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.
Currencies were at the centre 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 November 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 stabilised 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 crystallising 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.
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.
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.
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.
(John Hardy has been heading Saxo Bank’s FX Strategy since October 2007. He focuses on delivering strategies and analyses in the currency market as defined by fundamentals, changes in macroeconomic themes and technical developments. The views expressed in this column are of the author.)
