G3 forecast revision - October 2017

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US Dollar (USD)

The US Dollar continued to suffer in the third quarter of 2017, despite the Federal Reserve signalling it is ready to hike interest rates again in December. The currency fell to its weakest position against its major peers since January 2015 in September (Figure 1), although has experienced a modest rebound in the past few weeks. Regardless, the Dollar still remains over 9% lower for the year.

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

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Source: Thomson Reuters Datastream Date: 05/10/2017

The Trump Administration has been of little help to the currency and the tax cuts and infrastructure spending promised during his election campaign have yet to materialise. With efforts to overhaul Obamacare looking dead in the water, the Trump administration will turn its attention to tax reform and it is now looking more likely than not that some form of tax cuts will be passed by early next year. Geopolitical tensions in North Korea following a series of missile strikes have also done little to improve sentiment towards the currency, causing investors to flock to the safe-havens and away from the greenback.

The Dollar did, however, receive some respite from its sharp sell-off following the Federal Reserve’s September meeting in which policymakers kept the door firmly open to a third interest rate hike in a calendar year in December. Policymakers took the market by surprise by keeping their interest rate projections broadly unchanged from June, despite a recent bout of below target inflation. The Fed’s ‘dot plot’, which indicates where each member of the committee expects rates to be at the end of each year, still sees one more rate increase in 2017 followed by an additional three hikes in 2018 (Figure 2). 11 of the 16 members of the committee expect the central bank’s benchmark interest rate to be in a range between 1.25% and 1.5% by the end of the year with only 4 forecasting no change, the same number as in June.

Figure 2: FOMC ‘Dot Plot’ versus OIS Curve (2017 - 2020)

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Source: Bloomberg Date: 22/09/2017

The Federal Reserve’s assessment of the US economy was also upbeat, slightly more so than the market had anticipated. While the September statement specifically mentioned the disruption in activity caused by Hurricane Harvey, Irma and Maria, the committee signalled that it would unlikely change its assessment of the economy over the medium term. Yellen also did nothing to damp optimism during her press conference, claiming that the recovery is still on track. She noted strength in exports and business investment, while suggesting that labour market slack had largely disappeared.

Recent economic data out of the US labour market has continued to point to a tightening in labour market conditions that would warrant higher interest rates. The most recent nonfarm payrolls report for August was a slight disappointment, although the economy continues to create jobs at a sufficiently fast pace to keep up with growth of the labour market. The US economy added 156,000 jobs in August, bringing the three month moving average back to a healthy 185,000 (Figure 3). Unemployment of 4.4% is also around the level deemed as full employment by the Fed.

Figure 3: US Nonfarm Payrolls (2013 - 2017)

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Source: Thomson Reuters Datastream Date: 05/10/2017

Despite recent hawkishness from the Fed, expectations for the pace of additional tightening has been dialled back somewhat since the beginning of the year following a slowdown in inflation. The main headline rate of price growth declined to an eight month low in June, although has since returned back to 1.9%, just shy of the Federal Reserve’s target (Figure 4). The Fed’s preferred measure of inflation the PCE index has, however, slipped to 1.4% and would need to see a more sustained rebound to convince the Fed to hike rates on multiple occasions next year.   

Figure 4: US Inflation Rate (2013 - 2017)

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Source: Thomson Reuters Datastream Date: 05/10/2017

In our view, it is clear that the Federal Reserve has every attention of hiking interest rates at its December meeting when a fresh set of economic projections will be released. Despite narrowing following the Fed’s hawkish assessment in September there is still a clear disconnect between markets expectations for future hikes and that of the Fed. Financial markets are just about pricing in another rate increase this year and only one additional hike in 2018, a much slower pace than the FOMC’s ‘dot plot’ (Figure 2). As financial markets begin to reprice their expectations for the future path of hikes more in line with that of the Fed, we expect to see a further strengthening of the US Dollar against most major currencies.

 

 

EUR/USD

GBP/USD

E-2017

1.14

1.33

Q1-2018

1.12

1.33

Q2-2018

1.10

1.34

Q3-2018

1.10

1.34

E-2018

1.10

1.35

 

 

UK Pound (GBP)

The Pound staged an impressive rally against its major peers in the third quarter. The currency appreciated sharply in the immediate aftermath of the Bank of England’s September meeting, in which policymakers in the UK hinted that higher interest rates were on the horizon.

Sterling jumped by over 5% against the Dollar in September alone to its strongest position since the Brexit vote and has now retraced over 10% of its losses since the referendum, albeit losing ground again since the start of October (Figure 1).

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

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Source: Thomson Reuters Datastream Date: 05/10/2017

We have been saying for a number of months now that the Bank of England would have no choice but to consider raising interest rates this year should inflation in the UK increase to around the 3% mark. This view appears to have been justified following the BoE’s most recent meeting, where we saw a rather dramatic shift in tone that would suggest a first interest rate hike in a decade is just around the corner. There were no surprises in the vote, with hawks Ian McCafferty and Michael Saunders remaining the two sole dissenters. Policymakers did, however, voice less tolerance for above target inflation with a ‘majority’ of members judging that some removal of stimulus would be appropriate should they see a ‘gradual rise in underlying inflationary pressure’. The minutes of the meeting also noted that there were signs that the slack in the economy was being absorbed more rapidly than expected.

We think there is now a very good chance that we’ll reach a tipping point at the next meeting in November in which at least five members of the MPC vote in favour of an immediate hike. We had speculated that chief economist Andy Haldane may be close to following suit in September and it may only be a matter of time before he supports a rate rise later in 2017. Even Gertjan Vlieghe, deemed by many as the most dovish of all the committee members, has claimed that the central bank may need to raise rates in the coming months. His rather dramatic hawkish shift suggests that the majority among the committee may be tilting towards tightening before year end.

The adoption of a more hawkish stance from the Bank of England has followed a recent sharp increase in the rate of UK inflation. Consumer prices rose to a five year high 2.9% in August. The core measure of inflation, which strips out the volatile energy component, also increased above forecast to 2.7%, its highest level since December 2011 (Figure 6). A weaker Sterling following last year’s referendum and the sharp increase in global oil prices since June should continue to filter its way through to higher prices in the near term.     

Figure 6: UK Inflation Rate (2012 - 2017)

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Source: Thomson Reuters Datastream Date: 05/10/2017

The UK economy has also continued to expand at a reasonable pace and the ongoing uncertainty from the Brexit negotiations has so far failed to have any materially damaging downside effects on output. Growth was a slightly underwhelming 0.3% in the second quarter of the year following a disappointing performance in consumer spending and investment. The business activity PMIs have, however, been solid and the crucial services index continues to print comfortably above the level of 50 that denotes expansion, coming in a 53.2 in August. As we mentioned in our last forecast revision a fairly significant stumbling block to higher growth in the UK is the negative real earnings growth which stands at -0.5%. This has, however, been driven almost entirely by the inflation pick-up and nominal earnings have remained at a fairly healthy level around 2%.

Figure 7: UK Real Earnings Growth (2011 - 2017)

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Source: Thomson Reuters Datastream Date: 05/10/2017

We remain relatively bullish about the prospects for the Pound. Concerns over the ongoing Brexit negotiations appear to have taken a backseat and it is pretty clear that we are unlikely to have any concrete details on the effect of the negotiations on the UK economy for some time.

In the absence of Brexit news, investors are firmly focusing on monetary policy and the market is increasingly coming round to the view that the Bank of England will hike interest rates for the first time since 2007 at its November meeting (Figure 9). The faster than expected pace of policy normalisation from the BoE should ensure Sterling is well supported against both the Dollar and Euro in 2018 and we maintain our forecasts for a gradual appreciation of the Pound against most major currencies.  

Figure 8: BoE Rate Hike Probability November 2017 (January ’17 - September ’17)

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Source: Bloomberg Date: 22/09/2017

 

 

GBP/USD

GBP/EUR

E-2017

1.33

1.17

Q1-2018

1.33

1.19

Q2-2018

1.34

1.22

Q3-2018

1.35

1.22

E-2018

1.36

1.23

 

 

Euro (EUR)

The seemingly relentless rally in the Euro in the first eight months of the year stalled somewhat in September. The surprisingly poor showing of Angela Merkel’s CDU Party at Germany’s general election sent the currency to a one month low against the US Dollar and has created renewed concern among investors regarding political fragmentation in Europe.

Germany’s general election at the end of September saw a surge in support for the far-right, anti-immigration Alternative for Germany, which became the first far-right party to obtain a seat in parliament in over half a century. Recently appointed French President Emmanuel Macron also suffered from an underwhelming showing in the latest Senate election amid rising disenchantment with his leadership. The ongoing conflict over Catalonia’s status within Spain has only added to the political uncertainty in the Eurozone.

The currency had previously jumped to its strongest position in over two-and-a-half years earlier in the month on growing expectations that the European Central Bank (ECB) will soon announce it is ready to begin tapering its large scale stimulus programme (Figure 10).

Figure 9: EUR/USD (October ’16 - October ’17)

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Source: Thomson Reuters Datastream Date: 05/10/2017

The European Central Bank hinted at its most recent meeting in September that it is close to beginning the process of winding down its quantitative easing programme. Comments from President Mario Draghi during the press conference were actually fairly dovish again as he added little new information. He claimed that the bank’s QE programme had not yet translated into stronger inflation dynamics and reiterated that both its size and duration could be extended, if required. On the topic of the Euro, Draghi also expressed concern about recent common currency strength that represents a source of uncertainty that must be monitored.

Draghi instead suggested that a policy announcement could happen at the next meeting, claiming that the ‘bulk of decisions’ on the stimulus programme will probably take place in October. The ECB had previously said that discussions among the Governing Council on the QE programme would take place ‘in the autumn’.

The ECB’s reluctance to commit to a tightening in policy suggests that the central bank is clearly wary of continually below target inflation in the Euro-area. Headline inflation hits its 2% target for the first time in four years at the beginning of 2017, although has since fallen back to just 1.5% in September.  The level of core inflation in the currency bloc also remains pinned well below the central bank’s ‘close to, but below’ 2% target, coming in at a mere 1.1%. This closely watched index has now failed to breach the 2% level for the past fourteen years and the chances of it returning back to the ECB’s target any time soon remain remote.  

Figure 10: Eurozone Inflation Rate (2013 - 2017)

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Source: Thomson Reuters Datastream Date: 05/10/2017

We’ve also seen another impressive bounce in economic activity in the currency bloc and the Eurozone economy is now far outpacing that of both the US and UK for the first time in a number of years. The recent business activity PMIs have been very impressive, suggesting that the Eurozone economy is likely to put in another robust performance in the third quarter of the year. The manufacturing PMI jumped to a six year high 58.2 in August following an impressive performance in both Germany and Italy, while August’s composite PMI is now just shy of its highest level since 2011. Draghi’s recent assessment of the Eurozone economy has been bullish, claiming that growth would outpace its historic average in the coming quarters.

Figure 11: Eurozone Composite PMI (2014 - 2017)

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Source: Thomson Reuters Datastream Date: 05/10/2017

Despite the clear improvement in economic conditions in the Eurozone we continue to think we’ll need to see an increase in core inflation before the European Central Bank announces it is ready to announce a tapering in its stimulus measures towards zero. We expect Draghi to announce in October that the Governing Council will extend the QE programme into 2018, with plans to begin gradually winding it down in January. Any tapering that does come is likely to be modest in nature and we do not anticipate an announcement on the timeframe for when the programme will be brought to an end.

Given our expectation for only a very gradual removal of stimulus from the ECB we continue to forecast a depreciation of the Euro against the US Dollar this year following a stabilisation in 2018.  However, we modestly revise higher our year end forecast to reflect recent common currency strength.

 

 

EUR/USD

EUR/GBP

E-2017

1.14

0.86

Q1-2018

1.12

0.84

Q2-2018

1.10

0.82

Q3-2018

1.10

0.82

E-2018

1.10

0.81

 

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