FX Outlook - Where are the Opportunities in 2018?
- 4 January 2018
Republishing our previous notes because we covered ALOT more than the U.S. dollar!
2017 marked the worst year for the U.S. dollar in more than a decade with the Dollar Index falling over 9%. The last time it faced such difficult times was in 2003 when it lost 14.6% of its value. In some ways, that year was similar to this one in that inflation was low, stocks performed well and the Federal Reserve raised interest rates. However back then the U.S. was dealing with deflation not low inflation, the Fed raised interest rates only once compared to 3 times this year and the stock market rebounded 8% versus this year's gain of nearly 20%.
Now, this does not subtract from the fact that 2017 was a terrible one for the greenback, which is surprising considering that the Federal Reserve was the most aggressive central bank. They raised interest rates by 75bp under the backdrop of stronger growth and low unemployment. GDP growth in 2017 was the strongest since 2014 and the unemployment rate was the lowest since 2000. For most of the year, President Trump struggled to advance his economic agenda and this along with a host of other factors including saber rattling between the U.S. and North Korea hurt the confidence of global investors who prefer to move away from the dollar.
Looking ahead to 2018, the Federal Reserve will continue to be the most hawkish central bank, raising interest rates anywhere from 50 to 100bp (though 75bp is most likely). Ultra-low unemployment, tax cuts, consumer and business confidence will lead to faster growth in the coming year. All of this should drive inflation and growth higher, leading to a recovery for the greenback in 2018. We may not see the Dollar Index back above 100 or USD/JPY back to 120 but we could see it a 5% appreciation. As the New Year kicks off, the coming week will be an important one for the dollar with Fed Presidents Bullard, Harker and Mester scheduled to speak. Mester is a 2018 FOMC voter and she's usually a vocal hawk. Non-farm payrolls are also on the calendar but with the Fed not expected to raise interest rates again until March at the earliest), this report may have a more limited impact on the dollar than past releases.
In contrast, 2017 was a phenomenal year for the euro. Despite widespread political troubles and a central bank that was reluctant to scale bank Quantitative Easing, the single currency appreciated 13% against the U.S. dollar, 10% against the New Zealand dollar, 8% against the Japanese Yen and 4% versus the British pound. The steady strength of the German economy played a role in the currency's outperformance but the majority of the move can be attributed to a weakening dollar. Most of Europe's major elections are over and while Macron's victory in France fostered some gains, the defeat of Merkel's party in Germany and Catalonia's independence vote only had a limited impact on the euro.
European politics will remain in focus in 2018. There will be elections in Italy sometime between March and May and the race is close. Angela Merkel will work on forming a new government as Spain continues to deal with Catalonia's secessionist desires. The European Central Bank expects robust growth to continue but with the euro up 13%, we think the pace will begin to moderate. The ECB made it very clear that they have no plans to raise interest rates until October at the earliest, putting them further behind the Fed. So while in the momentum is on the side of euro bulls in the near term and we could easily see EUR/USD trade to 1.21, gains should start to ease above those levels. Outside of German labor data and the Eurozone's December CPI estimate, there are no major Eurozone economic reports scheduled for release the first week of 2017. Instead, it is important to remember that as an export dependent nation, the Eurozone thrives when the currency is weak and struggles when it is strong. The further the euro climbs, the harder the central bank will try to talk it down which would inevitably be negative for the currency.
More than a year has past since Britain voted to leave the European Union. It is one of this decade's biggest political shocks and many are still in denial. Some members of the European Union continue to believe that Brexit is reversible and while legally that may be true, the U.K. government has no plans to overturn the vote. The prospect of Brexit hurt sterling hard in 2016 but 2017 was a year of consolidation and recovery. Sterling rebounded 8% against the U.S. dollar and more than 4% versus the Japanese Yen and Swiss Franc. Although it added another 4% to last year's losses against the euro, EUR/GBP is well off its 2017 highs.
The soft date for Brexit is March 2019, which means next year will be all about Brexit concessions. Prime Minister May has shown that she is willing to do whatever it takes to appease the EU who have been playing hardball from day one. She's motivated to get a deal done and chances are, we'll see a soft transitional deal that results in a soft exit. Brexit is still negative for growth but the pain will be felt in 2019 and beyond and not the coming year. Instead 2018 will be the year where a Brexit deal gets done. As the market has completely discounted the Brexit mess, breakthroughs and progress in the coming year will be positive for sterling and its greatest gains will be against the euro. In the near term, the U.K. economy is chugging along and next week's PMI reports will give us a sense of how the year closes out.
2018 should also be a good year for the Canadian dollar. Although the most recent GDP numbers fell short of expectations, the economy is growing, consumers are spending and the labor market is strong. The Bank of Canada raised interest rates twice this past year and is poised to tighten again in 2018. Interest rate futures show the market pricing in a 72% chance of a quarter point hike in March and an 85% chance that it will happen by April. They are also pricing in a 75% chance of two hikes before the end of next year. The BoC may be slow to hike but they are expected to tighten alongside the Fed with the economy outperforming and inflation exceeding 2% year over year. The prospect of stronger global growth in 2018 should also drive oil prices higher which would fuel additional gains for the loonie. The greatest risk for CAD is NAFTA re-negotiations but what this past year has shown is that the economy is more resilient to the U.S.' rumbles than ever before. We see USD/CAD trading back to 1.20 in the coming year. USD/CAD will be in play next week with trade, employment and the IVEY PMI numbers due for release. After last month's strong labor market gains, a pullback is likely.
Both the Australian and New Zealand dollars appreciated against the greenback this past year, but the scale of the gains couldn't be more different especially for 2 countries who are suppose to be more tightly correlated. The Australian dollar rose more than 8% against the greenback while the New Zealand dollar's gains were limited to 2%. Both currencies were driven higher by U.S. dollar weakness and an improving environment for risk, but New Zealand's domestic troubles prevented it from enjoying the same gains as AUD. From a political upset to a downward trend in dairy prices, New Zealand's economy has been plagued with troubles but as we look forward to the New Year, lower unemployment, the prospect of fiscal stimulus, wage hikes and hotter inflation could prompt the Reserve Bank to start talking about rate hikes. Over the next 3 years, the minimum wage is expected to increase 20%. Higher wages should lead to more spending, growth and price pressures that should drive the New Zealand dollar higher. In Australian, wage gains have been a persistent problem and while the rotation from mining to non-mining based economy helped support the economy, the prospect of weaker growth in 2018 could limit the gains for AUD. The Reserve Bank of Australia could raise interest rates but they will be slow to do so and will tighten less aggressively than the Fed.That makes the outlook for AUD unclear as the currency could benefit from stronger global growth but also suffer from weaker Chinese growth. In the near term, AUD and NZD appear poised for more gains but a large part of that will be predicated on stronger PMI numbers from Australia next week.
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