What to expect in the Foreign Exchange markets in 2018

Print Friendly and PDF

Perhaps the two most significant stories in the currency markets in 2017 were the impressive performance of the Euro and the sharp sell-off in the US Dollar against every other G10 currency.

The Euro rebounded strongly from its fourteen year low last year, appreciating by around 15% and ending the year as the world’s best performing major currency. Fears of Eurosceptic parties triumphing in key elections failed to materialise. Spain managed to brush aside the separatist flare-up in Catalonia, the Netherlands voted for the status quo in its general election, while the market reacted positively to the election of centrist Emmanuel Macron in France. European politics will continue to take on importance this year with Italy set to go to the polls in March and Angela Merkel still working on forming a coalition government in Germany.

The Euro-area economy also continued its impressive recovery in the second half of last year, expanding at a pace that has far exceeded even optimistic expectations. Investors have subsequently grown increasingly confident that the European Central Bank could end its quantitative easing programme this year, having extended the programme through to September 2018 at its October meeting. It has, however, made it clear it has no plans to raise rates until after the end of the QE programme amid soft inflation and we think its reluctance to do so could recommence the trend of Euro weakness this year.    

Despite the Federal Reserve raising interest rates on three occasions in 2017, the greenback had a difficult year, losing over 10% of its value against its major counterparts (Figure 1).

Figure 1: US Dollar Index (January ‘17 - January ‘18)

Captura_de_pantalla_2018-01-11_a_las_10.57.18.png

Source: Thomson Reuters Datastream Date: 10/01/2018

 

Officials at the Federal Reserve continued to strike an optimistic tone over the state of the US economy at the central bank’s most recent meeting in December and we are unlikely to see a let up in its plans to normalise monetary policy this year. US core inflation is close to target, the country’s labour market is creating jobs at a steady pace ten years into the current expansion and Trump’s tax overhaul is expected to provide a modest boost to both consumption and investment.

The Fed’s December ‘dot plot’ showed that it expects to raise rates on around three occasions before the year is out. We expect to see three or possibly even four additional hikes in the US this year starting in March, a faster pace than markets would suggest. Fed fund futures show two hikes are currently 75% priced in by the market, with three hikes 35% priced in before the end of 2018. Once the market becomes more in line with the Fed, we think an appreciation of the Dollar is likely. The appointment of Jerome Powell as the Fed’s next Chair to succeed Janet Yellen in February will not, in our view, materially impact either the pace or timing of hikes this year.   

In the UK, the ongoing Brexit discussions will remain the main risk to the outlook for the Pound in 2018. After a disastrous 2016, last year was one of consolidation for Sterling with investors taking on a generally more optimistic stance over the state of the negotiations. The end date for Brexit to be completed is March 2019, and with Theresa May seemingly motivated to get a deal done before then, we could see a transitional deal that results in a softer exit that many had feared, and may include UK access to the common market for an indeterminate period of time.

We also think that the market is currently underestimating the chances of another interest rate increase from the Bank of England this year, following its first hike in a decade in November. We see a solid chance that the BoE could raises rates towards the end of the year, should consumer inflation in the UK remains stubbornly above its 2% target (Figure 2).  

Figure 2: UK Inflation Rate (2013 - 2017)

Captura_de_pantalla_2018-01-11_a_las_10.59.17.png

Source: Thomson Reuters Datastream Date: 10/01/2018

 

Elsewhere, global growth and inflation are both starting to pick-up pace and we see a number of G10 central banks following suit with the Federal Reserve in beginning on a gradual path of interest rate increases. The Bank of Canada has already begun tightening policy, raising rates on two occasions last year and signalling it is ready to hike again in the first quarter. An improving economic environment in both Australia and New Zealand means that the RBNZ and RBNZ could also, at the very least, signal that hikes are possible.   

As for emerging markets, geopolitical risks could take on added importance in 2018. Federal Reserve rate hikes have traditionally been a headwind for emerging market currencies. However, these remain, generally speaking, at undervalued levels. The interplay between these factors means that EM currency performance is likely to be highly idiosyncratic and investors will favour those with the strongest fundamentals.

 

 

Have more questions? Submit a request