Bannockburn Global Forex –
March 2018 FX outlook
February saw the USD stabilize after 3 months of weakness. Having fallen around 7% from the beginning of November to the end of January, the dollar index made small net gains in February after making a new low mid-month. However, the big market moves during the month were not really in FX but in bonds and equities. US 10 year bond yields continued to rise early in the month and nearly reached 3% – the highest yield seen since 2013. Primarily in a response to rising yields, equities fell sharply, with the S&P 500 falling more than 10% over the first four trading days of the month, hitting the lowest level seen since October. However, the decline was relatively short lived, with equities recovering more than half their losses by the end of the month. The FX market was affected by these moves, with the USD benefitting from the rise in US yields and, against the more risky currencies, from the decline in risk appetite. However, the impact on the majors was relatively muted, with JPY strength the main feature along with some weakness in the AUD and CAD. Even so, the moves were fairly minor by historic standards given the extent of the moves in equities, and the data from the futures exchanges showed that positioning in the major currencies was not dramatically reduced, with long EUR and short JPY positions remaining the largest speculative exposures.
1) US Rates and the Fed – FOMC Meeting March 21
US 10 year bond yields continued to rise in February, helped by a combination of strong economic data, evidence of rising wages and inflation, increased expectations of a boost to growth from the Trump/Republican tax reform, and the perception of a slightly more hawkish Fed under the new Chair Powell. The market is now pricing in four Fed rate hikes this year, which is realistic but three is probably more likely than five, so the market is erring towards the hawkish end of likely outcomes. Nevertheless, this view is unlikely to change this month, as a Fed hike on March 21 seems very likely and is not quite fully priced in. This suggests that US yields can continue to edge higher as long as confidence and expectations of Fed tightening are not undermined by equity weakness.
2) ECB Meeting March 8
This ECB meeting will garner a lot of attention as the ECB are expected to outline their plan for exiting their bond buying program. They have pledged to continue buying bonds until at least September and to keep rates steady for an extended period after that, which is seen to mean at least 3 months and probably more. Most expect there to be some further bond buying for a few months after September with the amount reduced from the current EUR30bn per month, but some on the ECB council have suggested bond buying could end in September. Few now expect a rate rise by the end of the year after recent comments from the Bundesbank’s Weidmann and others, but an announcement of an immediate end to bond buying in September might rekindle such expectations and would in any case certainly be seen as a hawkish step. In practice, this seems unlikely with the ECB concerned to sustain the recovery and limit the strength of the EUR, so they are likely either to further delay the decision on bond buying or announce some further tapered buying after September.
3) Italian Election/German Coalition Poll March 4
The result of the Italian election is uncertain. The populist Five Star party looks favorite to win the most votes, but is unlikely to form a government as it doesn’t intend to form a coalition. The polls currently suggest a hung parliament, with neither a right wing nor a left wing coalition having a majority. This would be seen as a reasonable outcome, possibly forcing a grand coalition between the left and the right. However, the polls are quite close, and many remain undecided. It is possible that the right wing alliance between Berlusconi’s Forza Italia and the League (formerly the Northern League), plus other right wing parties, gains a majority. This could be a problem for the markets especially if the League are the largest party, as they are very anti-EU. While Italian EU exit would still be very unlikely, markets would show significant concern if this was the outcome.
On the same day we get the results of the poll of the German SPD members on whether the SPD should join Merkel’s CDU in government. A “yes” would be seen as positive, but a “no” would create significant political uncertainty. A “yes” is expected, with a poll of SPD supporters showing two thirds back a “yes”, but the members’ stance may be less friendly to Merkel.
4) Equity Markets and Risk Appetite
The sharp dip in February has restored uncertainty to the equity markets and trading looks likely to be much more two way going forward after the long period of steady equity recovery. Nevertheless, in the absence of a major inflation surprise the risks do not seem too severe. Although yields have risen, they are up in large part because of the healthier global economy. Real yields remain low by historic standards, and in a strong growth world with rising inflation and low yields, equities remain the favored asset class (along with real assets) provided the initial valuation is not too high. While US market valuation does look a little stretched, global markets do not seem particularly expensive so while this environment continues, the downside for equities – and consequently for the perceived “risky” currencies – is unlikely to be too severe.
A complex month for the EUR, with the Italian election, German SPD poll and ECB meeting to contend with, as well as the impact on the USD of rising yields and equity market gyrations. The outlook is event dependent, but risks are greater to the downside from current levels. While the most likely political outcomes in Italy and Germany should favor the EUR, these are widely expected and the positive impact is likely to be mild, while negative outcomes would have a more severe effect. This is all the more true because speculative positioning remains heavily weighted in favor of long EUR positions. The ECB are also unlikely to come to any decision that boosts the EUR if it is near its recent highs at the time of their meeting as a result of the political outcomes earlier in the month. Meanwhile, rising US yields will tend to favor the USD. So the February EUR/USD high of 1.2556 should not be threatened, with any EUR/USD gains on positive news unlikely to extend beyond 1.24. Risks are greater on the downside, especially if there is negative political news. While there is likely to be some good support for EUR/USD in the 1.2150 region, a break below here could trigger losses below 1.20, even though the EUR remains good value from a longer term perspective.
GBP/USD has fallen back below 1.40 in recent weeks after the brief foray above this level in late January/early February. It is hard to find reasons for any renewed GBP/USD gains. While there may be a UK rate hike in May, any UK rate rise is lagging the US and is in any case a response to high inflation more than strong growth, so UK real rates remain particularly low. While the immediate economic news is reasonable, this seems to be mostly a result of strong performances in the EU and other trading partners, rather than domestic UK strength. Meanwhile, there is precious little positive news on Brexit, with the latest comments from the EU underlining the difficulties involved in even achieving a transition agreement by the target data of October. Risks to GBP/USD should therefore be on the downside. GBP/USD can be expected to be dragged lower by any negative Eurozone political news, even if EUR/GBP also falls, while positive Eurozone political news is unlikely to have as much impact. 1.40 is now looking like a ceiling for GBP/USD, at least in the short term, with a dip back to at least 1.35 expected.
The CAD has suffered against a generally stronger USD in the second half of February, but has also been undermined by disappointment at the latest Canadian data, with employment falling sharply in January and retail sales falling sharply in December. However, both of these releases were only reversing previous strength, and perhaps more significant was the higher than expected CPI reading of 1.7% in January. Nevertheless, the Bank of Canada is expected to leave rates on hold at its March 7 meeting, so the likely Fed rate hike later in the month will open up a modest rate advantage for the USD. Combined with continued concerns about the NAFTA negotiations, this may be enough to push USD/CAD through 1.30, but upside beyond there is likely to be quite limited given that the BoC is expected to raise rates again in May.
USD/MXN had a fairly quiet month in February, edging a little higher after weakness in the previous few months in line with the general USD recovery. The risks in the short term look to be for continued USD gains as US rates rise, trade concerns continue and rising US yields create greater uncertainty in the equity market and undermine risk appetite – including appetite for higher yield currencies like the MXN. Nevertheless, the MXN remains good long term value in the absence of a dissolution of NAFTA, and USD/MXN gains above 19 should be seen as a longer term selling opportunity.
Compliments of Bannockburn Global Forex – a member of the EACC in New York