Part two in a series. Paresh Upadhyaya is Senior Vice President, Director of Currencies, US.
In my last post, USD Bull Market: Key Drivers in 2017, I discussed the first of three drivers of the US dollar (USD) bull market: fiscal stimulus. Here I’ll examine the second two: rate normalization and idiosyncratic factors.
US Rate Normalization Gathers Steam
The monetary policy divergence theme is the other big and reliable driver behind the USD rally. We expect two key themes could lead the Federal Reserve to tighten at a quicker pace, compared with the last 12 months. Our analysis shows the Federal Reserve is behind the curve in tightening monetary policy. In the post-Volker Rule era, the Federal Reserve has increased interest rates an average of 270 basis points during its tightening cycle while Personal Consumption Expenditures Core Index has risen 0.2% and the unemployment rate has fallen 2.4%. In this tightening cycle so far, the Federal Reserve has increased interest rates 50 basis points but the inflation rate is up 0.8% and the unemployment rate has plunged 5.3%.
What is unusual about this tightening cycle is that the Federal Reserve has waited one year before increasing interest rates again. In addition, inflation and wage indicators are on a firm upward trend and within striking range of the Federal Reserve’s target, while spare capacity in the labor markets has completely disappeared. Likely to aggravate the situation, there is no sign that the US economy is losing momentum heading into 2017. In fact, we expect the US economy to grow steadily above trend, with upside risks. A loosening of regulations could incentivize investors and perhaps finally revive fixed investment. Easier fiscal policy will certainly add to growth. There is a disconnect between the Federal Reserve’s dot plot (showing the rate predictions of the FOMC members) and market expectations for interest rate increases in 2017. As a result, we expect the Federal Reserve to pick up its tightening cycle and increase rates more than is currently priced into the markets.
Finally, there will be idiosyncratic factors driving the USD stronger against the euro, British pound and Chinese yuan.
The rise in far right populist parties will add to political uncertainty and weigh on the currency. Politics are having a stronger impact on the currency. The examples of Brexit and the Italian Referendum show how the currency came under pressure ahead of the event as investors were selling British and Italian fixed income securities. The French presidential elections in April and May and German general elections in September are potential risk events that could add to euro volatility. Following the shocking results from Brexit and the US presidential elections, investors are sure to be anxious as we approach these two critical European political elections in 2017. Widening interest rate differentials and rising political volatility should lead to a serious test of EUR/USD parity in 2017.
The British Pound
The pound remains highly vulnerable to Brexit-related news. This will remain the case next year as Prime Minister Theresa May is expected to trigger Article 50 of the Lisbon Treaty sometime in late first quarter or early second quarter of 2017. As long as Brexit remains the course, the British pound will come under downside pressure. In addition, the likely continued lack of foreign direct investment will highlight the difficulty of financing the massive current account deficit that will act as a structural headwind on British pound. As a result, we expect the value of the pound to fall below $1.20 in 2017.
The Chinese Yuan
The renminbi depreciated 6.5% in 2016 – the fourth worst-performing foreign exchange among major G101 and emerging market countries. Capital outflows, as well as sluggish domestic and global growth were the key forces weakening the currency. Last year, outflows peaked at just over $1 trillion on a rolling 12-month period (see chart below). We expect capital outflows to remain the biggest depreciating factor behind the renminbi. The economy could weaken as credit growth slows once again and could revive market anxiety over the size of China’s massive private sector debt. There remains some uncertainty if there is a rise in trade tensions between the US and China. This could potentially become another factor behind renminbi weakness. We project the Chinese yuan to depreciate around 6% to ¥7.30 vs the USD in 2017.
China’s Capital Outflows Contributed to Its Weakened Currency
Source: Bloomberg and Pioneer Investments. Last data point 12/30/16.
1 G10 are nations that meet on an annual basis. The member countries are: France, Germany, Belgium, Italy, Japan, the Netherlands, Sweden, the United Kingdom, the United States and Canada, with Switzerland playing a minor role.