NatWest Markets Desk Strategy | FX FX Outlook
World Healing, Carry Seeking :
The focus on politics and policy has ebbed and flowed in 2017. Politics has been in the ascendency more recently in the US, but more obviously in Europe. With US core PCE deflator numbers (March 1st) on the slate and French political risk more fully priced, the focus may pivot back to US yields next week.
US real yields are too low relative to growth, so we expect a rise in nominal rates along the curve over coming months. If realized, this can further support the USD. But for now, a bogged down White House means that the Fed is reluctant to show its hand despite strong data at home and abroad. Comments from US Treasury Secretary Mnuchin suggests a fiscal deal is unlikely before the Summer and this is probably later than many hoped. But next week President Trump addresses both Houses of Congress (Feb 28th), so there’s a chance we get some clarity on the new administration’s fiscal priorities.
Stronger data and a steadfast Fed is music to the ears of EM carry lovers. The world is healing and concerns about China have ebbed as capital controls keep outflows in check. The persistent recovery of commodity prices will feed through to EM growth, which in turn supports global growth, which in turn feeds back to commodity prices. The vicious cycle of 2015 has reversed and a virtuous cycle continues to develop. It has further to go in our view.
Our short-term EURUSD Rich/Cheap model based on relative monetary conditions suggests 1.03 is now fair-value (page 3). Bubbling political risks in Europe has been an added kicker to the downside. Rallies have become less pronounced. With political risks better priced, yields can increasingly be the focus. At the same time, Europe has printed very solid data beats. So it’s not a one way bet and EURUSD could eventually have significant upside if the political fog clears in Europe and the Fed delays.
The EU referendum hasn’t changed Sterling’s ‘relative’ safe haven attributes and the currency still offers positive yields. With
positioning short and Brexit headline risks receding (for now at least), Sterling should do well if European political risks build
further. It’s a similar story for the SEK, although long positioning is a concern.
We see BoJ Governor Kuroda’s push back on the view that rising US yields would pressure the central bank’s zero 10y target
as supportive of our view that policy will be unchanged in 2017. At the same time, real rates still matter, so we watch this
week’s Japan CPI report with particular interest.
This week’s key points for currencies are:
– US core PCE deflator and Yellen speech at the Executive Club of Chicago
– US President Trump’s address to Congress
– Global PMIs show world is healing
– Eurozone inflation to hit four year high
– Japan CPI keeps us bearish yen
– Hawkish Riksbank minutes, stay long SEK
– Australian Q4 GDP supports AUD growth story
– Bank of Canada Rate Decision likely uneventful
– Turkey, South Africa and Kazakhstan welcome FX appreciation, while Russia and Hungary seem to prefer to slow it
– Asia PMIs in focus, particularly India, Korea and Singapore. China’s PMI will likely remain solid
– We expect Bank Negara Malaysia to leave policy unchanged
Majors – Politics distracts but policy divergence still key
With French political risk more fully priced, US core PCE deflator numbers could see the focus pivot back to US yields.
President Trump address to both Houses of Congress could see some clarity on the new administration’s fiscal plans.
Our models suggest EURUSD short-term fair-value continues to slip, weighed down by relative monetary policy.
BoJ Governor Kuroda’s push-back on impact of rising US yields supports our view that policy divergence will push USDJPY higher.
In the week ahead, we watch a variety of CPI reports (German, Euro area, US, Japan CPI and Sweden) and Q4’16 Australian current account and GDP.
EUR political risk premium
It was always going to take something quite significant to over shadow the new Trump Administration, but French politics has done just that.
This week’s moves in European asset prices suggest the markets preferred outcome is a win by right of centre candidate Macron in May’s French Presidential election. The risk premium assigned to European assets grew as he slipped to third in the polls and then eased back as centre candidate Bayrou said that he would not run for President, but instead would back Macron.
Macron and Bayrou are both at the centre of the political spectrum; so we believe Macron is the one who benefits the most from the news. This also indicates to us that the market worries more about a left of centre run off with far right candidate Le Pen. The first TV debate on March 20th is definitely one for the diary.
It hasn’t all been about France. Former Italian Prime Minister Renzi was reported as perhaps seeking new elections in June.
There was better news on Greece debt financing, with EU officials sent back to Athens to assess the program before financing pressures come to a head in the summer. There is a history of last minute deals and the position seems less precarious than in 2015. However, the political landscape across Europe is also more fluid.
During the periphery crisis, heightened political risks only really impacted the EUR once the ECB responded. First by stating it was the buyer of last resort (that supported the EUR), but then cutting rates and starting the Asset Purchase Program (APP) that weakened the EUR. But today’s issues are about core, large Euro area members and thus have a more immediate unsettling aroma.
With EUR risk reversals at multi-year highs, risks are better seen. Unless opinion polls shift noticeably, yields should increasingly be a focus. At the same time as politics become a greater focus, Europe has printed very decent data beats. So it’s not a one way bet and EURUSD could have significant up-side if the political fog clears in Europe.
European data resilience and capital flows
The past week has seen solid Germany IFO numbers and Euro area wide composite PMIs. The improvement in activity obviously comes in the face of political uncertainty. This leaves us watching for unhedged equity capital flows given the relatively low level of the EUR. This is one reason why for now our forecasts still show EUR/USD higher by year end, rather than lower than today’s levels.
Weak core inflation pressures provide a counter-balance. This week’s full breakdown of the Euro area CPI basket suggests
underlying inflation remains weak. This was apparent in core measures as well as the categories that are most representative
of domestic prices. The week ahead sees both German and Euro area wide CPI reports for February.
Monetary policy weighing on EUR/USD
This week’s set of FOMC meeting minutes provided little for USD bulls like us.
NWM Economics see the key passage as: “Many participants expressed the view that it might be appropriate to raise the federal funds rate again fairly soon if incoming information on the labor market and inflation was in line with or stronger than their current expectations or if the risks of overshooting the committee’s maximum-employment and inflation objectives increased.” While a March rate hike is probably on the table, the committee requires much more clarity on the economy.
Clarity on fiscal policy seems unlikely to come this week.
US Treasury Secretary Mnuchin indicated that when the Trump administration comes out with a plan, it will be a combined plan with House and Senate, and White House. This is somewhat at odds with the 2-3 week timeline suggested by President Trump. If Trump is planning on releasing something in the next few weeks, it seems likely it will largely be symbolic or an opening point for further discussions with Congress. He also said the focus is on tax reform, that ‘making our business tax competitive’ is a priority and that he expects to have something completed on taxes before the August recess. Asked specifically about border-tax adjustment, he was somewhat non-committal, saying only that they are currently looking at it and that they are listening to businesses.
President Trump’s address to both Houses of Congress on Feb 28th could provide some clarity on the new administration’s fiscal plans. However, increasingly it looks as if US core PCE deflator numbers (March 1st) will determine whether the focus pivots back to US yields next week.
For now, our short-term EURUSD Rich/Cheap model that’s based on relative monetary conditions suggests 1.03 is now fairvalue (Chart 1).
Japan CPI keeps us bearish yen
We expect dollar-yen will trade in a higher 115-125 range this year as the Federal Reserve hikes rates three times while the Bank of Japan keeps targeting ten year Japanese government bond yields ‘around zero.’
In the week ahead, Japan’s January CPI release will serve as a reminder that the Bank of Japan’s 10 year yield target isn’t moving anywhere fast, anytime soon. NWM Desk Strategy Economist Jin Kenzaki expects the headline figure to grow by 0.4% y/y and the core number (excluding only fresh food) to be flat at 0% y/y. The main drivers of the core inflation data will likely be food, clothing, gasoline and electricity prices. Still low inflation keeps the BoJ yield target in place for longer.
We see an attractive asymmetric payoff profile in short JPY vs. long high carry EM positions, specifically Turkey and Brazil. If US real yields continue to move lower, EM should outperform JPY as a goldilocks (carry friendly) scenario unfolds, where stronger US activity is not matched by Fed action and Trump’s policy is seen as creating more inflation than growth. If US real yields were to rise, potentially driven by a hawkish Fed, we would expect JPY to underperform EM. Our virtuous cycle thesis, regarding the feedback loop between higher commodity prices and corporate profits, should mean EM outperforms non-USD G10 on any dollar rallies associated with higher US real yields. Our EM Strategist Gabor Ambrus sees good entry levels here for Turkey longs as the currency has cheapened significantly (please see his section for more). Meanwhile, Brazil is a good candidate for longs against yen as it has low ‘Trump exposure’. Brazil is not involved in certain heavily scrutinized trade deals such as NAFTA and it is the most closed emerging market economy. The currency is rallying against USD and Brazil also runs a $4bn goods trade deficit with the US, so it’s less prone to currency manipulator status. Favour short JPY vs. TRY and BRL.
Last week in parliament, BoJ governor Kuroda reinforced his stance on the 10 year yield target. He said that rising US rates doesn’t mean automatic pressure on Japan, implying that it doesn’t necessarily mean a hike for the 10 year yield target. This again keeps us bearish yen as the yield target remains. BoJ board member and regular dissenter, Kiuchi, said that it is unreasonable to expect a notable increase in wages. Muted wage growth will also mean the BoJ is likely to keep its yield target ‘around 0%’.
Australian growth to support AUD
In the week ahead, Q4 GDP for Australia is released on Wednesday. We will get some of the components of the GDP number beforehand, with inventories and company profits for the quarter released on Monday and net exports on Tuesday. Our bias remains for the commodity price rally to drive higher company earnings, especially in the resource sector given the outperformance of raw materials prices. Net exports will also be a positive contributor to GDP for the same reason. Business investment will likely pick up in Q1 and Q2 as the private sector feels more of the benefit of the terms of trade improvement. Higher profits will hopefully allow higher private investment down the line.
Last week, RBA governor Phillip Lowe expanded on his currency rhetoric from his speech at the Australian Economic Forum Dinner two weeks ago. He said that he would like to see AUD lower rather than higher, but that it’s hard to say AUD is fundamentally overvalued. This was a more mixed tone vs. his comment two weeks ago where he said that “it’s hard to say AUD is too high given the reasonable growth outlook”. On the one hand, Lowe is trying to push back on AUD strength by saying he would ideally like it lower, but on the other hand he is again admitting that on a fundamental basis (given the growth outlook) he can’t present a strong argument for AUD to depreciate significantly.
We continue to favour AUD upside as a proxy for global reflation. Last week, the RBA February policy meeting minutes contained a discussion around the benefits of the terms of trade improvement. Terms of trade has fed through to the current account and will likely feed through to growth, that’s why we favour AUD upside. But the deciding factor for RBA rate hikes is whether it creates wage growth. Q4 wage data saw wage growth unchanged at 1.9% y/y. If there is eventually wage growth that will likely be in the resource sector, where export prices have been rising because of loose fiscal policy in China. We thus keep favouring the currency over the NZ dollar, where the Reserve Bank of New Zealand remains more concerned about exchange rate strength.
Bank of Canada Decision Likely Uneventful
The Canadian economy continues to benefit from a bounce in oil prices. Like in the US, and around the globe, energy related base-effects were behind a surge in Canadian headline inflation from 1.5% y/y to 2.1% y/y in January. But on the various measures of core inflation, there were few changes in January and each measure still sits below the 2.0% target, reflecting ongoing spare capacity in the economy. As discussed in previous weekly updates, we continue to worry that a combination of delayed impact of fiscal stimulus on growth and a softer housing market will weigh on Canadian activity. Retail data in December was notably softer than expected. Further, we also feel the overhang of NAFTA will keep business investment muted, outside of a bottoming out of energy sector investment.
Next week’s Bank of Canada decision will likely be an uneventful one. We expect no change in the overnight rate at 0.5%, and we expect the Bank to note a similar state of uncertainty due to potential changes in US fiscal policy. The Bank will likely remain satisfied with the strength shown in recent activity and employment data (Dec. retail sales aside). Language on inflation is likely to be shifted to reflect the January surge, but we see the overall picture as consistent with the January language. The BoC said in January that “as consumer energy prices rise and the impact of lower food prices dissipates, inflation is expected to move close to the 2 per cent target in the months ahead.” As has been the case over the next several months, we anticipate the BoC will attempt to lean against a tightening in financial conditions alongside the US by flagging the clear divergence in economic performance between the US and Canada.
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