2018 – the year ahead
It’s this time of year where we can look back the major themes in markets and look to identify the currencies that will potentially outperform in the quarters ahead. Of course, forecasts can be useful for investors with a global balanced mandate and, of course, exporters.
However, for short-term traders, forecasts are about as useful as a barbers on the steps to the guillotine; it just creates a bias that rarely helps with obtaining an edge. As we look forward, and this is obviously only relevant if one focuses on fundamental drivers, then it can pay to have an intermittent understanding of each currency's key characteristics and price drivers, but also the likely upcoming catalysts and triggers.
There are many ways we can think about a currency, but one way I feel makes sense is to look at it key defining characteristics. These being a cyclical, a political and a funding currency.
The first characteristic or status is to assess whether the currency is a ‘cyclical’ currency. This is perhaps the status most can identify with and is the most logical. This is where the exchange rate is driven by the economic data flow, the perception of future inflation trends and how active a central bank will be in either raising interest rates or pulling back on emergency monetary stimulus. As it stands, this would include the majority of G10 currencies and we can immediately think of USD, AUD, NZD, CAD, SEK, NOK and DKK.
In a cyclical world, the Federal Reserve (Fed) dominate the markets thought process, and rightly so, given it's by far the dominant force in the majority of cross-border capital flows. There was once a school of thought that it was the market that dictated the Fed.
That regime has now shifted and the Fed beat to their own drum. They have effectively detailed the markets in the 14 December Federal Open Market Committee (FOMC) meeting that they no longer see a hot labour market, resulting in runaway inflation. They have also made it perfectly clear they are happy to allow growth to overshoot, with full employment unlikely to result in rampant wage pressure. This is a headwind for any cyclical currency, as it means slow and steady when it comes to interest rate hikes, when USD bulls really want to see four hikes in 2018.
The AUD has traded in a range of $0.7897 to $0.7501 this quarter and this has been driven, most prominently, by bond yield differentials. Here we can see the yield premium demanded to hold Aussie 10-year Treasuries over US Treasuries come from 61bp in September to 8bp in November – the lowest premium since 2000 and this has removed a lot of fundamental support for the AUD.
The weekly chart of AUD/USD is interesting and gives strong perspective, with the price holding the uptrend drawn from the 2016 low and mitigating a bearish outside week reversal on 4 December. One to watch in the quarters ahead but, just as the market was sensing a key technical break of the longer-term trend, the Fed have removed a massive USD driver and we are going to need to see US inflation expectations really head higher to get us excited about the USD.