By John J Hardy*
FROM intense speculation on how US policy will take shape under President Trump to EU existential questions in a busy election calendar for Europe, currency traders have a veritable laundry list of urgent questions for the year ahead.
As we present this quarterly exercise of peering ahead into the next three months and the fresh calendar year of 2017, it’s worth recapping the key currency events of 2016. The year we’re leaving behind was, to an unusually large degree, marked by high drama and unexpected turns. That’s not to say that 2017 won’t provide any number of fresh plot twists and diversions, but heavy market positioning and anticipation for what 2017 will bring will inevitably mean large swings across markets, particularly if widespread assumptions for the New Year prove misplaced.
Currencies were at the center of attention in an action packed 2016 for asset markets. The year was off to a galloping start on fears that China was allowing a sharp yuan devaluation. Amid the ensuing global meltdown in asset markets, the Bank of Japan announced a surprising and, it turned out, misguided move into negative interest rate territory that was met with a wall of Japanese yen short-covering after the initial knee-jerk selloff. Asset markets then bounced strongly and the USD strength was put on the back burner until late in the year on assurance from the Fed that it was backing away from its rate hike schedule for the year and after China declared support for the renminbi. Then of course, we had the sterling train-wreck on the surprise June 23 Brexit vote.
Later in the year, and after an aggravated rise in the yen, the Bank of Japan got its revenge as its new yield-curve control policy announced in September proved perfectly timed as global interest rates rose sharply in Q4. That rise took on new urgency with Donald Trump’s stunning victory at the Nov. 8 US presidential election. That victory also recast the anticipation of future US policy and lit a fire under what had been a sidelined US dollar for much of 2016. Meanwhile, for much of the year, and with little fanfare, selected emerging market currencies emerged as the biggest winners, partly on carry trades making a comeback as interest rates fell in the first half of the year, but also because fears of yuan-devaluation Armageddon faded and many key commodity prices stabilized and even rallied strongly.
After an action-packed 2016 that saw the US dollar ending the year near 13-year highs after only the second Fed rate hike for the cycle, the transition into 2017 is once again loaded with anticipation. Below, we take a stab at crystallizing a few of the most important trading themes for the year, and we suspect that the New Year will get off to a swift start and that the year as a whole might prove a proverbial roller coaster of market action as policy and political risks abound almost everywhere.
Are the policies of President Trump fully priced and will they continue to drive a stronger US dollar?
It’s a tough time for USD forecasters, as the US dollar is getting quite expensive as we head into 2017 and in Dollar Index terms, has posted a new 13-year high. The market has taken the position that Trump could spark a Reagan-like boom in the US economy based on a supply-side bonanza of increased fiscal spending and reduced taxes, especially for corporations, which could encourage domestic-bound investment. The differences between the possible impact of Reaganomics in the early 1980s of and Trumpnomics in 2017, however, are many. Back then, the nation’s balance sheet, both public and private, was less than half as leveraged and interest rates were about to begin a secular decline. Now? Interest rates have scraped record lows and the economy is as leveraged as it has ever been (those two go hand in hand, of course).
In short, higher interest rates from the anticipation of stimulus and Fed rate hikes will quickly lean against any economic growth and eventually tighten credit and slow whatever momentum develops. The tricky bit is the timing for this – do we see the headwinds developing already in Q1 or do we underestimate the ability for the cycle to extend on a revival of moribund animal spirits? As always, traders will need to stay nimble.
The base case is that the coming Trump presidency and Trumpnomics (or Reaganomics, Version 2.0 – after all, Trump has key advisers that were also Reagan’s advisers) may initially provide some further momentum from tax policy and fiscal stimulus fireworks that the market has already partially priced in. And the Fed may feel that is increasingly behind the curve early in the year as inflation revives further (some of which is coming out of China and its policies aimed at eliminating overcapacity in key industries).
But as the year wears on, any inflation or growth that comes about will eventually be seen as “the wrong kind”, with prices only rising due to fiscal profligacy and inflation gauges rising well above the level of real growth. Real US interest rates, in other words, will risk turning increasingly negative, as nominal growth outperforms real growth. This negative real rate dynamic could quickly catch up with the US dollar, which may peak in Q1 or perhaps Q2, possibly for the cycle after its long rally from 2011 secular lows.
Will EU political turmoil mean risks of a new EU political and financial crisis?
Uncertainty surrounding the EU’s political and even existential future will come roaring back in 2017 after the post-2012 period in which the European Central Bank has kept the EU patient on life support with monetary morphine. Elections in the Netherlands in March, in France in April/May (first round/runoff) and Germany in the early Autumn. On top of this we have wildcard risks of early elections for Italy after ex-prime minister Matteo Renzi’s failed referendum in late 2016 as well as Greece once again coming to the table for a new bailout restructuring deal.
We would expect the euro to bottom early in the year or possibly shortly before the French elections, though these may provide less volatility than anticipated. Still, the outlook for the euro is beset with uncertainty from political forces even if the ECB keeps the monetary pedal to the metal. A reworking of the EU framework is necessary in the long run to keep the EU in its current form, but such a process would take years, even if no country leaves the monetary union over the next 12 months.
Chinese currency policy – what’s next?
It is a given that the Chinese regime above all likes to think that it can control the economic destiny of the country, but its policy choices, given the seemingly inviolable and absolute mandate for continued forced GDP growth, are going from bad to worse. Reflate and destroy savers, thus frustrating the planned switch to a consumption-centered economy or shut down inefficient state operated companies and create enormous stress in the financial system? The chief political event of the year is does not arrive until October’s Central Committee Plenum, a key political event that establishes the key leadership for the next five years.
At least until then, the complacent assumption is that we will see a continuation of the gentle downward slope for the CNY over the next year (a lower CNY is one of China’s less painful outlets for reflating itself out of the enormous debt load it has created in recent years). But it is increasingly evident that this slow grind lower in the CNY aggravates the capital flight problem as those looking to take money out of the country can draw a line on the chart, knowing that the price tomorrow will be lower than the price today. The danger period for a large step devaluation, should that be China’s policy choice, could be shortly after the Chinese New Year holiday (the lunar new year this year falls on January 28, rather than the too-long wait until after the party plenum.) Are increasingly strict capital controls that were implemented in late 2016 simply a tool in their own right to maintain control or are they laying the groundwork for a large devaluation? Can we answer the question in our headline for this section with another question? No – but Chinese currency policy could loom large in 2017 if China chooses the dramatic devaluation option.
How low can the Japanese yen go on the BoJ’s new yield-curve-control policy?
The Japanese yen was at the epicenter of late 2016 trading themes as the Bank of Japan’s new yield-curve-control policy, announced in September, coincided serendipitously with a subsequent rise in interest rates. The lucky timing, enhanced further by the rush higher in rates after the US election, meant that Japan’s bond yields – at least out to the 10-year JGBs – supposedly wouldn’t be allowed to stray far above zero, meaning that rise in bond yields in the rest of the world would have to be absorbed in the Japanese yen rather than in Japan’s bond yields. So the bottom for the yen in 2017 will perhaps be found when/if bond yields globally top out and decline again.
Another factor to track will be Japan’s inflation levels and the government’s commitment to fiscal stimulus. The Bank of Japan’s new policy essentially cedes control of the Bank of Japan’s balance sheet to the government, which can theoretically expand stimulus to its heart content. But with the yen weakening apace, however, the urgency for new fiscal stimulus measures in Japan may be lower as inflation begins rising, so prime minister Shinzo Abe may fail to lean hard on the third policy arrow (reforms) or more stimulus. Any timidity from the Abe government’s side to realise the full implications of the BoJ’s QQE with YCC could mean that Japan’s real rates aren’t as negative as elsewhere and provide some eventual support for the JPY as well.
Has sterling bottomed and are the hard Brexit risks fully priced?
If sterling did not bottom in late 2016, it may do so quickly in 2017. Yes, the perils of Brexit are many, but we have to remember that everything has a price and sterling has been severely discounted by the dramatic events of 2016. As we look at the EU political calendar this year and the potential for euro weakness stemming from it, we suspect that sterling may have seen its low versus the single currency. Even if we see little collateral damage from the “populist uprising” theme in Europe in the coming year, the likely new French president, Fillon, is widely seen as an anglophile and a staunch critic of the EU Commission in favour of reforming its remit. A friendlier breeze blowing across the Channel could do wonders for sterling on anticipation of a reasonable Brexit deal (one that will take forever to hammer out and implement anyway), even if the UK’s longer-term structural deficits remain insufficiently addressed. Against the US dollar, we’re unsure whether we’ll see minor new lows for GBPUSD early in the year.
As for the rest:
CHF – with the fraught EU political calendar of 2017, we may continue to see pressure on EURCHF to remain at the lower end of the range and for the Swiss National Bank to maintain its defenses. For EURCHF to rise sharply and for CHF to “normalize”, we would need the ECB to shine a light on the end of the QE tunnel amid normalizing EU inflation or some new, unanticipated SNB policy measures.
AUD, CAD, and NZD – the commodity dollars saw a middling performance in 2016, finding quite strong support from the lows early in the year as commodity prices stabilized and even rallied in places. Later in the year, the anticipation of Trump stimulus and Opec’s successful gambit to raise oil prices boosted CAD against the Antipodeans. There could be further relative resilience for early 2017 in some of the crosses (against JPY and EUR, for example) on the reflation theme, but we suspect this theme will see increasing headwinds as 2017 progresses. We see high risks in particular for AUD and NZD from Chinese currency policy and as Australia’s credit boom tilts toward bust. CAD is similarly exposed to the credit cycle, though its exposure to a stronger USD south and anticipation of Trump could see relative outperformance among the commodity dollars, at least earlier in the year.
NOK and SEK – the Scandies are far more fairly valued going into 2017, if still relatively cheap compared with historic norms. On balance, we’d look for outperformance versus the euro and perhaps AUD and NZD (though that makes for odd pairings) if somewhat indifferent performances in general. EURSEK could be one to fade on rallies all year as late 2016, the Riksbank’s aggressive dovishness took on political implications after Sweden’s finance ministry made sharp comments asking the central bank to consider the risks to financial stability from its radical monetary policy programme.
EM: Emerging market currencies are likely to prove a mixed bag in 2017 after what was, on balance a very good to mixed bag in 2016, depending on the EM focus. A stronger US dollar is likely to keep dollar-sensitive emerging market currencies (those that borrowed extensively in US dollars during the weak USD years) under pressure early in the year. From a valuation perspective, last year was largely about a “reset” after the market threw the baby out with the bathwater in 2016. Emerging Asia could see the most pressure regionally, a continuation of developments in late 2016. Commodity-linked currencies are unlikely to do very well in the longer haul as we’re not strong believers in the reflation trade beyond the early part of the year.
*The writer is Head of FX Strategy at Saxo Bank
