Bannockburn Global Forex –
Outlook for February
1) Bond market weakness and risk appetite
US 10 year bond yields hit their highest level for 4 years at the end of January spurred by the combination of positive economic news, a weak USD and the perception that the period of financial repression is coming to an end as globally central banks all consider exits from asset purchase schemes. While yields are still very low by historic standards the break of the 2017 yield highs is technically significant and could signal a shift in market risk appetite. Equities have slipped back in response to the rise in yields, and given current extended valuations US equities look vulnerable to any further rise. While yields in Europe and Japan are lower, and have less reason to rise at this stage given the lack of any monetary tightening, they have nevertheless been dragged higher by the rise in US yields. Global equities are also likely to suffer from any sell off in US equities, even though valuations are less extended in Europe. This need not mean a major reversal of the equity bull market as economic news remains positive and earnings growth generally healthy, but could well signal a significant correction in equities and risk appetite. For FX this is likely to favor the safe haven currencies – the JPY and CHF, and probably the USD too given the recent USD weakness in a risk positive environment.
2) Bank of England MPC meeting/Inflation report – Feb 8
As this is an Inflation Report meeting it carries more weight than usual, and provides a chance for the Bank to react to the recent recovery of GBP and any developments on the Brexit front. In reality, the MPC will likely be very careful to say as little as possible about Brexit, especially since Carney was reported to have commented on its costliness at Davos. With the Conservative party hard line Brexiteers indicting the possibility of a challenge to May largely because of concerns that she is heading for a “soft” Brexit, the Bank will want to avoid any accusations of political interference. Having said this, Carney is unlikely to step away from his position that Brexit is economically costly.
On the monetary policy side, there is little risk of another rate hike, in part because of the strength of GBP since the last meeting. The gain of around 2.5% since the December meeting should be enough to head off any calls for another rate rise.
EUR/USD broke higher in January and maintained a positive tone through to the end of the month. As outlined above, the primary cause of EUR strength and USD weakness is the continuing improvement in sentiment towards the Eurozone as a result of improved growth and the related decline in concerns about political stability. This has led to a greater willingness of investors to put money into the region. Net portfolio outflows continue, but are much reduced, while the big current account remains a major source of inflows. The ECB’s indication that they are likely to stop asset purchases this year has reduced the attraction of bonds but prevented any widening of long term yield spreads with the US. However, there is no rate hike likely in the Eurozone this year, and while still good value, the EUR is no longer exceptionally cheap at these levels, with EUR/USD purchasing power parity (PPP) around 1.33. Speculative positioning is now very extended, with the net speculative long positions hitting a new record in the week to January 23rd (see chart below)
The ECB are also a little unhappy about the recent pace of the EUR rise. So while there is still scope for EUR gains in the long run, technical resistance in the 1.25-1.27 area seems likely to hold for now. It is not clear what the trigger for a major position adjustment might be, but rising US yields triggering a drop in equities could well trigger a general position liquidation. Any drop could initially be quite sharp given the extent of positioning, but EUR/USD should now be well supported above 1.21.
GBP/USD showed accelerated gains through January, breaking back above 1.40 and hitting its highest level since the Brexit referendum. Some of this strength is predicated on a more positive attitude to Brexit, with the fallout probably now expected to be less substantial and also more delayed, with a transition agreement expected to be agreed that will delay the main impact for 2 years or more after 2019. Having said this, the news on Brexit and UK politics in general has not objectively been that obviously favorable. Although there is perhaps a greater prospect of a transition deal being agreed by the end of the quarter, Theresa May is under increasing pressure domestically as “hard” Brexiteers in the Conservative party are unhappy that negotiations with the EU are compromising the ideals of Brexit, and there is increasing talk that she will face a leadership challenge before long.
Nevertheless, GBP was the best performing major currency in January, with speculative positioning now substantially net positive. This partially reflects USD weakness, but the outperformance of GBP also indicates independent GBP strength. However, these are significant levels. The high the week before the Brexit vote was 1.4389, only 50 pips above the high in January. While these may still be low levels for GBP/USD by historic standards, GBP/USD is now trading close to or above PPP (estimated at 1.42 for GDP by the OECD in 2016, and 1.32 for a measure based on consumption). Given Brexit risks, UK political uncertainty, a big current account deficit and growth underperformance relative to most major economies, further gains seem hard to justify. 1.45 should offer strong resistance, and while it will likely require either a general USD recovery or significant negative UK news for an aggressive move back below 1.40, upside looks limited short term. We would not expect anything from the February Inflation report/MPC meeting to provide GBP with a further boost at this stage.
The CAD has benefitted with other currencies against a weak USD in January, but gains have been more modest than most of the other majors. This always tends to be the case because the US is by far the largest Canadian trading partner so currency moves against the USD have a much bigger significance for Canada than the other majors. So even though the Bank of Canada raised rates in January, which was not expected at the beginning of the month (but was anticipated after the strong Canadian employment data), and the oil price rose to a 3 year high, CAD gains were fairly modest. There is some sense to this because as we noted in our 2018 outlook, the Canadian and US cycles are broadly in sync and USD/CAD is close to long term fair value in the mid-1.20s. So although USD/CAD is likely to continue to drop with any general USD weakness, it is likely to be tough to break below 1.20. The NAFTA negotiations remain a medium term concern, although the January meeting in Montreal reported some modest progress.
USD/MXN more than reversed its December gains in January as the MXN benefitted from general USD weakness and some fading of the impact of the US tax reform, as most seen to have concluded that it won’t result in US businesses moving out of Mexico. There is still some concern surrounding the NAFTA negotiations, but to some extent this is already in the price given the level of the MXN which remains extremely cheap by historic standards. The USD/MXN break below the November low of 18.45 looks technically significant, and in the absence of NAFTA news the downtrend in USD/MXN should have potential to continue, though there will continue to be some nervousness both about NAFTA and the June elections. The July 2017 low of 17.45 is the big support but should break if the election does not undermine confidence.
USD/CNH fell sharply in January mostly reflecting general USD weakness rather than independent CNH strength. The EUR and GBP both gained against the CNH on the month, while the JPY was little changed. In trade-weighted terms the CNH rose only modestly – less than 1%. This reflects the fact that the CNH (or more accurately the onshore CNY) is effectively targeted against a basket of currencies. It has generally been allowed to appreciate on a trend of around 3-5% a year for the last 13 years, but started this year towards the low end of its targeted range after depreciating through 2016/2017 (following strong gains with the USD through 2015). While the CNH can be expected to continue to appreciate against the USD if it remains generally weak, it should be able to hold its current higher level against the USD even if the USD recovers more generally. If, as we expect, the USD manages a general short term stabilization or modest recovery, CNH should remain strong and any USD/CNH rallies to 6.40 or above should be seen as a selling opportunity for the medium or longer term.
Compliments of Bannockburn Global Forex – a member of the EACC in New York.