December FX Outlook – The Fed, Brexit, and US Fiscal Policy

By Bannockburn Global Forex

Having strengthened in October, the USD fell back towards the bottom of recent ranges against most major currencies in November. Renewed USD weakness was not severe, and had several different drivers. Initial losses were correlated with some weakening in equity markets, but losses later in the month occurred despite stronger equity performance, and was related more to uncertainty about future Fed tightening following the release of the FOMC minutes for September on the 22^nd, which revealed some uncertainties about the wisdom of tightening. GBP and to some extent EUR strength towards the end of the month was driven by reports that the UK had agreed a deal with the EU on the “divorce settlement” for Brexit which would allow trade talks to begin.

Five-Year USD Index Movement:

Outlook for December

1) US fiscal/monetary policy – key date – FOMC meeting December 13/14

The market is fully priced for the December 13/14 FOMC meeting to produce another 25bp rate hike following the comments from chairman-elect Powell indicating that the case was “coming together” for another move in December. In fact, the hike was very nearly fully priced before those comments, so their impact was minimal, and there should be little impact on the USD from the hike itself assuming it is delivered. Any impact is likely to come from any indications the Fed provides in their statement or Yellen in her press conference about the likely future path of policy. There were some concerns expressed in the November minutes about the low rates of inflation and if these concerns are restated after the December meeting, the USD may weaken even though the funds rate target is likely to be raised.

There will also be some focus on fiscal policy, with the Trump/Republican tax reform likely to be approved by the Senate and moved to the House for approval in December. However, there now seems to be a general consensus that even if the tax reform is passed, impact on growth is unlikely to be very significant, with most of the benefits accruing to the wealthy and consequently unlikely to have a big impact on consumer spending.

2) Brexit negotiations – key date – EU summit December 14/15

The Press reported at the end of November that the UK had effectively reached agreement with the EU over the details of the “divorce bill” that the UK would have to pay, and that this would be formalized at the summit on December 14/15. This, along with agreement on the rights of EU citizens in the UK and the  details on the Irish border, are the issues that the EU have said need to be resolved before substantive talks on post-Brexit trade relations can begin. The deal on the divorce bill is reported to involve the UK paying the EU around a net £50bn over the next 40 years, and is generally seen as a UK climb-down as this is close to the EU’s original demands. However, the pound rose on the news as some progress, however costly, was seen as better than no progress. Nevertheless, there is nothing official yet, and the EU has set a deadline of Monday December 4^th for clear progress to be made if the EU is to agree to start trade talks at the December 14/15 summit. The problem of the Irish border is still seen as very difficult to resolve, as no-one wants a “hard” border, but some customs checks seem necessary if the UK is to be outside the customs union. Nevertheless, there are reports that a workable solution is near to being agreed. The problem for May’s government is that even if progress is being made on these negotiations and they get the green light at the EU Summit, any deal is dependent on a UK parliament vote in 2019. Winning this will require unity in the Tory Party, many of whom are none too happy about the shape of the deal as rumored, in particular the payment to the EU, and will certainly want a very attractive trade deal if they are to vote it through. May also needs the support of the DUP (the Northern Irish Democratic Unionist Party) who the government rely on for a majority and who will be very sensitive to the details of the deal on the Irish border.

3) Oil

OPEC has reportedly agreed to extend production cuts until the end of 2018 – a little more than the nine month extension the Saudis had been proposing. Oil prices have rallied slightly on the news, and remain near the highs of the year. Experience teaches that OPEC announcements often aren’t mirrored by action, but if the oil price holds up the recent weakness of the CAD may fade, and the MXN should also benefit.

4) Seasonals

Historically, December has tended to be a month of USD weakness, often followed by USD strength in January. However, it should be underlined that this is a tendency and very far from being a hard and fast rule and with speculative positioning in the futures market now generally short USD (except against the JPY) it seems less likely that here will be significant USD weakness this December.

Currency Outlooks

EUR/USD

EUR/USD has been in a 1.15-1.21 range for the second half of 2017, and while it is now testing the top end of that range, it seems unlikely that the range will easily break with yield spreads still very much in the USD’s favor. The T-note/bund spread continued to hover around 200bps, and with the Fed set to raise rates in December and the ECB continuing with QE until at least September 2018, it is hard to see a substantial narrowing of this spread in the short run, even if the market starts to reduce expectations of Fed tightening going forward because of concerns about the lack of a rise in US inflation. Typically, it would require a significant narrowing of yield spreads for the EUR/USD rally to extend far from here, especially since speculative positioning remains substantially long EUR according to the data from the CME. Nevertheless, the seasonal tendency towards a weak USD in December and the potential for a little disappointment around the FOMC meeting suggests a mild upside bias for EUR/USD in December, especially if optimism about Brexit negotiations continues to develop. But a major upside break seems unlikely at this stage.

Five-Year EUR/USD Movement:

GBP/USD

GBP/USD strength through late November has been based on the news of a likely agreement on the “divorce settlement”, Ireland and EU citizens’ rights in time for the December 14/15 EU summit. This is expected to allow EU ministers to give the green light to start talks on a free trade agreement with the UK post-Brexit. However, a lot of the good news looks to be already in the price of GBP/USD. Even if free trade talks do begin, there is no guarantee that they can be concluded favorably for the UK. The negotiations with the EU so far underline that he EU have the upper hand, and are unlikely to easily concede a favorable deal to the UK in areas such as financial services where many EU countries will be looking to benefit from Brexit. With the UK MPC also looking content to rest up after their first rate hike, yield spreads are also unlikely to move favorably for GBP, and most still see the UK economy continuing to underperform going forward. Positioning in the futures market is also no longer short GBP, so even though December may provide a seasonal boost, and further apparent progress on Brexit could favor GBP, GBP/USD levels approaching 1.38 would look rich.

Five-Year GBP/USD Movement:

USD/CAD

The CAD has significantly underperformed in the last month, losing a lot of ground against the EUR and GBP in spite of gains in the oil price which would normally be expected to favor the CAD. This is partly because the market doesn’t expect any action from the BoC at the December meeting, and with the Fed tightening this puts them a little behind the US cycle. But there may also be some impact from uncertainty surrounding the NAFTA negotiations, which are reported to be struggling. Even so, with the CAD weakening the BoC may soon be thinking about another rate hike, especially if the oil price remains well supported, so gains through 1.30 seem unlikely to be achieved as long as the general USD tone is at best neutral. If the USD starts to make general gains on expectations of either US fiscal or monetary policy, USD/CAD could advance through 1.30, but in the absence of clear bad news on NAFTA such advances should be modest and short lived.

Five-Year USD/CAD Movement:

USD/MXN

The MXN has outperformed the CAD in the last few weeks, benefiting from the generally softer USD tone towards the end of November, and although the MXN is also potentially threatened by NAFTA news, it has greater protection in that it is starting from much lower valuation levels, similar in real terms to those seen during the “Tequila crisis” in the mid-1990s. In the absence of clear negative news on NAFTA the 19.00 area looks likely to prove toppish, and while there are also risks in the Mexican election next year, the downside towards 17.50 is favored.

Five-Year USD/MXN Movement: