2017 Start, Trump, G10 and Emerging Markets
2017 so far has been characterized by a relative lack of new direction in G10 markets. Indeed the action has largely been in the EM space, with some familiar players from last year such as CNH, TRY and MXN again dominating the headlines. From our perspective, one reason for this is the relatively benign outlook now priced in for changes in monetary policy. In the G3 space, the Fed is priced to hike twice in 2017, at roughly 6-monthly intervals. But both the ECB and BoJ are expected to take 2017 off entirely, with core inflation low enough to allow rates to stay suppressed and QE programs to continue despite a much brighter economic outlook and the disappearance of key disinflationary forces. The BoE is also widely expected to stand pat given Brexit macro risks, while the RBA and BoC are also priced to do either nothing or in Canada’s case only grudgingly follow the Fed’s rate hike path. The market appears to be saying that, bar a sudden and unexpected surge in inflation expectations, there is little reason for major central banks to do anything other than cruise along in autopilot along a largely pre-set course for now. It is no surprise in this context that, with the exception of Brexit-plagued GBP, most G10 FX vols are down so far in 2017. Nonetheless, today could see a change if the proposed press conference by presidentelect Trump leads to statements that upset the apple cart. In our view, there are three scenarios to consider from an FX perspective:
1. If Trump sticks to selling a positive economic story characterized by promises of tax reform, de-regulation and infrastructure spending, the USD should feel comfortable maintaining an overall upward trajectory given that US rates would likely move higher again in this scenario. Our current 3m forecast profile (EURUSD 1.03, USDJPY 122) is in line with this as our central case. Indeed, with markets only pricing in a 20-25% chance of another Fed hike in March, we see some upside USD risk if these odds rise in the weeks ahead, assuming US equities stay bid and fiscal expansion plans become more transparent.
2. If Trump focuses more on themes like Nafta withdrawal and especially labelling China a currency manipulator, the market may finally start to price in some possibility of a negative growth shock at a global level, which in our view would be best expressed in G10 space by buying safe havens like CHF and especially JPY. It is notable that JPY implied volatility remains lofty despite the overall pressure on G10 vols, with risk reversals still bid for JPY calls, suggesting that the market already owns some insurance against such an outcome. This suggests that a Trump press conference viewed as entirely benign would ease tensions and provide for a fresh reason for the market to buy USDJPY again after recent profit-taking. Indeed till now we have argued that the best places to trade specific Trump risks to global trade are in the currencies that most reflect likely losers, i.e. to be short MXN (3m forecast : USDMXN 23.00) and CNH (3m forecast: USDCNH 7.07). Although the carry costs are high and have risen still more on balance, the Trump message has been nuanced enough so far to warrant this approach.
3. The true wild card the Trump press conference could generate would be comment attacking overall USD strength. We see this as a very low delta outcome at this stage – recent events suggest more time is likely to be spent discussing actresses and TV shows than discussing the currency specifically – but it should not be ignored altogether. If this does emerge we can imagine it generating significant resistance to further USD strength, at least in G10 space, given current market positioning. A comparison would be with the March 2015 FOMC that saw the “dots” lowered partly as a function of USD strength, which helped to draw a line in the sand for EURUSD around 1.05 until December 2016. With the market more focused on long USDJPY as its most effective G10 USD-bullish expression, we would expect this pair to have the most significant retracement under this scenario, perhaps as far as the 110 level.
Assuming Trump addresses matters that can have relevance to the FX market at all, we would ascribe a 20% probability of just scenario 1 happening, a 10% probability of just scenario 2, a 65% probability of some fusion of 1 and 2 and a 5% probability of scenario 3 being the dominant message. In EM, we note that last week’s CNH funding squeeze has run its course for now, with implied CNH rates materially lower in the past few days. This has allowed spot USDCNH to move higher again, even as longer-term forward outrights are not much changed from last week’s levels. We acknowledge that onshore liquidity has also tightened somewhat of late, but the bottom line is that there is little evidence as yet that policymakers are willing to tighten the screws enough to change the underlying psychology in favour of acquiring overseas assets in a rising dollar world. As such we retain a view that buying longer-term USDCNH tenors makes sense, for example the 5m outright around 7.05. Meanwhile in Mexico, higher MXN funding costs combined with Banxico intervention are likely only to stall MXN losses as opposed to actually changing the downward trajectory. We discuss both these currencies in depth in this week’s FX Compass. As for the Turkish lira, we remain bearish against forwards even from current levels and are unconvinced that either the central bank or the government have the willingness or ability to support the lira. We revise our 3-month forecast to 4.00 and our 12-month target from 4.10 (from 3.65 and 3.85 previously). If extremely shallow liquidity, poor investor confidence and repeated disappointments from the central bank are becoming a new reality for the lira, there may be no clear upper bound on where USDTRY may be heading. Indeed yesterday’s attempts by the central bank to tighten TRY liquidity remind us of several similar attempts over 2016, where small measures did not prove to be sufficient substitutes for hikes. In the current environment markets may be disappointed with anything less than 100bp on 24th January – especially with the political environment becoming more awkward for the central bank to act in an aggressive manner as April’s referendum approaches. To make matters worse, a potential downgrade from Fitch to junk on January 27th is unlikely to help sentiment, even if it is the third major rating agency to do so.