Forex Forecast for 2017 (part2)

Forex Forecast for 2017 -Heading into 2017, US dollar bulls have much to be joyous about The Federal Reserve plans to embark on a gradual mission to tighten policy further from current levels. Inflation is at the highest point in years and the slack in the labor force has gradually been reduced. Moreover, the proposed fiscal stimulus in form of spending and tax cuts are still on the table despite some doubts. All told, the US remains the least dirty shirt of the major advanced economies heading into the new year.

 Global Forex Market

The global recovery engine is set to turn towards developed markets from emerging markets. This is likely to make carry trades vulnerable,  while long FX volatility strategies become right skewed. The Scandi outlook suggests a bullish NOK stance but a more cautious SEK stance.  Inflation is likely to increase in 2017 and monetary policy conditions are set to tighten. Market pricing leaves scope for hawkish CZK surprise. Higher global inflation is likely to support CEE and commodity currencies, while an increase in 10Y UST yields would be JPY negative.

Advanced Economies Hit the Gas

Looking outside the United States for a second, risks for economies considered part of the major currency crosses are considerably to the downside, at least over the medium-term. Nearly every Central Bank across Europe and Asia has signaled that it intends to hold firm and continue printing,  or in some cases ease even further. Nobody is really discussing rate hikes before the beginning of 2018 and that is if inflation is miraculously rising.
The European Central Bank has extended its asset purchases while the Bank of England enlarged its quantitative easing by £60 billion. Japan intends to keep targeting yields on bonds while the Swiss National Bank attempts to escape from persistent deflation.
New Zealand and Australia are also fighting stubbornly low inflation. As a result of more expansionary and accommodative policies prevailing across much of the developed world while the Federal Reserve is the sole institution tightening policy amongst the majors is paving a clear path for the dollar to not only book gains but continue climbing.
On the Euro side, the European Central Bank’s decision in December 2016 to alter its QE program proved significant. In our Q4’16 forecast, we said “The ECB will very likely be forced to remove the -0.40% barrier (allowing more German bunds to be purchased), or to remove the capital key restriction (allowing more peripheral sovereign debt to be purchased).” By going the former route as opposed to the latter, the ECB has primed the Euro to be in a disadvantageous position if interest rates elsewhere continue to rise. Previously, yield curves in Europe were flattening as investors front-ran ECB bond-buying: with the ECB saying it wouldn’t buy debt with yields to maturity below the deposit threshold of -0.40%, there was a scarcity effect along the yield curve. This is no longer the case now that the ECB will buy bonds at any YTM, which reduces the need for investors to buy bonds at longer tenors down the curve. Concurrently, with the decision to buy 1-year debt, the ECB has  signaled that it is altering policy to keep the front-end of European yield curves pinned as low as possible — even in increasingly negative territory.
We base the 2017 publication on four themes we think will drive FX performance in 2017: (i) cyclical outlook, (ii) monetary policy and reflation, (iii) currency vulnerability and (iv) the Trump factor. In addition, we have a ‘wild card’, which is our tail-risk scenario. In our wild card scenario, we consider political instability in Europe. In our view, a sharp increase in political uncertainty in Europe would be EUR negative and create demand for traditional ‘safe havens’ such as CHF, JPY and DKK.

China GDP swells to 8% and the SHCOMP hits 5,000 China understands that it has reached the end of the road of its manufacturing and infrastructure growth phase and, through a massive stimulus from fiscal and monetary policies, opens up capital markets to successfully steer a transition to consumption-led growth.
Tiis results in 8% growth in 2017, with the resurgence owing to the growth in the services sector. Euphoria over private consumption-driven growth sees  the Shanghai Composite Index double from its 2016 level, surpassing 5,000.

Fed follows BoJ lead to fix 10-year Treasuries at 1.5%

As US dollar and US interest rates rise in increasingly painful fashion in 2017, the testosterone driven fiscal policy of the new US President leads US 10-year yields  to reach 3%, causing market panic. On the verge of disaster, the Federal Reserve copies the Bank of Japan’s Yield Curve Control, by fixing the 10-year  Government yield at 1.5%, but from a different angle, effectively introducing QE4 or QE Endless. This in turn promptly stops the selloff in global equity and bond markets, leading to the biggest gain for bond markets in seven years. Critical voices are lost in the roar of yet another central bank-infused rally.

 Some Serious Stuff

Our current assessment is that the Trump administration’s tax and infrastructure plans will have a mildly positive impact on the U.S. economy toward the second  half of 2017 and into 2018. We currently make no assumptions with respect to trade policy changes other than modestly marking down our forecast through the  first half of 2017 to account for increased uncertainty. Given the potentially serious negative consequences of Mr. Trump’s possible trade policies, we expect that firms will remain cautious until there is greater clarity on his plans. Our overall assessment on growth is highly preliminary and will be adjust

United States

In the U.S., tax cuts and infrastructure spending will provide a modest boost to growth when implemented. Compared with our previous forecasts, we have trimmed U.S. growth in 2017 by 0.1 percentage points to 2.1% owing to initial caution in private investment decisions. U.S. growth is  expected to remain otherwise broadly supported by mildly improving consumer spending, solid job growth, rising wages, and income gains, as well  as by stronger industrial activity after a period of inventory de-stocking. Moving into 2018, we have boosted our U.S. growth forecast from 2.2% to 2.4%  on the back of an expected increase in infrastructure spending, as well as personal and corporate tax cuts. This should sustain a stronger than previously  forecast recovery in domestic demand.
The USD will strengthen in 2017, supported by growth optimism and shifting Fed policy risks in the aftermath of the U.S. election.
We have adjusted the CAD profile to reflect a larger and longer decline against the USD next year. This is due to our expectation of broader strengthening in the USD, ongoing growth challenges at home. The USD will remain well supported against the main European currencies. We expect
Brexit to be an ongoing challenge for the GBP, especially with respect to the activation of Article 50 early next year. We have adjusted the EUR forecast slightly lower .nto 2017 to reflect the likelihood of additional ECB easing measures and political event risk in the Eurozone during the coming months (e.g., December’s Italian referendum on political reforms and several national elections across Europe). The previously forecast weakening path for the JPY remains intact

Inflation

Core personal consumption expenditures (PCE) inflation in the U.S. is expected to increase to 1.9 percent by the end of next year, approaching  if not overshooting the Fed’s 2 percent target. Although the inflation party started elsewhere in the world, Europe didn’t get an invitation.
The eurozone 10-year/20-year inflation break-even has jumped recently, nearing the European Central Bank’s “below but close to 2 percent” target, yet the ECB could disappoint by tapering prematurely or not extending quantitative easing beyond next March.

Monetary easing gives way to fiscal easing

The history of populism is one of fiscal largesse. U.S. rates have backed up quickly after the election, driven largely by a repricing of inflation expectations. With long-term inflation break-evens closing on their historical averages, we think the next phase of the rates move will be led by the belly of the curve and real interest rates. The market expectation for Fed hikes in the coming years has sufficient room to increase relative to the current projections in our view.

Globalization of anti-globalization

While the U.S. fixed income sell-off is likely to continue spilling over into other bond markets, yield differentials are still likely to move in favor of the USD. In our view, long positions in emerging markets remain crowded, liquidity conditions are poor, and downside risks remain in a strong dollar environment. USD/JPY will likely be the main foreign exchange beneficiary of U.S. fiscal expansion, given its high sensitivity to rates and the Bank of Japan’s 10 year JGB yield target. We see continued CNY depreciation with a strong dollar, adding pressure on China to weaken its currency to loosen financial conditions, while increased trade tensions could further pressure the currency.

U.S. and global economic growth

Nominal growth in the U.S. could rise from 3 percent to 4 percent, with a real GDP gain of 2 percent. Slower growth is expected in the first half of the year, picking up in the second half once fiscal stimulus measures kick in. In the rest of the world, nominal growth could near 7 percent, with a real economic gain of 3.4 percent, up from 3.0 percent in 2016. We expect global growth, however, will be driven by supply  versus the demand side of the economy.