By Phil Lynch Introduction Hello, and welcome to the EncoreFX 2018 Market Preview. This is the first instalment of a…
By Phil Lynch
Hello, and welcome to the EncoreFX 2018 Market Preview. This is the first instalment of a monthly special report for Chief Financial Officers and Finance Managers responsible for looking after foreign exchange risk.
As markets face increasing uncertainty, we break down the key themes that will affect currency markets in 2018.
The first theme we cover is the US Federal Reserve. The most powerful Central Bank in the world is getting a new boss in Jerome Powell, amidst a tricky set of circumstances.
The Federal Reserve is in the middle of a tightening cycle – with a projected three rate hikes in 2018 and three rate hikes in 2019. This will take the Fed Funds Target Rate to 2.75-3.00%. Inflation remains an issue for the Fed – with inflation failing to meet the 2% target. Policymakers are continuing to grapple with the 2% target, with some concerned that the slower than expected inflation number is not transitory, but more fundamental. Powell has already commented, “We’ll have to be guided by the data as they come in, that’s what will dictate the path of our policy.”
Trump’s tax cuts will play a major part in the development of the economy. US Dollars should flow back into the US as corporations take advantage of the tax benefits. Theoretically – this should stimulate the economy, create growth, and fuel inflation – which may see the Fed need to take more aggressive action. For now, the Federal Reserve is taking a more modest opinion of the tax reform benefits.
Reducing the enormous balance sheet will be another major battle for Jerome Powell, who had reservations about the third round of quantitative easing. This could add to the tightening environment in the US.
All in all – the Federal Reserve is likely to continue to raise rates more aggressively than any other central bank in the world. This will fuel demand for the US dollar and should continue to prop it up as the year goes on. So what about other central banks?
The Reserve Bank of New Zealand is set to continue with its staggeringly boring and neutral course in 2018. The RBNZ is not projecting any rate hikes until the end of 2019 (which could see the US Dollar trading at a 1.25% premium to the New Zealand Dollar).
However – the RBNZ is also getting a new boss in NZ Super Fund Chief Adrian Orr. The kiwi has already rallied on the prospect of such a strong candidate coming into the role, especially amidst proposed changes to the Reserve Bank Act.
The changes to Reserve Bank Act are still being reviewed, but are likely to include the addition of an employment mandate, and shifting to a committee based policy decision rather than that of a sole Governor. The Terms of Engagement are available online.
The changes above should not alter the RBNZ’s neutral outlook, and the incoming Governor should have no problem managing the change.
Markets, however, have a more hawkish outlook than the RBNZ is projecting. Whilst some analysts (eg Westpac) are expecting rates to stay on hold for a long time, many analysts are still projecting at least one rate hike in 2018. BNZ are expecting rates to be hiked to 2.75% by June 2019. There is still a divergence of opinions with few on the side of the neutral RBNZ, and most being more hawkish.
One thing we’ve learned from 2017 is to expect the unexpected. We can expect more of the same in 2018. We’ve done our best to break down the themes.
The first major change from Trump’s administration is the tax reform, which was passed into law in late 2017. There are dozens of changes (which can be hard to keep track of). The key changes affecting FX markets stem from:
Just how these changes play out are yet to be seen, but the consensus is that these will lead to an uptick in demand for the US dollar.
It is worthwhile checking in on the Trump-Russia investigation. The headlines continue to slam Trump yet the risk of impeachment remains somewhat distant. For now – it seems like a waiting game whilst the FBI continue to investigate links between Trump’s campaign and Russian interference. However – there is still a possibility this comes to a head in 2018 – and I don’t think anyone could predict how that would play out in markets. There is also a slim possibility of a coup through the execution of powers under Amendment 25 – but this is another highly unlikely scenario.
Trump may also be running out of time, with the possibility of the American public voting in a Democrat-led Congress that will challenge his every move.
Of course, there will be plenty of other curve balls provided by Trump in 2018, that not even the best crystal balls can pick up.
The jury is out. And there are plenty of spanners in the works. The latest (and final) reading of Q3 GDP in the USA came in at 3.2% – the fastest pace since Q1 2015. Growth in 2017 came from robust business spending and is now poised for what could be a modest lift in 2018 on the back of the new tax regime being ushered in.
Employment growth remains strong, with the Unemployment Rate firm at 4.1% and new jobs growth encouraging. Wage growth remains somewhat subdued.
Europe is looking to pull back on their Quantitative Easing this year, and the interest will centre on how it goes about achieving that, and who will lead that process with Mario Draghi finishing his term as Head of the ECB.
With the ECB tightening their stance, now only buying 30 billion euros of bonds each month. The Euro could strengthen considerably – but economic data will have to support the tightening of policy and the ECB have reserved the right to extend beyond September if necessary.
Draghi, an Italian, is not eligible to serve again after his eight-year term, which ends in late 2019. Decisions to replace Draghi will be made well in advance.
The biggest threats to Europe and the European Union in 2018 (as cited by EU President Donald Tusk) included a more assertive China, an aggressive Russia, along with war/terror/anarchy.
There is also the messy divorce to consider – with Brexit negotiations continuing.
The world will be watching to see how the UK and Europe settle Britain’s divorce from the EU. The main questions will be:
So far – Britain’s economy has weathered most of the negative forecasts. But the fact remains that Britain must leave the EU by March 2019. Teresa May has secured the bones of a Brexit deal (and probably secured her job for the foreseeable future), but there is still so much uncertainty and we can expect volatility to continue.
China will continue to grow at 6.5% or more, especially with the Chinese authorities ‘smoothing’ the numbers. Manufacturing costs in China will also continue to rise. A trade war with the US is in the cards.
The Bank of Japan will continue with its ultra-loose monetary policy. It is highly unlikely they will move rates in 2018. However, by the end of 2018, they may indicate their intentions to tighten their current stance and this would benefit the Yen – the adage of ‘buy the rumour, sell the fact’ could come into play.
Prime Minister Modi may make additional aggressive plays, like his move to ban high-value bank notes in efforts to curb corruption. This could include a shake-up for wealthy Indian property owners who hold property in other people’s names but may extend to currency markets.
North Korea will probably not go to war with the USA or the West (or they will face obliteration, as Trump puts it, quite correctly). However – we can expect the rhetoric to continue to upset markets and add to a risk-sensitive environment.
The headline-grabbing Bitcoin will not become the global currency of choice. As a decentralized “currency”, its value is determined by ‘traders’ and ‘supply/demand’. Its volatility will remain extremely high with no mechanism to protect against ‘bubbles bursting’. Quite simply, it is not suitable for businesses to use on tangible trade.
Banks and FX Service Providers will have almost no scope to offer services in Bitcoin, as we’re heavily regulated and need to ensure compliance with Anti-Money Laundering and Counter-Terrorist Financing legislation – making trading in Bitcoin for import/export very difficult.
Other cryptocurrencies will likely face a similar fate – even those with centralised mechanisms (such as Ripple). Businesses simply cannot cope/operate with such high risks.
However, the blockchain technology (underpinning cryptocurrencies) will continue to expand and challenge the way markets operate – forcing central banks and the financial services industry to evolve.
Equity markets, including both the Dow Jones and S&P 500, are continuing their strength early in 2018. Whilst many believe an equity bubble is forming, others argue that Trump’s tax cuts will continue to support record growth in equities. Liquidity remains high to protect against shocks, but there is a sense of caution after equity markets went through 2017 unscathed (unlike in 2007 – GFC; 1997 – Asian Crises; 1987 – Market Crash).
The Fed is projecting to raise rates dramatically in 2018, and continue with unwinding QE. But Treasury yields might lag behind in 2018, with inflationary pressures still failing to shift treasury yields.
Oil prices have risen dramatically over the past month, with the prices rising on all the major oil indicators. Most analysts and experts are predicting this to continue – with many expecting to see oil at USD $70 a barrel again, if not higher.
The top five contenders, in order, are Germany, France, Brazil, Spain & Argentina. It’s hard to see anyone else winning. Australia has a particularly tough road in the finals. First up they face France, followed six days later by Denmark. Then they face the might of Peru (who even managed to squeeze out New Zealand in the qualifiers). But with odds as long as $251 to one it is hard to deny a bet on the great sporting nation’s soccer football team.
The key themes outlined above mean there is a high likelihood of volatility in 2018. The EncoreFX team are experienced in helping you navigate the challenges faced in managing FX risk. To learn more about how we can help, contact us today at email@example.com. Or call 09 941 4050. You can also contact authors Phil Lynch on the numbers below.
Phil Lynch – Corporate Hedging Director – Asia Pacific
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