The year ahead

We close out the final quarter of 2017 with a resurging greenback; the USD finding solid gains against all G10 FX, notably the ‘Skandies’ (NOK and SEK).

Source: Bloomberg

EUR/USD has held in well, and looks to close out the quarter largely unchanged. I think it should perform well in the New Year and is poised to break into $1.2000 in the first quarter (Q1), where I think the market (in 2018) will start to price in a move from the European Central Bank (ECB), away from emergency policy settings. Even if the central bank try their best to convince them otherwise.

I also think it’s important to note that despite some excitement about the front-loaded fiscal stimulus from President Donald Trump's tax cuts and the higher US dollar (USD) funding costs, USD/JPY cannot break the ¥114.40 triple top and 2015 downtrend resistance currently seen at ¥114.00. Any market that struggles to rally when the stars are aligned is a genuine red flag and USD/JPY is a pair that divides opinion for 2018. The forecasts for year end range from ¥127.00 down to ¥105.00.

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.

Cyclical status

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.

A ‘political’ currency

We can often define the GBP as a political currency. Where, despite inflation running above target at 3.1% and the economy humming along fairly well, FX and gilt (UK bonds) traders are more concerned with what the economy looks like in 18 months time. Furthermore, the penitential for clarity about the UK’s relationship with the EU and how business may be impacted by a potential customs border and trade tariffs, not to mention the impact on the City of London and whether businesses leave for other European destinations, such as Paris or Frankfurt. Not only have traders shown a poor track record of predicting outcomes in political events and pricing risk accordingly, but they have to react to each headline out on the wires, and that makes trading just that bit harder.

That’s exactly where the GBP is now, but we are seeing signs that perhaps Theresa May can actually pull a rabbit out of a hat, in which case the GBP should have good upside in 2018. But that is a massive ‘if’, and if you don’t have a strong strategy of managing risk then you could be found out pretty quickly. That said, we have seen GBP/USD print a series of higher lows and highs throughout 2017 and, despite being beholden to headlines, GBP has actually been one of the better performing G10 currency in Q4. In fact, looking at the daily or weekly chart it feels that on balance there is an argument GBP/USD could be headed for $1.4000 and even higher in 2018.

A ‘funding' currency

The EUR has some cyclical qualities of its own as the European economy is the success story of 2017 and on the ECB’s own forecasts should push 2.3% growth in 2018. However, President of the ECB, Mario Draghi, has made it perfectly clear that the ECB are still in the market with deposit rates expected to remain at -40bp, and further balance sheet expansion (through Quantitative Easing) expected through much of next year. So while the Fed are focused intently on inflation and allowing other economic variables (such as growth) to overheat, the ECB do this to the power of two.

They take the overshooting to a whole new level, although as I say, I think the market will start to price in a move away from emergency settings in 2018. This is one of the reasons why I like the EUR in 2018. While forecasts are seldom accurate, I see EUR/USD testing $1.2500 in 2018, although that will be determined by a smooth outcome in the Italian election (expected on 4 March).

Another status assigned to a currency is that of being a ‘funding’ currency and specifically, we can lump the JPY and CHF in this list. In times of subdued volatility, upbeat sentiment and positive trending equity and credit markets, traders seek out yield and therefore use the JPY to fund this trade. Interestingly, we can actually see the JPY modestly higher on the quarter, despite the global economy firing on all cylinders and the MSCI World Index pushing to all-time highs.

The Japanese economy is taking part in the global growth story and there are some bullish factors in play in Japan in a number of their data points. That said, the Bank of Japan (BoJ), like the ECB, take monetary policy accommodative to a different level. And while there is some speculation the BoJ will look to steepen the yield curve in 2018 by targeting 5 or 7-year JGB’s (Japanese government bonds), on the whole, the market is seeing attractions in owning the JPY.

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