By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
A New Year means new trading opportunities and January will start with a bang. Here in the U.S., a new President who has inspired an impressive rally in the U.S. dollar and U.S. equities will be taking office and there is a busy economic calendar to contend with. Countries around the world will be releasing ISM and PMI numbers, the FOMC minutes and account of the last ECB meeting are scheduled for release along with employment reports Germany, the U.S. and Canada. Although there was a bit of a pullback this past week, most institutional and retail investors are stepping into this New Year with a bounce in their step and optimism on their minds. Sentiment has changed dramatically in the past 3 months with the Dow rising more than 9% and the Dollar Index rising over 8%. Investors typically look for corrections after such strong gains, but there’s hope that the Trump rally will turn into the Reagan rally, which saw U.S. equities rise 32% from the time he was elected President to the end of his first term. Of course the majority of those gains occurred between August 1982 and January 1984. From the start of the year to the end of his the first 100 days, the Dow rose another 4% -- but that was only after a 4% drop in the first 6 weeks. The moves in the dollar was much more consistent with the Dollar Index slipping 1.75% in the first week before a stronger rally that took the index up 10% by the end of President’s Reagan’s first 100 days.
But is Donald Trump really Ronald Reagan? Only time will tell because right now there is still a lot of uncertainty around his policies. The first test will be what he pushes through in the first 3 months. Reagan came out of the gate swing -- less than a month after he took office, Reagan sent Congress a plan for sweeping changes to the budget and tax policy that encouraged the rallies. If Trump follows suit, continuation will be the opportunity in the New Year. If he comes up short, takes longer than expected or meets resistance from Capitol Hill, there could be a quick and aggressive reversal in the greenback that creates near-term bottoms for other major currencies. However between now and January 20 -- inauguration day -- markets will continue to be fueled by the prospect of fiscal stimulus and rate hikes. Which means that dips in USD/JPY and rallies in EUR/USD and GBP/USD should be shallow.
On a shorter-term basis, the main focus in the U.S. next week will be the December nonfarm payrolls report, which will help shape expectations for how quickly the Federal Reserve will raise interest rates again. Job growth is expected to be strong and a pickup in wage growth is expected after a drop in November. The FOMC minutes will reinforce the Fed’s hawkishness while the ISM data should show that so far, the strong dollar has had a limited impact on manufacturing and service-sector activity.
While EUR/USD soared above 1.06 in thin, light liquidity conditions the last week of December, the New Year starts with investors still wondering if the currency pair will hit parity. The sharp move on Thursday was driven by stops at 1.05. When this level broke, automatic orders were triggered and with no offsetting flow in quiet markets, the currency pair shot higher. The question of parity hinges less on European developments than those in the U.S. If the U.S. dollar continues to strengthen, the euro will continue to weaken. The Eurozone has its own troubles, but as weak as the euro may be, the slide in the currency is changing the outlook for inflation and growth. In the recent ECB economic bulletin, the central bank said it sees inflation picking up strongly at the turn of the year, a view that the Bank of England shares. We’ll likely see this view repeated in the ECB’s account of its last monetary policy meeting, which is due for release next week. Data should also be relatively healthy with sentiment up and job growth growing, albeit at a slightly slower pace. The ECB’s easy monetary policy is paying dividends, but Europe’s problems extend beyond day-to-day business activity. The greatest risk for the Eurozone and the euro next year are politics, terrorism, elections and Italy's banking crisis. Many of these events are difficult to handicap but each scenario could have a dramatic impact on the currency, overshadowing positive improvements in the economy. Looking ahead, we hope to sell rallies in the EUR/USD between 1.0550 and 1.07, targeting a move to 1.01 or lower.
Sterling, on the other hand, remained under pressure versus the euro and U.S. dollar. In fact, the currency’s underperformance drove EUR/GBP to its strongest level in a month. Brexit concerns will be front and center at the start of the year and the real focus will be the issue of a hard versus soft exit from the European Union. The PMI reports that are scheduled for release will take a back seat to political developments. Most members of Parliament prefer a softer exit, but some hardliners want to put immigration above everything else, leaving Britain at risk of losing access to the single market. The best-case scenario for the U.K. economy and sterling would be if the U.K. remains within the single market, allowing for tariff-free movement of goods, services, money and people within the EU. This would be similar to the Norway model, but to receive the benefits, Norway had to accept the EU’s rules for free movement of labor. The Brits are unlikely to concede to these terms as immigration was one of the main reasons for leaving the European Union. In the coming year, delays in Brexit negotiations could provide temporary support to the currency, but the ongoing uncertainty is negative for the economy and currency. Businesses have already delayed spending and according to the IMF, even if EU negotiations limit political fallout next year, the U.K. economy will still grow by only 1.1% -- half of its previous forecast. Unfortunately, the Bank of England can’t provide much help as its ability to ease monetary policy in the event of slower growth is limited by the sharp rise in inflation. Sterling is down 16% year to date, and policymakers expect this weakness to lead to a sharp rise in inflation in the coming year. So with the central bank’s hands tied and investment expected to remain weak, we anticipate a further decline in sterling versus the U.S. dollar and euro in the first half of 2017.
As for the commodity currencies, the big question is whether they have bottomed and in our opinion, the answer is 'no'. Part of that has to do with the prospect of further U.S. dollar strength but the 4% drop in the Chinese yuan since October and the 7.7% drop since April takes a big bite out of the purchasing power of the Chinese, who play a big role in the outlook for Canada, Australia and New Zealand. The Canadian dollar is at the greatest risk in the coming year. Not only is OPEC likely to come up short in its production cuts, but overhauling NAFTA was a big part of Trump’s campaign. Combine that with weaker Chinese demand and a stronger U.S. dollar, and USD/CAD could easily extend its gains. However underneath the currency movements, a stronger U.S. economy and a weaker Canadian dollar will go a long way in supporting the economy. So the Bank of Canada shouldn’t need to lower interest rates again and in fact could start to think about raising rates in 2017. Canadian employment numbers will be the main focus for the loonie in the coming week. After a few months of subdued job growth, a rebound is expected in December.
Australia and New Zealand, on the other hand, could feel the pinch of higher interest rates in the U.S. and weaker Chinese growth. Many Australian companies have also borrowed in U.S. dollars and the cost of borrowing will rise in the coming year. Since we are looking for further U.S. dollar strength, AUD and NZD are likely to move lower and this downtrend will ease the pressure on the reserve banks to lower rates. Growth should be slow as job growth remains a problem. There’s room for fiscal stimulus, but it's unclear whether the Turnbull government will provide it. In New Zealand, growth has been better than expected while weaker dairy prices and slower Chinese growth could curtail the recovery in the coming year. There are no major economic reports from New Zealand in the coming week, but Australia and China’s PMI numbers will be in focus along with Australia’s trade balance.