At the beginning of the year the FX market was rather cautious due to persistent political uncertainties, a slow recovery and rather subdued inflation. The FX market was fueled by a risk-off sentiment and safe currencies such as CHF benefited.
However, the picture has changed a lot since then. Throughout the course of the year we have witnessed a plethora of elections in the number of eurozone countries that have all turned out to be market positive. The election of Emmanuel Macron as President of France, who is in favor of deepening the monetary union and supported by the German chancellor Angela Merkel, increased the likelihood that the eurozone countries will move closer together in the future - which in turn reduced the systemic EUR risks and calmed the market.
The recent closure of the first chapter of Brexit negotiations, US tax reform and substantial growth upgrade from both the ECB and the Fed at their latest meetings in December fueled investor optimism. All this, combined with stronger growth, boosted consumer and business confidence indicators that reached post-crisis highs.
As growth is set to accelerate further, still-subdued inflation in most of the world economies and forthcoming monetary policy tightening will become the 2018 main FX topics. With that in mind, I have decided to give a quick 2018 outlook regarding the main world currencies I follow.
At its latest meeting in December, the ECB increased its growth forecast upwards cumulatively by 0,9pp by 2020, of which 0,5pp was projected for 2018. However, in spite of such growth performance, the eurozone is still dealing with a relatively high unemployment rate of 8.8% on average - which is roughly 1.5pp above the pre-crisis low and is especially accentuated at the periphery of the eurozone. Moreover, according to the ECB bulletin, supplementary unemployment indicators signal that the labor market slack currently affects around 18% of the euro area extended labor force, which is double the official unemployment rate. In such circumstances, inflationary pressures remain weak and inflation is set to stay below the 2% medium-term target through the ECB’s entire forecast horizon.
Besides low inflation, still-high levels of public debt in certain eurozone countries suggest that the ECB will refrain from an early rate increase. The situation is especially worrying in Greece (180.8% of GDP), Italy (132.0% of GDP), Portugal (130.1% of GDP) and Cyprus (107.1% of GDP). Due to the so-called "snowball effect" (impact on the debt-to-GDP ratio provided by the difference between nominal growth and the implicit interest rates paid on debt), an interest rate increase in the relatively early period of economic recovery would further increase the debt burden of the most vulnerable economies and potentially lead to another debt crisis.
The ECB lowered monthly bond purchases from EUR60bn to EUR30bn (effective from January 2018), but still held the right to extend the program beyond September 2018. Furthermore, the ECB is maintaining its optimistic but cautious rhetoric as they repeat their commitment to keep interest rates around currently low levels for a long time after the bond purchasing program ends and certainly until they see evidence of a self-sustained inflation pick-up.
All that being said, I expect that the ECB will refrain from an interest rate increase through the course of 2018 and will hike rates at the end of 2019 at the earliest. The euro will therefore be supported by stronger macro performance, but accommodative ECB monetary policy will prevent any stronger pressures.
The US economy's strong performance continued in the recent period, and the Fed revised its GDP projections cumulatively upwards by 0.8pp by 2020, of which 0.4pp was projected for 2018. At the same time, the unemployment rate is currently standing at just 4.1% and the Fed expects to see a further decline towards 3.9% by the end of 2018. Meanwhile, inflationary pressures are still subdued and the Fed has kept its core inflation forecast unchanged through the entire forecast horizon, reaching a target of 2% in 2019.
While the Fed is rather optimistic regarding forthcoming macroeconomic movements, they still decided to keep the median policy rate outlook unchanged for the next two years, implying three rate hikes through the course of 2018 and two throughout 2019. At the same time, the 2020 median dot increased by almost one full rate hike.
An expected 2pp decline in unemployment rate in 2018 and 2019 will increase wage and inflationary pressures, which will require a stronger hiking pace. Furthermore, lower unemployment rate by itself requires stronger monetary policy tightening according to the Taylor rule, which the Fed regularly consults.
I believe that in the absence of a confirmed tax bill in Congress before the latest Fed meeting, the Fed took a wait-and-see stance in order to get more clarity on future economic prospects. This is reasonable given the market's tendency to be less sensitive to the revisions of economic projections than it is to revisions in the monetary policy outlook.
The market is rather skeptical about the Fed’s current expected hiking pace: the the fed funds futures imply a rate of 1.9% at the end of the next year (versus teh Fed's estimate of 2.1%), while at the end of 2019 fed fund futures imply the a rate of just 2.0% against the Fed's expectations of 2.7%. I believe that at some point the market will have to adapt its expectations which will in return boost US dollar and yields, leading to further curve flattening. While I would not exclude the possibility of further dollar depreciation pressures through the course of the 1Q18 as the market awaits more policy clarity from the new chair, I expect that the dollar will strengthen through the rest of the year.
The CHF depreciated by roughly 9% against the euro through the course of this year and the pair is currently trading at its highest level since the minimum exchange rate was abandoned in January 2015. There are two main reasons for this performance - a decline in the systemic euro risk due to the calmer political situation in the eurozone and a recent pickup in euro area activity, and the ECB bond tapering announcement in October that increased market expectations for a more hawkish ECB policy stance in the future.
A moderate recovery of the Swiss economy has continued in recent quarters, but with an average 0.8% yoy GDP growth in the year through September. However, with this performance, the Swiss economy is still lagging the eurozone (+2.3% yoy GDP growth in the same period). Swiss inflationary pressures picked up recently to their highest level in the past six years (+0.8% yoy in November) but the rate is still substantially below the so-called healthy inflation of around 2%.
At their latest meeting the SNB described the CHF as still highly valued but no longer overvalued, as was described before. At that time the EUR/CHF traded around 1.15 mark (comparing with the current levels that are closer to 1.17). At the same time, the SNB still emphasized their willingness to remain active in the foreign exchange if necessary. However, the EUR/CHF pair is still trading roughly 25% below its pre-crisis level and has a tendency of falling further in periods of renewed risk-off aversion.
All that being said, I see the SNB sticking to its ultra-expansionary monetary policy for the time being. Monetary divergence between the SNB and the ECB should therefore be the key driver of further EUR/CHF upward pressures throughout the next two years. With bond tapering on the way, the EUR/CHF will be initially supported by a higher interest rate differential at the longer end of the curve, and after that, the short end of the curve will be widening as well once the market starts to price in the ECB's key rate normalization.
In times of increased risk aversion CHF still has a tendency to appreciate due to its role of a safe heaven currency. I would use such circumstances to short the CHF on more favorable terms.
While Prime Minister Shinzo Abe's Abenomics programme is set to continue, no major policy changes will take place over the course of 2018. The announced VAT increase of 2pp to 10% is currently planned for October 2019. The expansionary fiscal policy is therefore set to stay intact for now, and the Japanese economy moderate expansion is set to continue.
While inflationary pressures have increased slowly over the course of the year, average 2017 inflation still barely reached 0.4%. The market based long-term inflation expectations are still subdued. The BoJ (Bank of Japan) is confident that inflation is on the right path and therefore plans to refrain from further easing. However, their current projections are showing that inflation will not increase to its medium-term target of 2% before 2019. Under such circumstances I foresee the BoJ keeping its ultra-expansionary monetary policy stance for the time being.
The longer end of the rate curve reflects neither the risk of higher national debt levels nor the ongoing Fed rate hiking cycle, as it is still controlled by the BoJ. The BoJ does this by keeping the yields of 10Y sovereign bonds near zero through its programme of asset purchases.
This BoJ monetary policy, and inflation still close to zero, imply weaker JPY in 2018 - especially in comparison with the US dollar as the Fed proceeds with its hiking pace. I would not exclude the possibility of JPY appreciation in a period of increased risk aversion, but I would use it as an opportunity to short the JPY on more favorable terms.
The BoE (Bank of England) increased its key interest rate by 25bp to 0.5% in November, only to bring it back to pre-Brexit levels. However, this should not be seen as the beginning of a tightening cycle. The BoE remains cautious and forecasts only two more rate hikes of 25 basis points over the next three years, which would bring the key interest rate to 1% by the end of 2020.
In the meantime, Great Britain and the European union have managed to successfully complete the first stage of Brexit negotiations and have struck an agreement regarding the exit bill and the border with Ireland. However, the two parties still need to agree on the details of how their future economic relations will look after the 29th March 2019 – the day of Brexit.
The pound (GBP) thus didn’t profit much either from the rate hike or from the successful completion of the first stage of negotiations. I see downside risks to the pound staying elevated; future exchange rate movements will be dependent on the news flow regarding the second stage of negotiations. The EUR/GBP pair movements will thus largely depend on Brexit negotiations while at the same time the pound is set to lose ground versus the dollar.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.