G3 Forecast Revision - April 2018

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US Dollar (USD)


The US Dollar (USD) has traded within a relatively tight range against its major peers since our last forecast revision, having slumped to its lowest level in more than three years in trade-weighted terms in mid-February (Figure 1). Headwinds from expectations for a faster pace of interest rate hikes from the Federal Reserve have been met by downward pressure from ongoing concerns surrounding the protectionist rhetoric out of the Trump administration, as well as strong economic data worldwide.


Figure 1: US Dollar Index (April ’17 - April ’18)

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Source: Thomson Reuters Datastream Date: 11/04/2018


We think that the market is still overlooking the widening in interest rate differentials between the Federal Reserve and almost every other G10 central bank. At its most recent monetary policy meeting in March, Jerome Powell’s first as the new Chair, the Federal Reserve announced it was raising interest rates for the first time so far in 2018, as was universally expected. The committee voted unanimously to hike rates by an additional 25 basis points to a range between 1.5-1.75% as the central bank continues on its path of gradual policy normalisation.


With fed fund futures showing that the market was fully pricing in a hike going into the meeting, investors were instead far more concerned with the release of the FOMC’s latest ‘dot plot’ for an indication as to the likely pace of further rate increases in the US in 2018. As we had anticipated prior to the meeting, the ‘dot plot’, which shows where each member of the committee expects rates to be at the end of each year, was revised higher from the previous set of economic projections released in December, albeit only modestly. Policymakers in the US continue to expect to hike on three occasions in 2018, although it is important to note that there is a sizeable disparity between the median and mean measures of future hikes in 2018. While the median estimate for hikes this year was more-or-less unchanged, there was a fairly sharp increase in the mean dot. This suggests to us that many of the voting members on the committee are open to the possibility of as many as four rate increases in the US this year.


Median rate projections for 2019 and 2020 were also shifted upwards. The committee now anticipates rates to end next year at an average of 2.9%, implying three hikes in 2019 compared to two expected in December, and 3.4% in 2020, up sharply from the previous 3.1% estimate (Figure 2)


Figure 2: FOMC March Meeting ‘Dot Plot’

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Source: Federal Reserve Date: 21/03/2018

 

Recent communications out of the central bank have also remained upbeat. The Fed argued in its March statement that the US jobs market was ‘strong’ and that the economic outlook had ‘strengthened in recent months’. The US jobs market, in particular, has actually strengthen from last year. The latest nonfarm payrolls report was slightly disappointing, although the overall outlook remains a healthy one. The US economy created another 103,000 net jobs in March which, while significantly below the near two-year high 326,00 created in February, ensures that the three month moving average is still running above the recent average at just above the 200,000 mark (Figure 3). The twelve month moving average is also now back at its highest level since August last year.


Figure 3: US Nonfarm Payrolls (2013 - 2018)

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Source: Thomson Reuters Datastream Date: 26/03/2018


At 4.1%, unemployment is the lowest seen in the country in nearly seventeen years and around the level deemed as full employment by the Fed. The participation rate has also climbed to 62.9% although still remains low by historical context, suggesting there is still some slack left in the US jobs market to draw workers into the labour force. Wage growth has also increased and at 2.7% is just shy its highest rate in a number of years. There are tentative signs that low unemployment is finally beginning to filter its way through to acceleration in wage growth, which has remained comfortably above the level of inflation in almost every month since late-2012.


The US economy has continued to grow at a healthy pace, expanding by another 2.5% annualised in the final quarter of last year, having accelerated to a three year high in Q3. Policymakers in the US revised upwards their forecasts for growth at the March FOMC meeting and now expect the world’s largest economy to expand by 2.7% in 2018 from the previous 2.5% estimate. It has been estimated that the passing of Donald Trump’s tax policies could add around 0.4% to growth in 2018 alone. The Fed has also recently updated its inflation outlook and could upgrade it further should unemployment continue to trend lower. Headline inflation has now been above 2% in each of the six months through to February (Figure 4). The core rate is just shy of the Fed’s 2% target while the PCE index, the Fed’s preferred measure of price growth, has also increased back to 1.8%.


Figure 4: US Inflation Rate (2013 - 2018)

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Source: Thomson Reuters Datastream Date: 11/04//2018


The main stumbling block to US Dollar strength of course remains the ongoing concerns over Donald Trump’s Presidency and the geopolitical tensions created by his protectionist rhetoric. Trump somewhat controversially announced the imposition of tariffs on steel and aluminium imports of 25% and 10% respectively in March. While both Canada and Mexico will be temporarily except from these tariffs, subject to a successful renegotiation of NAFTA, this has ignited serious concerns over a full on trade war with many of the country’s major trading partners, particularly China. We still believe, however, that the protectionist rhetoric is a negotiation ploy rather than a serious attempt to restrict international trade flows. Any move in this direction would be opposed by the US economic and financial establishment, and we doubt Trump has the interest or political capital to start a serious war on this front. Trump is also scheduled to hold denuclearisation talks with North Korean leader Kim Jong-Un in May, which has eased some of the geopolitical concerns.

 

Following the Federal Reserve’s latest interest rate hike in March, we think that the central bank will raise rates again at its June meeting when its next set of economic projections will be released. We also continue to think there is a very strong possibility that we could see a total of four rate increases in the US this year, with the remaining two coming at the September and December meetings. Financial markets are currently only pricing in around a 75% chance of a total of 3 hikes this year and just under a 25% chance of 4 hikes.


Considering that we think the market is continuing to underestimate the chances of Fed hikes we remain of the opinion that the US Dollar is overdue an upward correction which, in our view, should offset concerns stemming from Trump’s protectionist policies.

 

 

EUR/USD

GBP/USD

Q2-2018

1.20

1.39

Q3-2018

1.17

1.40

E-2018

1.16

1.42

Q1-2019

1.16

1.42

E-2019

1.15

1.44

 

 

UK Pound (GBP)

 

The Pound has continued to recover well in the past few months from its Brexit induced sell-off in mid-2016, having now rallied by over 3% against the US Dollar since the beginning of March alone (Figure 5). Sterling is currently trading just shy of its highest position since the immediate aftermath of the EU referendum after the news of an agreement on a translational Brexit deal and increasing expectations that the Bank of England will raise interest rates again at its May meeting. The currency has been one of the best performers in the G10 so far this year.

 

Figure 5: GBP/USD (April ’17 - April ’18)

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Source: Thomson Reuters Datastream Date: 11/04/2018


Sterling broke back through the key 1.40 resistance level versus the Dollar in late-March on the news that Britain and the European Union had agreed terms on a transitional Brexit period. The transitional period will last from 29th March 2019 to December 2020 and, according to the EU’s chief negotiator Michel Barnier would lead to an ‘orderly withdrawal’ of the UK from the bloc. During this period, the status quo would be maintained and access to the single market kept, although Britain would continue to contribute to the EU budget and lose its voting rights. While an agreement of a deal was largely expected ahead of March’s EU Summit, there were concerns that the deadlock over the Irish Border could thwart a possible deal. The proposed deal will instead include an emergency ‘backstop’ option that would see Northern Ireland remain in parts of the single market if no deal was reached.


With the transitional period now agreed, parties on both sides can turn their full attention to negotiations over trade. Investors appear largely optimistic that an agreement on a ‘softer’ Brexit can be achieved. Reports have suggested that Spain and the Netherlands are ready to back a softer exit, easing concerns over the possibility that the UK would maintain very little access to the single market post-Brexit.


The prospect of higher interest rates in the UK has also supported the Pound. At the Bank of England’s latest monetary policy meeting in March the committee gave a strong indication that it is ready to raise interest rates following its first hike in a decade in November last year. The vote on rates was unexpectedly split 7-2 in favour of keeping rates steady at 0.5%, a departure from the unanimous vote at the most recent MPC meeting in February. Members Ian McCafferty and Michael Saunders, both of whom were the first two to call for an increase in rates in 2017, were the two dissenters. This came as somewhat of a surprise given much of the market that had pencilled in another unanimous vote.


Communications from the Bank of England have been hawkish so far this year, causing the market to come around to the idea of another hike when the bank’s next quarterly Inflation Report is released. The BoE stated in the minutes of its March meeting that prospects for global GDP growth ‘remain strong’ and that inflation in the UK is expected to remain above the 2% target. The minutes reiterated that ‘given the prospect of excess demand over the forecast period, an ongoing tightening of monetary policy over the forecast period would be appropriate to return inflation sustainably to its target’. We think that the lack of reaction in the Pound following the meeting was largely down to the fact that the split vote confirmed something that the market had already been mostly pricing in prior to the meeting; that interest rates are likely to be raised again at the BoE’s May meeting. Overnight index swaps (OIS) are now placing a near 90% chance of a May hike, which we think will continue to trend towards 100% in the coming weeks should economic data in the interim, namely on the inflation front, surprise to the upside.


The Bank of England continues to remain wary of high inflation which has undoubtedly been one of the primary drivers behind the need for higher interest rates in the UK. Headline inflation came in above the 3% level in each of the five months through to January (Figure 6), albeit it eased back to 2.7% in February, its slowest pace since July 2017. This still remains lofty by recent standards and well above the BoE’s 2% medium term target. Crucially, the central bank stated in February that it had shortened its timeframe for hitting its inflation target from three years to two years, which would suggest that a faster pace of hikes could be on the cards if price growth remains stubbornly above target.


Figure 6: UK Inflation Rate (2013 - 2018)

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Source: Thomson Reuters Datastream Date: 11/04//2018


Of potential encouragement to the BoE will be the improvement in real earnings growth, which looks on course to tip back into positive territory in the coming months. Wage growth in the UK has been on a steady upward trend since the second quarter of 2017, while the recent drop off in inflation should help support consumer spending and, in turn, growth. Overall growth in Britain last year was relatively soft, albeit output did pick up modestly to 0.4% in the final quarter and is expected to be well supported by an improving external outlook.


Figure 7: UK Real Earnings Growth (2011 - 2018)

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Source: Thomson Reuters Datastream Date: 11/04/2018


We continue to think that the outlook for the Pound remains positive. The Bank of England looks on course to raise interest rates again in May, and possibly on one other occasion before the end of 2018. A transitional Brexit deal has also been agreed and there is increasing optimism of a more favourable deal being struck. We therefore continue to forecast a gradual appreciation of the Pound against the US Dollar and, to a greater extent, the Euro in 2018.

 

 

GBP/USD

GBP/EUR

Q2-2018

1.39

1.16

Q3-2018

1.40

1.20

E-2018

1.42

1.22

Q1-2019

1.42

1.22

E-2019

1.44

1.25

 

 

Euro (EUR)

 

The Euro’s recent sharp appreciation against the US Dollar has eased since the end of January and the currency has traded almost entirely within the 1.22-1.25 range since then. FX traders have already heavily priced in the likelihood that the European Central Bank (ECB) will end its QE programme this year, while the uncertain political backdrop in Italy and recent disappointing economic news has limited upside for the currency. Regardless, the Euro still remains almost 15% stronger against the US Dollar than this time twelve months ago (Figure 8).

 

Figure 8: EUR/USD (April ’17 - April ’18)

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Source: Thomson Reuters Datastream Date: 11/04/2018

 

Last year’s sharp appreciation in the Euro followed a much faster-than-expected recovery in the Eurozone economy that has led markets to assume that the ECB will end its large scale quantitative easing programme this September. Growth in the Eurozone jumped to its fastest pace in a decade in 2017, with the economy of the 19-nation bloc expanding by 2.5% last year. Following this period of higher-than-expected growth, leading indicators for the Eurozone economy appear to have stalled a bit in 2018. The recent business activity PMIs have slowed relatively sharply in the first three months of the year. The services index slumped to a five month low 55.0 dragging the composite index, which represents a weighted average of the services and manufacturing sectors, to 55.3, its lowest reading since January 2017 (Figure 9). These indicators do, however, still remain comfortably above the level of 50 that denotes expansion.

 

Figure 9: Eurozone PMIs (2015 - 2018)

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Source: Thomson Reuters Datastream Date: 11/04//2018

 

President of the European Central Bank (ECB) Mario Draghi delivered another dovish assessment of the Eurozone economy at its most recent monetary policy meeting in early-March. Policy was kept unchanged as expected, although the market was taken by surprise after the central bank removed the line in its monetary policy statement that suggested it could increase its asset purchasing programme if the outlook becomes less favourable. Draghi continued to emphasise the need to maintain an accommodative policy, reiterating the presence of downside risks from abroad. He also again mentioned the risks stemming from a stronger Euro and threats from protectionism that could weigh on the Euro-area economy. Crucially, he warned that underlying inflation remain subdued and, as we had anticipated prior to the meeting, issued a modest downward revision to its inflation forecast for 2019. The bank now expects consumer prices to grow by just 1.4% next year compared to the previous 1.5% estimate.

 

Cautiousness over the inflation outlook comes off the back of a complete lack of inflationary pressure in the Eurozone. The ECB’s heavily scrutinised measure of core inflation, one of the most significant determinants of the central bank’s monetary policy, has continued to print comfortably short of the ‘close to, but below’ 2% target level. Core inflation was unchanged at 1.0% in March and has now failed to exceed the 1% level in each of the past six months. The headline rate declined for the third straight month in February, although did at least pick up pace to a three month high 1.4% in March (Figure 10). Policymakers will no doubt be concerned that a strong Euro could filter its way through to slower price growth. We also think it will be a long time before low unemployment begins to filter its way through to faster wage growth and the prospect of the ECB hitting its ‘close to but below’ 2% target any time soon remains very remote. The ECB itself does not expecting inflation to exceed its target level until after the end of 2020.

 

Figure 10: Eurozone Inflation Rate (2013 - 2018)

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Source: Thomson Reuters Datastream Date: 11/04/2018

 

As we have mentioned previously, we think that investors have now largely priced in the likelihood that the European Central Bank will call its quantitative easing programme to a close at its scheduled end date in September, with an announcement likely in the summer. The ECB has already cut the programme in half from €60 billion a month to €30 billion a month. Draghi has, however, continued to strike a fairly cautious tone during recent communications, suggesting to us an interest rate hike in the Eurozone remains some way off. On the topic of interest rate policy, Draghi has made it clear he does not anticipate the need for higher rates in 2018, saying he saw ‘very few chances that interest rates could be raised at all this year’. We think that a hike is highly unlikely until mid-2019 at the very earliest.

 

As we have mentioned in the past, we think that the market is currently placing too much emphasis on the recent growth surprise in the currency bloc and is overlooking the complete lack of inflationary pressure, the primary mandate to ECB decision making. Given we think that any rate hike is a long way off in the Eurozone, we continue to forecast a gradual depreciation of the Euro against the US Dollar this year.

 

 

EUR/USD

EUR/GBP

Q2-2018

1.20

0.86

Q3-2018

1.17

0.84

E-2018

1.16

0.82

Q1-2019

1.16

0.82

E-2019

1.15

0.80

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