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The Fed rose its benchmark rate by a quarter point during its December 2016 meeting, just as it did during the same period in 2015. However, there are some important distinctions this time around.
Last year, the Fed hiked interest rates for the first time since the financial crisis. Expectations were high for further rate hikes, but as other central banks remained globally accommodative and inflation was subdued, the Fed continuously pushed back the deadline.
This year, things are different for five key reasons:
- Expectations for a rate hike have somewhat softened as investors are more wary about projections from the Fed.
The year is starting with a change of US government and a US president elect who intends to implement a large-scale fiscal push.
- Oil prices may continue to be supported upwards after the first coordinated output cut by both OPEC and non-OPEC members since 2001.
- Copper, iron ore and other industrial commodities have reversed what was a multiyear downtrend.
- US wages are starting to rise, after having being under pressure for several years.
- The Fed and other central banks have come to realise that low rates and flat yield curves over a long period do little for the real economy. 2017 may become the year of reflation, as the Fed has been waiting to further adopt monetary tightening.
In contrast, the situation looks very different in Europe, with limited flexibility from governments and the European Central Bank (ECB) ahead of the major elections in France and Germany.
The ECB pledged to extend its quantitative easing programme at least until end of 2017, during which it will purchase €780 billion worth of assets. This is money that would also more effectively reach the economy, as European banks benefit from rising yields and increase their lending activity.
A weaker euro would also force the Swiss National Bank (SNB) to keep rates low and to continue printing francs in order to purchase foreign assets. Hence, we expect the dollar to gain about 10% compared to both the euro and the franc over the course of next year.
A risk to our scenario would be delays or a lack of support for the implementation of Trump’s fiscal policy. However, yield differentials should keep any downside to the dollar limited.
Currently, the yield on the 10 US government bond is around 2.5% compared to 0.25% for the eurozone and -0.16% for Switzerland.
EUR/CHF to fall to 1.05
The SNB will be hard pushed to maintain the current levels in EUR/CHF this year. The ECB’s decision to extend its programme of quantitative easing to the end of 2017 (and beyond if needed) has already weakened the euro across all major currencies.
The ECB also modified its bond-purchase programme, which means bonds can now be bought on the short end of the yield curve. This move should make the euro more attractive as a funding currency and increase its turnover, thus putting it under even more pressure.
Political risks from national elections in France, the Netherlands and Germany, as well as the initiation of Brexit negotiations, are further risks for the euro. The only way the SNB can now fight the uncontrolled strengthening of the Swiss franc is with FX market interventions. With FX reserves having skyrocketed to 650b CHF from 50b CHF prior to the financial crisis, this would be a risky but potentially necessary move. EUR/CHF should gradually decline to 1.05 throughout 2017.