Member News

January FX Outlook – Tax Reform, Fed Transition, and Equity Markets

The USD fell back towards the end of December against the majors despite the passage of the US tax reform, which is expected to provide a modest boost to US growth through 2018 and beyond. The USD weakness towards the end of the month did not have an obvious trigger, and may be best ascribed to seasonal factors, which do tend to weaken the USD towards the end of the year. However, the EUR did benefit from a stronger than expected German CPI number late in the month, and European CPI may be a focus in January as a result. While some have suggested there is some disappointment at the shape of the US tax reform, in reality it is hard to see the reform as anything other than positive for the USD, given that earlier hopes of a border tax adjustment being attached to the reform had been discarded some time ago. The USD may recover in January when it traditionally shows a better seasonal performance, though often this recovery doesn’t happen until the second week.

Five-Year DXY:
Outlook for January
1) US fiscal/monetary policy – key date – FOMC meeting January 30/31
Although this meeting is not followed by a press conference and no policy change is expected, it will be the first time the Fed is able to officially comment on the impact of the tax reform passed at the end of December.  It also could be Yellen’s last meeting – though she may not attend if Powell is confirmed as Chair by the Senate in time. It seems likely that the passage of the reform will lead the Fed to take a more positive view of the economy going forward, as most expect the reform to boost GDP around 0.5% in 2018. The January meeting contains no updated projections or press conference – for that we will have to wait until March – but will release a statement which seems likely to be on the upbeat side given the reform and recent strong GDP data.
2) Equity market performance
US equities continued to perform well through December capping a very strong performance through the year, but with valuations stretched and the market anticipating higher interest rates through the year, the trend is looking potentially vulnerable to correction. However, foreign equities finished the year in more mixed fashion, with European markets in particular dropping back in the last couple of months, suggesting they provide better value. That being said, European equities rarely manage to rise when the US market is falling. Many FX markets will be affected by the general tone in risk appetite, so equity market performance at the start of the year will be important, particularly for the traditional safe havens.
3) Brexit
There is nothing notable scheduled in Brexit negotiations, but the first shots across the bows in trade talks are likely to be heard. Initial positions are likely to be deliberately tough, and early indications from the EU suggest they see the likely trade deal with the UK as being similar to that for Canada and South Korea rather than the closer ties with Norway and Switzerland. In particular, the initial EU position is that financial services will get no special treatment, and that the hopes of the City of London that current arrangements will be largely unaffected will be disappointed. It is hard to know how the markets will take any statements, as most believe that at this stage everything is a negotiating position. But the progress so far suggests that the EU will not be backing down very far from their initial stance.
4) European politics
The announcement of the Italian election for March 4 and the Catalan regional election in December which returned a separatist majority have had little initial impact on markets, but the issue of populist and separatist politics in Europe is likely to be in the news in the early part of the year as a result. In the UK, a cabinet reshuffle in January looks likely, but shouldn’t significantly impact the political equilibrium.
5) NAFTA negotiations – late January in Montreal
These negotiations have been continuing for some months without any noticeable progress, and fears are rising that Trump is prepared to announce a withdrawal if progress is not made. The next round of talks is scheduled for late January in Montreal. In practice, it would seem that few see much advantage in withdrawal, so such a radical step seems unlikely, but concerns may intensify as meetings approach.
Currency Outlooks
EUR/USD remains confined to the 1.15-1.21 range seen since late July, but continued to press the top end of this in December despite the passage of the US tax reform which, on the face of it, should have been supportive for the USD. While some of the EUR’s strength may be ascribed to the stronger than expected German CPI data released late in December, the USD’s weakness in the last week of the year is in line with a seasonal tendency, and we are inclined to ascribe the latest USD weakness to seasonality. This tends to unwind by the end of January, but often persists in the early part of the month, so the 1.2093 high from September may yet be broken in early 2018 trading. Nevertheless, the conditions do not yet seem right for sustained strength in EUR/USD with yield spreads broadly stable at attractive levels for the USD. Although EUR/USD gained through the second half of 2017 without the support of yield spreads, this could be viewed as a valuation correction in part due to unwinding of positions, and is less likely to be repeated with speculative positioning heavily long EUR and valuation at more sensible levels. Even so, the top end of the range looks, for the moment, more in danger than the downside, which is only likely to be threatened if Italian and Spanish politics move more into focus, or if Brexit negotiations turn extremely acrimonious.

Five-Year EUR/USD:

As with EUR/USD, GBP/USD showed strength through late December, with seasonality probably the best explanation, though the agreement of the divorce deal with the EU early in December helped to provide some support. Even though it is hard to see the deal as anything other than a defeat for UK negotiators, with the EU essentially achieving all their key demands, the markets seem to take the opposite view to the UK government, tending to believe that a bad deal is better than no deal. Brexit will remain top of the agenda for GBP through 2018, but progress in trade talks will be very slow in the early stages, and domestic UK politics may provide more initial focus, with Theresa May expected to reshuffle her cabinet, though the impact of this is on GBP is unlikely to be large. As always in the UK, there will be a focus on Christmas retail sales, and while this data is typically unreliable from a big picture perspective, it could determine the direction of GBP later in the month. GBP/USD levels approaching 1.38 would look rich, and the downside is favoured longer term, but a more general USD recovery is likely to be needed to secure this.

Five-Year GBP/USD:

USD/CAD has had several attempts at breaking above 1.29 in the past few months but has failed each time, and the CAD caught a bid against a generally weak USD towards the end of December. Strong Canadian data through December, notably on employment, and an upbeat assessment of the economy from BoC governor Poloz in his latest speech, combined with a firmer oil price, are all supportive factors. The BoC seems likely to match Fed rate rises in 2018 suggesting limited downside risks for the CAD if solid and coordinated global growth means risk appetite remains well supported, especially for commodities and commodity currencies. Nevertheless, the NAFTA negotiations are a background concern with the Trump administration potentially capable of aggressive and destabilizing tactics. These continue in Montreal at the end of the month, but ahead of that the CAD should remain well supported.

Five-Year USD/CAD:

The MXN was one of the weakest currencies against the USD in December, suffering from a combination of concerns about the implications for Mexican business of the US tax reform, and political corruption scandals that are seen as a boost for the chances of the leftist candidate in the July election. There is also some concern about rising inflation and some weakness in growth. While the election is likely to remain a concern through the first half of the year, the implications of the tax reform seem unlikely to be too severe given the cost advantages of producing in Mexico, providing the NAFTA negotiations aren’t derailed, and such concerns have been priced in for some time in any case. The MXN remains very cheap from a long-term perspective, and while there may be a foray above 20, such levels still look like a good selling area for USD/MXN in the absence of clearly negative news.

Five-Year USD/MXN:

Compliments of Bannockburn Global Forex LLC, a member of the EACCNY