USD Rally Running Out of Steam, GBP Scenarios

For now the USD rally has run out of steam, suggesting some consolidation before the secular USD bull market may resume its rally, supported by rising relative return differentials. GBP and CAD are best positioned to benefit from corrective USD activity envisaged ahead of Christmas. Despite relative hawkish comments from Dudley yesterday suggesting that the US economy is on its way to reach it dual employment and inflation targets, it would be a surprise to see next week’s Fed action going beyond what we call “a lazy rate hike”.

In many aspects the US economy surprised to the upside, but business investment has remained slow. Lacklustre investment growth has held back productivity, which has fed low wage growth and real income stagnation. Now the incoming US administration envisages a neo Keynesian fiscal programme there is the chance of breaking the low productivity low real income growth link, but this policy requires investment spending getting kick-started. Keeping monetary accommodation in place may help this process. Yesterday, St.Louis Fed President James Bullard suggested that President-elect Donald Trump’s policy could jolt the US economy out of its low interest rate, low productivity regime if his initiatives improve productivity.

The US bond market continues to rule the FX markets. High put option premiums suggest that the recent bond yield increase may be in for some near-term consolidation. The latest IMM report showed investors switching from JPY longs to shorts for the first time since the end of December 2015, supporting our view that USDJPY has developed a short-term top near 114.90 after gaining more than 14% in less than four weeks. However, the anticipated correction may be muted and setbacks into the 112handle offer strategic buying opportunities with a stop placed below 111. Hence our call for a near-term setback must not be confused with our strategic view suggesting USDJPY breaking into the 130 handle next year.

Despite the release of disappointing UK November like-for-like sales (0.6%Y after 1.7%Y), sterling is positioned to extend its recent advance. Our trade of the week is to buy GBP/USD towards 1.31. The Exhibit below illustrates how much GBP has moved away from cyclical indicators such as provided by relative real wage growth. Over recent weeks ithas been the political risk discount combined with easy UK monetary conditions pushing GBP lower. On both ends there is now relief under way. Yesterday, the UK’s Supreme Court started its hearing concerning the government’s wishes to use royal prerogative rights to trigger Article 50. Early in November, the High Court of England and Wales declared that the notification could not be done by royal prerogative. A verdict is expected in early January. An important element of this law case will be whether the Article 50 notification can be revoked. If so, the government would not need to ask parliament for approval, but a potential revocation of Article 50 could open the possibility of the UK staying in the common market should negotiations work against the interest of the UK. Ironically, the Supreme Court could refer the case to the ECJ to find a decision on this case. The FT argues that according to Article 127 of the Lisbon Treaty,an exit from the EU does not automatically remove a country from the common market. Against this background, the GBP risk discount appears too high.