prospects for a Donald Trump Presidency since his election victory in November. The Dollar soared in the immediate aftermath of the election and rallied to its strongest position in 14 years against its trade-weighted basket of currencies in early-January in anticipation of greater spending, lower taxes and higher interest rates in the US under a Donald Trump presidency.

However, the Dollar rally appears to have lost stream on the back of Trump’s hard line stance on trade and the lack of clarity on his future infrastructure spending plans and tax policy. Trump’s bleak and confrontational inauguration speech on 20 January emphasised his protectionist policies and disappointed investors hoping for a repeat of his upbeat victory speech in November.

Moreover, in a relatively unusually move for a United States President, Trump has voiced his concern that the US Dollar is “too strong”. While his pick for Treasury Secretary quickly downplayed these comments, this was enough to send the US Dollar index to its weakest position in six weeks against its major peers (Figure 1).

 

Figure 1: US Dollar Index (January ’16 - January ’17)

Source: Thomson Reuters Datastream Date: 23/01/2017

Meanwhile, 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. 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. The FOMC’s ‘dot plot’, which makes explicit 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 2).

 

Figure 2: FOMC December ‘Dot Plot’

Source: Federal Reserve Date: 15/12/2016

Comments from Federal Reserve Chair Janet Yellen have remained fairly hawkish so far in 2017, reiterating that the FOMC is close to achieving its dual mandate of on target inflation and full employment. Rhetoric from FOMC members since the election has remained generally hawkish, and we see a risk that the Fed could hike more aggressively than the market is currently pricing.

Economic news out of the US remains impressive. The jobs market has continued to perform strongly, with the US economy creating 156,000 jobs in December (Figure 3). Unemployment remained at a nine year low 4.7%, while perhaps even more importantly, job market tightness is clearly starting to feed through to wage increases. Average earnings rose by 2.9% in 2016, the highest rate since the financial crisis.

 

Figure 3: US Nonfarm Payrolls (2010 - 2016)

Source: Thomson Reuters Datastream Date: 23/01/2017

We think the Fed is almost certain to hold rates steady at its 1 February meeting - the market is currently placing less than a 15% chance that rates will be raised. However, providing the labour market continues to perform well, we see March as a strong possibility for the next hike and expect to see the Fed raise interest rates three or four times in 2017, in line with the latest dot plot.

The process of rising interest rates by the Federal Reserve in the US should provide good support for the US Dollar in 2017 and we expect a gradual strengthening of the US Dollar from current levels against almost every G10 currency.

 

 

EUR/USD

GBP/USD

Q1-2017

0.99

1.20

Q2-2017

0.97

1.20

Q3-2017

0.96

1.21

E-2017

0.95

1.22

E-2018

0.95

1.24

 

UK Pound (GBP)

Sterling has continued to suffer from a volatile ride since the mysterious ‘flash crash’ in October. The Pound has been particularly sensitive to all news regarding the Brexit process, and the currency fell to a fresh 31 year low at the beginning of January on expectations that the UK was heading for a “hard Brexit”, where access to the European common market is limited (Figure 4).

 

Figure 4: GBP/USD (January ‘16 – January ’17)

Source: Thomson Reuters Datastream Date: 24/01/2017

This speculation was confirmed by Prime Minister Theresa May’s highly anticipated Brexit speech in the third week of January. May acknowledged that the UK would not remain within the single market, although she claimed the UK will seek the “greatest possible” access. The Pound soared off the back of May’s tone, which was slightly more conciliatory than had been expected, and received further support from the confirmation that parliament will vote on the terms of the deal.

The Supreme Court ruling in January also ensures that parliamentary approval will be required on the timing of Article 50, which sets the two year clock ticking on Britain’s exit from the European Union. The news that the Scottish Parliament does not require a say removes a potential major stumbling block. The vote does, however, ensure it remains uncertain as to whether Theresa May will be able to follow through with her plans to trigger the formal Brexit process before the end of March.

Economic news in the UK in the past few weeks has been mixed, although the economy has actually performed fairly well since interest rates were cut to a record low in reaction to the surprise Brexit vote in August. We think the economy is performing nowhere near the dire levels that would convince the Bank of England to cut interest rates further in the coming months and overall economic performance in the UK since June has certainly surprised to the upside.

The effect of a weaker Sterling, which is currently trading over 15% lower than its pre-referendum peak, is beginning to filter its way through to domestic prices. Inflation in the UK jumped to 1.6% in December, its highest level since July 2014 and comfortably above the levels recorded in November (Figure 5).

 

Figure 5: UK Inflation Rate (2013 – 2016)

Source: Thomson Reuters Datastream Date: 24/01/2017

Moreover, the labour market in the UK continues to perform impressively. Unemployment has remained at its lowest level in a decade at 4.8%, while average earnings growth excluding bonuses also accelerated to 2.7% in the three months to November. The latest business sentiment PMI’s have also all picked up pace (Figure 6). The services PMI increased to 56.2 in December from 55.2, its highest level in 17 months, while the manufacturing PMI spiked to a 30 month high 56.1 from 53.6. Both of these key measures are comfortably above the level of 50 that denotes contraction and bode well for the final estimate of fourth quarter growth.

 

Figure 6: UK Services & Manufacturing PMI’s (2014 - 2016)

Source: Thomson Reuters Datastream Date: 24/01/2017

The Bank of England sprung no surprises in December by voting unanimously to keep its benchmark interest rate unchanged. Policymakers appeared in no rush to alter policy, although kept its options open to respond in either direction to changes in the economic outlook. The Bank of England is likely to remain in wait and see mode, although we think the next move in rates is far more likely to be a hike than a cut.

We think that the Pound will continue to remain sensitive and volatile to news and details of Britain’s EU exit in the coming months. However, we maintain existing levels are unsustainable low, and not justified by economic fundamentals. Investors also continue to price in just about the worst possible outcome to Brexit negotiations and we subsequently expect Sterling to trade in the 1.20 to 1.25 range against the Dollar, while rallying sharply versus the Euro this year.

 

 

GBP/USD

GBP/EUR

Q1-2017

1.20

1.21

Q2-2017

1.20

1.24

Q3-2017

1.21

1.26

E-2017

1.22

1.28

E-2018

1.24

1.31

 

Euro (EUR)

The Euro has stabilised somewhat so far in 2017, having had a torrid end to 2016 that saw the single currency tumble to a 14 year low against the US Dollar (Figure 7).

 

Figure 7: EUR/USD (January ’16 - January ’17)

Source: Thomson Reuters Datastream Date: 24/01/2017

This weakness in the Euro came after the European Central Bank (ECB) ramped up its efforts to boost both growth and inflation in the Eurozone in December. 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 this year or beyond, if necessary.

The Governing Council will continue purchasing 80 billion Euros a month up until the end of March, then will be lowering the monthly purchases to 60 billion Euros for the remainder of 2017. This increase in the ECB’s QE programme will now see an extra 540 billion Euros pumped into the Eurozone economy.

At its January meeting, President of the ECB Mario Draghi provided no real surprises, keeping policy unchanged and maintaining a fairly dovish tone. Draghi appeared unimpressed by the recent improvement in inflation in the Eurozone, suggesting the ECB would look past the latest spike in prices which he attributed to the recent stabilisation in global oil prices. Further, Draghi introduced a critical new focus for the ECB. In addition to overall Eurozone inflation, the divergences in inflation levels between the different countries are being monitored by the central bank.

Headline inflation in the Eurozone picked up towards the back end of 2016, increasing to a more than three year high 1.1% in December as low oil prices begin to provide less of a drag on prices (Figure 8).



Figure 8: Eurozone Inflation Rate (2012 - 2016)

Source: Thomson Reuters Datastream Date: 24/01/2017

The business activities have also picked up pace in the past few months. The composite PMI dipped slightly in January, although remains around a multi-year high 53.3 (Figure 9). Manufacturing activity also rose above expectations to its highest level in over five years.

 

Figure 9: Eurozone Composite PMI (2012 - 2016)

Source: Thomson Reuters Datastream Date: 24/01/2017

Given the improvement in economic conditions in the Euro-area we see no immediate need for the ECB to increase its already sizable stimulus measures. However, it is clear the policy divergence between the Governing Council and Federal Reserve will remain deep into 2018.

In tandem with the very loose monetary policy adopted by the European Central Bank, we also think the Euro will remain under pressure from political developments in Europe in 2017. A number of high profile elections this year are likely to begin coming into the spotlight in the next few weeks, the result of which could prove crucial to the long term future of the Euro-area as a whole.

First up, we have the general election in the Netherlands on 15 March, although anti-EU Party for Freedom leader Geert Wilders is looking very unlikely to garner enough support to form a majority government. France will also go to the polls in the final round of its election in May with populist National Front leader Marine Le Pen now in with a realistic chance of becoming next President. Online prediction website PredictIt currently gives Le Pen around a one-in-three chance of victory.

We remain of the opinion that the growing divergence in monetary policy between the European Central Bank and the Federal Reserve, combined with the growing political uncertainty in Europe, should recommence the Euro’s gradual downtrend against almost every G10 currency this year.

 

 

EUR/USD

EUR/GBP

Q1-2017

0.99

0.83

Q2-2017

0.97

0.81

Q3-2017

0.96

0.79

E-2017

0.95

0.78

E-2018

0.95

0.77

 

Japanese Yen (JPY)

The Japanese Yen (JPY) has rebounded somewhat so far in 2017, having sold-off sharply at the end of last year in reaction to a reversal in safe-haven flows into the currency in the aftermath of Donald Trump’s Presidential election victory in November.

The Yen had fallen to its weakest position in 10 months against the Dollar in December, although has since recovered around one-third of its losses (Figure 10).

 

Figure 10: USD/JPY (January ’16 – January ’17)

Source: Thomson Reuters Datastream Date: 24/01/2017
Recent weakness in the Yen will be welcome news to the Bank of Japan in its bid to lift both growth and inflation in Asia’s second largest economy. The central bank has continued to defy expectations by keeping its monetary policy unchanged. Its so-called “quantitative and qualitative monetary easing with yield curve control” will see the bank purchasing government bonds at an annual pace of 80 trillion Yen in order to maintain a 10 year government yield of around zero. This large scale easing, combined with its negative -0.1% deposit rate, will continue until inflation exceeds the central bank’s 2% target.

There have, at last, been some positive developments in inflation in the country in the past few months. The headline rate of price growth jumped to 0.5% in the year to November, only the third month of positive inflation in 2016 and its highest reading since May 2015 (Figure 11). However, consumer inflation expectations remain low and actually fell to its lowest level in four years in the three months to December. Core inflation also remains stuck below zero, with core prices declining by 0.3% in November.

 

Figure 11: Japan Inflation Rate (2013 - 2016)

Source: Thomson Reuters Datastream Date: 25/01/2017
Growth in Japan also remains relatively weak with the GDP growing by just 1.3% annualised in the third quarter of 2016. The IMF now expects the economy to grow by 0.8% in 2017, a very modest upward revision from the 0.6% predicted back in November. On a more encouraging note, exports have finally risen for the first time in 15 months year-on-year in December. Exports rose by 5.4% (Figure 12), although Donald Trump’s potential protectionist policies have raised uncertainty over the future of Japan’s trade with the US, the country’s second largest trading partner.

 

Figure 12: Japan Exports vs. Imports (2012 - 2016)

Source: Thomson Reuters Datastream Date: 25/01/2017


The Yen has weakened in line with our forecasts so far in 2017. We think that the Bank of Japan will keep its monetary policy unchanged at a very aggressive level throughout 2017. Some in the markets are expecting a tightening of Bank of Japan policy at some point in 2017. We think these expectations will be disappointed, and therefore the Yen will remain under pressure against most major currencies into 2018.

 

 

USD/JPY

EUR/JPY

GBP/JPY

Q1-2017

113

112

136

Q2-2017

118

114

142

Q3-2017

119

114

144

E-2017

120

114

146

E-2018

120

114

149

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