Euro under pressure ahead of crucial December announcements

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December 2016 is shaping up as an especially busy month in the currency markets. A number of significant economic and political announcements are likely to create a volatile and uncertain trading environment.

The Federal Reserve in the US is almost certain to hike interest rates for the first time in a year, while the European Central Bank is looking likely to extend its quantitative easing programme. Italy goes to the polls in a constitutional referendum, the result of which could ramp up support for anti-establishment movements across Europe ahead of a number of crucial elections in 2017. Investors are also weighing up the possible impact of a Donald Trump presidency in the US next year, while newswires in the UK are focusing heavily on the likely timing of when Britain’s government will trigger Article 50.

The prospect of higher growth and interest rates in the US and jitters about the political calendar in Europe have already caused a sharp appreciation of the Dollar against almost every major and emerging market currency since the US election.

The Euro and Japanese Yen have proven particularly vulnerable among G10 currencies. The common currency has fallen sharply since the election, sinking to its weakest position against the Dollar since March 2015 (Figure 1) and the Yen has plunged by over 10% to its lowest level in ten months.

Figure 1: EUR/USD (November ’15 - November ’16)

Source: Thomson Reuters Datastream Date: 30/11/2016

We think there is scope for a further strengthening in the Dollar in the coming months as the macroeconomic divergence between the US and Europe increases and political risks in the Eurozone come into focus.

ECB set to extend QE programme

The European Central Bank (ECB) will be announcing its monetary policy decision following its two day meeting on 8 December. Expectations for an extension in the ECB’s quantitative easing programme have grown in the past few months as policymakers continue their efforts to boost growth and stimulate inflation in the Euro-area.

At the Governing Council’s last meeting in October, the central bank kept its monetary policy unchanged. The main refinancing and deposit rates were unaltered at 0% and -0.4% respectively, with the quantitative easing programme maintained at 80 billion Euros a month. President of the ECB Mario Draghi has defied recent speculation by failing to formally announce an extension in the large scale asset purchasing programme beyond the existing March 2017 end date.

However, Draghi sent a strong signal that an extension in the QE programme could be on the way, brushing aside an earlier report that the ECB might start tapering the programme. Draghi reiterated the central bank remained “committed to preserving the very substantial degree of monetary stimulus”, and is likely to be awaiting next month’s new set of economic projections before deciding on its next change in policy.

So far, the central bank’s large scale asset purchasing programme has failed to deliver the desired effect on consumer prices. Core inflation has remained well under one percent throughout the entire year so far, registering just 0.8% in November. The headline rate of inflation has improved in the past few months, although still remains well below the ECB’s “close to but below” 2% target at 0.6% (Figure 2).

Figure 2: Eurozone Inflation Rate (2013 - 2016)

Source: Thomson Reuters Datastream Date: 30/11/2016

The persistently weak level of inflation in the Eurozone and string of dovish comments from Mario Draghi of late means that we think the Governing Council is now very likely to announce at least a six month extension in its QE programme at its 8 December meeting.

Federal Reserve on course for second rate hike

Less than a week after the ECB announces its monetary policy decision, the Federal Reserve in the US is almost universally expected to hike interest rates for the second time since the financial crisis of 2008-9.

In the immediate aftermath of the election result, markets initially discounted the possibility of an interest rate hike by the Fed this year. However, the chances of a hike before the end of the year priced in by markets have increased significantly in the past couple of weeks and we think there is now a strong argument that the Fed could hike at a faster pace than most analysts had originally envisaged.

Trump’s plans to significantly expand infrastructure spending and cut taxes means growth in the US may now surprise to the upside next year. His protectionist policies are also likely to drive up inflation, and there is increased risk that inflation will overshoot the Fed’s 2% target in 2017. Consumer prices have already accelerated rather rapidly in the past few months, with headline inflation rising to a two year high 1.6% in October (Figure 3). Recent rises in commodity prices mean that the dampening effect on inflation of lower energy prices will no longer be present throughout 2017.

Figure 3: US Inflation Rate (2013 - 2016)

Source: Thomson Reuters Datastream Date: 30/11/2016

Even prior to the election the Fed made it clear that higher interest rates were coming. At the FOMC’s November meeting, there were already two dissenters calling for immediate interest rate increases. We think a hike in December is now a near certainty and think that upward pressure on both growth and inflation will force the Fed’s hand next year. Even more important, we expect to see upward revisions in the FOMC’s projections for future inflation, growth and rates

A general improvement in economic conditions in the US is clearly noticeable in the latest data. This is particularly visible in the labour market. Unemployment has fallen, while earnings growth remains comfortably above 2%. The latest nonfarm payrolls figures have also been consistent with the need for higher rates. The US economy created 156,000 jobs in September, with the twelve month average of job creation remaining in excess of 200,000 throughout 2016 (Figure 4).

Figure 4: US Nonfarm Payrolls (2010 - 2016)

Source: Thomson Reuters Datastream Date: 30/11/2016

Financial markets are placing in excess of a 95% chance of a rate hike at the Fed’s December meeting. We think that the Fed will continue to increase rates by about 0.25% a quarter throughout 2017 and 2018, as fiscal stimulus hits an economy already nearing full employment and inflation and wages growth continues to trend higher.

‘No’ vote ahead in Italian referendum polls

Since taking office in 2014, Italy’s Prime Minister Matteo Renzi has made it one of his top priorities to push through a number of key constitutional changes aimed at slimming down the country’s legislature and speeding up lawmaking. The referendum, to take place on 4 December, will give Italians a chance to vote on a package of reforms aimed at reducing the size and powers of the Senate and overhauling the electoral system.

Almost all of the recent opinion polls have put the “No” vote ahead, albeit only by a very narrow margin. The PredictIt website, where users bet on the outcome of political events, puts the chances of a Yes vote at a lowly 20% (Figure 5). Bookmakers are currently placing around a three-in-four chance that the proposed reforms will be rejected.

Figure 5: PredictIt Italian Referendum [Probability of Yes vote] (October ‘16 - November ‘16)

Source: Date: 30/11/2016

However, the high percentage of undecided voters (which has ranged between 16-26%) means that the outcome of the referendum remains relatively uncertain. Renzi has promised to resign should the No vote prevail. This would lead to an unwanted period of political uncertainty and may bring forward parliamentary elections, currently due to take place in 2018. This could pave the way for anti-establishment and Eurosceptic Five-Star Movement Party to rise to power in Italy - they are currently polling neck and neck with the ruling Democratic Party at around 30%.

What’s next for the Euro?

We’ve already seen an overwhelmingly positive reaction in the US Dollar to the prospect of a Donald Trump presidency. Higher growth and gradually increasing interest rates by the Fed next year should continue to support the greenback, and we maintain our view for a continued strengthening of the Dollar against almost every other major currency in 2017.

The significant uncertainty from the rising support for anti-establish movements within Europe should lead to an especially pronounced appreciation of the Dollar against the Euro. We expect EUR/USD to reach parity at some point in the first quarter of next year.



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