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October FX outlook – the run up to the US election

Major FX markets remained largely range-bound in September, with EUR/USD trading inside August’s range while initial mild GBP strength faded and initial JPY weakness also proved temporary. The main focuses of the month were the Fed and Bank of Japan meetings on the 20th/21st. The BoJ proved less dovish than expected, failing to cut rates or expand QE, but instead announcing long term yield targeting.  This proved JPY supportive.

The Fed decision was largely as expected, leaving rates unchanged but hinting at a strong possibility of tightening in December. The US election campaign will come more into focus in October, with USD/MXN the main FX barometer of sentiment. The US Q3 GDP data on October 28th looks like being the key data release. Current concerns about Deutsche Bank are creating a risk negative tone to the markets and favoring the USD and JPY.

1) US monetary policy. Key event: US GDP October 28th.

•    Expectations for Fed policy remain crucial. At this stage the market sees around a 60% chance of a Fed rate hike in December. If this becomes more likely over the month, the USD should advance in general, especially against the higher yielding currencies, as rising expectations of tightening may damage risk appetite unless supported by evidence of strengthening growth.
•    The Q3 GDP data on October 28th is likely to prove important in this regard. Something stronger than 3% is likely to secure expectations of Fed tightening. Recent comments from the Fed suggest they are inclined to hike rates in December unless they have a good reason not to, with some concerned about bubble conditions in asset markets.

2)    The run up to the US election. Key events: Presidential debates October 9th and 19th.

•    It is not entirely clear how US election expectations will affect the USD in general, but it seems a Clinton victory is being viewed as slightly more positive for risky assets, notably the MXN, but also other risk assets, judging by the reaction to the first presidential debate. Concerns about trade policy under Trump may be the reason for this.
•    However, some also see a Trump victory as more growth positive, as he is perceived as more likely to encourage increased fiscal spending. This is not entirely clear, as both candidates appear to support some fiscal expansion, and the president is in any case not in real control of spending. Nevertheless, a slightly more expansionary fiscal policy under Trump might favor the USD in general, though less so against the JPY and other safe havens.

3) Still waiting for Brexit news

•    Sentiment towards GBP is likely to be primarily determined by perceptions of whether we are likely to see a “hard” or a “soft” Brexit. A “hard” Brexit essentially means the UK losing access to the European single market and having to either negotiate a new trade deal or fall back on WTO rules.
•    The biggest concern is around UK banking business losing “passporting” rights to operate in the EU. Currently, a “hard” Brexit seems the most likely outcome, as the UK government appears unwilling to accept the free movement of labor that would be required to get access to the single EU market.
•    These issues are likely to remain unclear, though statements from the UK and EU officials can be expected to affect sentiment. In the meantime UK data indicating how the economy is holding up in the face of the initial Brexit referendum shock will remain a focus.

4) The OPEC deal and the oil price.

•    The commitment from OPEC to reduce output by 740,000 bpd from the end of the year is a much stronger outcome than anyone expected from the meeting just concluded in Algiers. However, the devil is in the detail, since at this stage there has been no allocation of the production cuts.
•    It is most likely that the vast majority of the cut will have to come from Saudi Arabia, but their incentive to cut production depends on how much the oil price rises in response.
•    The difficulty for them is that even if the initial impact of their cuts was sufficient to boost the price to acceptable levels, a rise in the price could easily trigger increased production from non-OPEC producers
•    However, the price rise seen on the announcement should hold at least until the formal November OPEC meeting, limiting the downside for oil related currencies.

Currency outlooks

EUR/USD has been very range-bound for the last month, with the September range inside the August range, both of which were inside the extremes around the day of the Brexit vote on June 24. Until this range breaks (1.0913-1.1430), it is hard to see any trend developing in the EUR. Rising yield spreads in favor of the USD suggest downside risks for EUR/USD if a Fed move in December becomes more likely, and vice versa. For now EUR/USD is finding it hard to break away from 1.12, though concern about Deutsche Bank and the European banking industry in general are currently putting pressure on the downside. Graph attached here.

GBP showed some strength in the first half of September as UK data turned out less weak than had been feared in the immediate aftermath of the Brexit vote. However, Bank of England indications that further easing is still likely, combined with increasing concerns of a “hard” Brexit leading to longer term economic problems weighed on GBP by the end of the month. So far GBP/USD has held above the August low of 1.2866 and remains in a fairly flat range defined by the post-Brexit highs and lows of 1.2798 and 1.3446. The downside risks look to be greater, as even weak US numbers would probably not be enough to push GBP/USD through these highs without some positive Brexit news. Graph attached here.

The CAD managed a sharp rally at the end of September on the news of an OPEC deal and the consequent oil price rally. However, USD/CAD has not managed to break the uptrend which has been in place since the early May low at 1.2462. The first significant support is around 1.30, with bigger support near 1.28. An oil price move above $50 (WTI) would be needed to threaten the USD/CAD uptrend, but ahead of the November OPEC meeting a major oil break seems unlikely. The CAD would likely prefer Clinton to Trump, so expect a positive/negative CAD reaction to Clinton/Trump positive polls. Graph attached here.

USD/MXN has become the market barometer of election sentiment, with the MXN suffering from any Trump advance in the polls. The MXN is also sensitive to the oil price and the general USD trend, and the MXN downtrend in the last two years has been based on these rather than politics. However, the latest MXN weakness has been Trump related. An oil price rally on the OPEC deal, a Clinton victory and a dovish Fed would be a perfect storm to push USD/MXN down, and the risks do seem to be mostly on the downside, as the current level prices in bad news that may not even materialise with a Trump victory. Graph attached here.

JPY strength has been a feature of this year’s trading and there are no real signs that it is reversing just yet. The lack of BoJ action at the last meeting triggered renewed JPY strength after a weaker start to September, but firmer expectations of Fed tightening could lead to a weaker JPY going forward. For now the USD/JPY downtrend is in place and a break of the September high at 104.32 would be needed to reverse bullish JPY sentiment. But the 99-100 area is likely to hold unless sentiment shifts against Fed tightening in December or equities fall sharply. Graph attached here.

Compliments of Bannockburn – a member of the EACCNY