FX Outlook: USD headwinds, debt ceiling, Bannon, Jackson Hole
The departure of President Trump’s chief strategist Steve Bannon from the White House last week has been flagged by media as an apparent victory for market-friendly “globalist” figures such as NEC Director Gary Cohn as well as traditionalist security figures such as National Security Advisor McMaster. The former concept so far has its best evidence in the form of the Cohn’s feared resignation not transpiring. The latter idea is best represented by Monday night’s speech by President Trump outlining recharged and indefinite US troop commitments to Afghanistan, a move that “alt-right” media has been quick to label a betrayal of Trump’s base.

While signs of Republican civil war may be welcomed by the political left in the US, which is more focused on the bigger and older Civil War, it is not helping investor sentiment as arguably it suppresses the energy available for a new Trump rally. The post-Bannon departure rally in stocks has been somewhat tepid so far, and notable investors have been on the wire signaling that they continue to de-risk as a function of disharmony in Washington DC. Markets are caught between optimism raised by the likes of Cohn and Treasury Secretary Mnuchin that tangible progress can be made this year towards delivering a tax cut and other pro-growth measures, and the reality that delivery on pro market policies has been weak so far, with the debt ceiling issue still unresolved and likely to hit a crescendo in about 5-6 weeks from now.

Nonetheless, from an FX market perspective, if these developments are sufficient to give rise to hope that at least there is some chance that the White House will be stable, unified and pro-market enough to deliver results, we would expect a lower volatility environment characterized by a subdued VIX Index. This would back our decision last week to keep key forecasts such as USDJPY unchanged for now despite the noise of recent weeks, and to look for a more stable (though not materially stronger) USD after the generalized losses of recent weeks. The key risks to our view are as follows:

1. more unexpected domestic incidents along the lines of the Charlottesville theme that illicit controversial messaging from President Trump and raise doubts about how tenable the support base from his current cabinet and other senior Republicans can be going forward,
2. a clear sign that the debt ceiling issue may not be easily resolved (which would be a large shock given that Senate majority leader McConnell said this week there is “zero chance” Congress does not raise the debt limit),
3. dovish statements by Fed chair Yellen or other senior Fed officials that cast further doubt on whether more rate hikes can materialize in 2017, or limit the market’s scope to see a sustained hiking cycle next year and beyond. As far as the third point above goes, the market is heavily focused on Friday’s speech by Yellen scheduled for 10:00 a.m. EST at the Jackson Hole symposium.

Given that the latest Fed minutes pointed to an emerging debate about the validity of more traditional Phillips Curve approaches in today’s global economy amid a backdrop of seemingly persistent low inflation, the market will be keen to see if Yellen can provide more color on whether this debate is material enough to require a repricing of US rates expectations. We note, though, that markets need to be careful about the risk of other Fed speakers speaking to the media around the same time and creating noise, as happened in 2016 when Fed vice chair Fischer made comments soon after Yellen to the media that were deemed more hawkish. Given the low level of US rates going into Jackson Hole, it would likely take a consistent and relatively direct set of statements from Fed officials highlighting issues such as low productivity, low inflation and a weakened Phillips Curve to lead to a break of key supports (e.g., 2.12% in 10-year Treasury rates) and lead the greenback lower across the board.