G3 forecast revision - July 2017

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US Dollar (USD)

 

The US Dollar has continued to trade around its weakest position since last year’s Presidential Election in the past month (Figure 1). The currency slipped to its lowest level in trade-weighted terms in nine months in June, with hopes evaporating that President Donald Trump will be able to force through any sort of fiscal stimulus in the US this year.

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

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Source: Thomson Reuters Datastream Date: 26/06/2017

Trump’s pledge during his election campaign to increase government spending on infrastructure by $1 trillion are unlikely to come to anything in our view, while the chances that he’ll be able to enact any sort of meaningful tax cuts in 2017 are now materially lower. The IMF has even cut its outlook for the US economy, removing its assumption that Trump’s plans to cut taxes and ramp up spending would increase growth.

Expectations for a slower than expected path of interest rate hikes by the Federal Reserve this year has also attributed to much of the softness in the Dollar, even though the Fed hiked interest rates again at its June meeting. The FOMC increased their main interest rate by a further 25 basis points to a range between 1-1.25%, their third consecutive quarterly increase in the fed funds rate. Chair Janet Yellen also struck a fairly optimistic tone on the overall health of the US economy during her press conference. Policymakers overlooked the relatively soft performance in the US in the first quarter of the year, which it deemed as temporary. GDP expanded by a slightly disappointing, albeit upwardly revised 1.4% annualised in the three months to March, its slowest rate of growth since the beginning of 2014.

Janet Yellen also sounding a hawkish note by referring to the “very strong” labour market, while claiming economic activity had been rising moderately so far this year. The recent jobs reports out of the US, arguably the main economic release the Fed looks at when deciding on monetary policy, have been fairly mixed, although sufficient in our view to warrant higher interest rates. The US economy added 138,000 jobs in May with a mere 224,000 created in the previous two months combined. The three month moving average of nonfarm payrolls has now even fallen to its lowest level since July 2012, although remains around the level deemed necessary to keep up with growth in the labour force. The unemployment rate has continued to impress and is now around the level deemed as full employment by the Fed, falling to a 16 year low 4.3% in May. Wage growth has, however, been fairly sluggish and slow to react to the recent decline in the jobless rate (Figure 2).

Figure 2: US Nonfarm Payrolls (2012 - 2017)

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Source: Thomson Reuters Datastream Date: 26/06/2017

Inflation in the US has also been on downward trend in the past few months, although the Fed has again attributed this largely to one off factors including a steep drop in the cost of mobile phone services. The headline rate of consumer price growth fell to a six month low 1.9% in May (Figure 3), while the core measure declined to just 1.7%, its lowest level since early 2015. The Fed’s preferred measure of inflation, the PCE index, has also slipped to 1.7%, although this is expected to increase back to the central bank’s 2% target at some point next year.

Figure 3: US Inflation Rate (2013 - 2017)

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Source: Thomson Reuters Datastream Date: 26/06/2017

Even amid the relatively disappointing inflation news, policymakers in the US surprised much of the market by keeping their expectations for future hikes broadly unchanged in June from their previous projections in March. The central bank’s “dot plot”, which represents where each member of the committee expects rates to be at the end of each year, showed that the Fed now expects one additional hike in 2017 and a further three next year, a much faster pace than the market is currently pricing in (Figure 4).

Figure 4: FOMC June Dot Plot

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Source: Federal Reserve Date: 14/06/2017

The indefinite delay of both the tax cut and the infrastructure package led us to revise our call from two hikes to just one in the second half of 2017. This will probably happen at the December meeting, while the Fed will use the September meeting to firm up plans to begin reducing its balance sheet. We also expect an additional three times next year provided the US economy continues to tick along nicely. There is now a major gap between interest rate expectations for further Fed moves and those of Federal Reserve officials themselves. We expect rate markets to eventually throw in the towel and price a path for hikes consistent with the dot plot. This should keep the Dollar well supported against its major peers, although any move to tighten policy on the ECB’s part would significantly limit any meaningful appreciation versus the Euro.

 

EUR/USD

GBP/USD

Q3-2017

1.08

1.29

E-2017

1.06

1.30

Q1-2018

1.05

1.30

Q2-2018

1.05

1.31

E-2018

1.05

1.32

 

UK Pound (GBP)

 

Sterling has suffered from a particularly volatile few weeks following the surprise result of the snap General Election in June. The Pound rallied to its strongest position in seven months in May in anticipation that Theresa May’s Conservative Party would secure a comfortable majority victory. However, the currency depreciated by 2% against the Dollar on election night after the Conservatives unexpectedly fell short of an overall majority (Figure 5).

Figure 5: GBP/USD (June ‘16 - June ’17)

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Source: Thomson Reuters Datastream Date: 26/06/2017

Once again the opinion polls were proven wrong in June. The bulk of the surveys had given Theresa May’s party a comfortable advantage going into the vote. The Conservative Party obtained just 317 seats, a drop of 13 on the 330 obtained in 2015, and 9 seats short of an overall majority. The Tories have since formed a minority government with the Democratic Union Party (DUP) after two weeks of negotiations. While this eliminates the near term uncertainty of a hung parliament, the election result is likely to weaken the Prime Minister’s hand in the crucial Brexit negotiations, which formally began in June. The negotiations themselves are likely to be long and drawn out and are looking increasingly likely to take longer than the two year window set out in Article 50.

On the macroeconomic front, the UK economy has continued to tick along relatively well, despite the uncertain political backdrop. The Bank of England’s MPC surprised the market in June with an additional two of the eight committee members, Ian McCafferty and Michael Saunders, joining outgoing policymaker Kristin Forbes in voting for an immediate interest rate hike. The minutes of the meeting were also relatively hawkish, citing an expectation that inflation will now overshoot the BoE’s target by more than previously expected.

The chances of a sooner-than-expected hike have been given a significant lift by the recent sharp increase in inflation in the UK which has surged back towards 3%. Headline consumer prices rose by 2.9% May (Figure 6), its highest level in four years, while core inflation also increased to 2.6%. We have been saying for a while there is a limit as to how high inflation can go before the Bank of England begins discussing higher rates and the increase in dissenters at the latest meeting vindicates this view. We think there is a good chance we could see additional committee members calling for higher rates at the next few meetings, particularly should inflation exceed the 3% level, as expected.

Figure 6: UK Inflation Rate (2013 - 2017)

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Source: Thomson Reuters Datastream Date: 15/05/2017

Activity in the UK economy has also picked up pace following a slightly disappointing start to the year that showed growth slowed to just 0.3% in the first three months of 2017. The services and manufacturing PMI’s have both accelerated, with the composite index comfortably above the level of 50 that denotes expansion at 56.2 in April (Figure 7). A significant stumbling block to higher growth in the UK this year is the now negative real earnings growth, which is now at a three year low -0.5%. We note, however, that this is entirely due to the pickup in inflation rather than any softness in nominal wage growth.

Figure 7: UK Services & Manufacturing PMI’s (2014 - 2016)

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Source: Thomson Reuters Datastream Date: 26/06/2017

We remain fairly optimistic about the UK economy and still think that there is a very good chance the Bank of England could acknowledge as much by raising interest rates for the first time in a decade at some point towards the back end of 2017. In fact, the chorus of hawkish voices from the MPC raises a real possibility that the hike will happen as early as September, unless inflation surprises clearly to the downside in the interim.

However, following the loss of the Tories’ majority at June’s election it is clear that hopes of Britain achieving a more favourable deal with the EU have taken a blow. We see Bank of England hawkishness more or less balanced out by this uncertainty, and keep our Sterling forecasts unchanged. We expect only a relatively modest appreciation of the currency against the US Dollar.

 

 

GBP/USD

GBP/EUR

Q2-2017

1.28

1.16

Q3-2017

1.29

1.19

E-2017

1.30

1.23

Q1-2018

1.30

1.24

E-2018

1.32

1.26

 

Euro (EUR)

 

The Euro has continued on its relentless upward trend against the US Dollar since mid-April, soaring to its strongest position in 14 months in June. Sentiment towards the common currency has improved significantly in the past few months amid a general improvement in economic conditions within the Euro-area and growing expectations that the European Central Bank (ECB) will announce a winding down of its stimulus programme at some point later this year (Figure 8).

Figure 8: EUR/USD (June ’16 - June ’17)

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Source: Thomson Reuters Datastream Date: 26/06/2017

The ECB sprung no surprises by keeping its policy unchanged again in June, although it did drop the reference in its statement about the possibility of further rate cuts. The ECB acknowledged momentum in the Euro-area economy had picked up pace since the last meeting and that growth would be stronger-than-expected. Yet, Draghi reiterated the message that while serious downside risks to the economy had receded, continued QE would be necessary for inflation to reach its target. The ECB actually issued a rather sharp downgrade to its inflation projections and now predicts prices to grow by 1.5% this year (down from 1.7%) and a meagre 1.3% in 2018 (down from 1.6%).

However, investors have grown increasingly confident that Draghi will soon announce a tapering, or dialling back, of the central bank’s QE programme following an impressive rebound in economic activity in the Eurozone. Growth in the first quarter of 2017 rose to 0.6%, outpacing both the US and UK economies. The latest business activity PMIs out of the Eurozone have also been impressive, pointing towards another robust performance in the second quarter of the year. Both the services and manufacturing PMIs have increased to multi-year highs in recent months. The crucial composite PMI, an index representing a weighted average of the two sectors, rose to its highest level since 2011 in May at an above forecast 56.8, albeit dipping to 55.7 in May following a slowdown in services activity (Figure 9).

Figure 9: Eurozone Composite PMI (2014 - 2017)

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Source: Thomson Reuters Datastream Date: 26/06/2017

Headline inflation rose to a four year high in February, although it has since trailed off to just 1.3% in June (Figure 10). The level of core inflation in the currency bloc, however, remains pinned well below the central bank’s “close to, but below” 2% target. Core inflation did increase to an above consensus 1.2% in June, although this was driven predominantly by volatile components and there is a good chance that this modest bounce could prove temporary.

Figure 10: Eurozone Inflation Rate (2013 - 2017)

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Source: Thomson Reuters Datastream Date: 26/06/2017

Expectations that Mario Draghi could soon be announcing a tapering of the QE programme were given a boost in June after he seemingly hinted that a policy adjustment could be on the way. We think that the sharp upward move in the Euro off the back of the news was an overreaction and a report from ECB sources acknowledged as much by claiming Draghi intended to prepare the market for decision on stimulus, rather than marking a firm commitment.

Regardless, it is clear that economic conditions in the Eurozone are improving and there is now a good chance we’ll see an announcement later in the year that a tapering in the quantitative easing programme is coming. However, we remain of the view that the Governing Council would need to see a more sustained rebound in inflation, particularly the core index, before it commits to dialling back its stimulus programme. Until we see such a rebound, we maintain our forecasts for a depreciation in the Euro, although the impressive rebound in activity in the Euro-area means we forecast only a gradual sell-off.

 

 

EUR/USD

EUR/GBP

Q3-2017

1.08

0.84

E-2017

1.06

0.82

Q1-2018

1.05

0.81

Q2-2018

1.05

0.80

E-2018

1.05

0.80

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