The course of 2018 saw a firming in the US dollar against just about every other currency. But the factors that contributed to this steady rise may be starting to diminish. The big question facing the FX markets this year is whether the dollar can continue to push higher or whether the softening in December is the start of a longer-term trend.
Economic outperformance in the US and monetary tightening by the Fed bolstered US yields and the dollar. Growth accelerated to above 4 per cent in the middle of the year, while unemployment sunk to a 50-year low. Inflation ticked higher and interest rates were hiked 4 times. But economic indicators are now starting to show a softening. GDP growth has retreated to the 2 per cent level and it seems unlikely that this will be beaten next year.
In particular, we expect the positive impact of Donald Trump’s tax cuts to diminish. Trade could also weigh on the dollar if the tariff war with China starts to raise input costs and hit growth. On the other hand, the greenback has enjoyed a degree of haven status in 2018 amid trade war fears. Finally, US yields rose sharply, opening up a decades-wide spread with German bunds. Yield spread differentials have contributed to a stronger USD, although hedging costs have moderated the uplift for the dollar.
The combination of slowing growth and an easing in Treasury yields would tend to suggest the dollar rally is over. However, when looking at USD strength we must always look at the alternatives, particularly the euro, sterling and yen. And on those scores, there is sufficient doubt about the degree to which they can strengthen in 2019: the dollar rally may yet have room to go. Moreover, markets are already pricing in no hikes in 2019 and whilst the dollar has faded against the yen on safe haven demand, it remains resolutely firm against the euro, sterling and commodity currencies like the Australian dollar.
Euro faces ECB headwind
The European Central Bank (ECB) looks in a tight spot. Whilst it has ended QE, the outlook for the Eurozone economy is very mixed. The goldilocks conditions of late 2017 are a distant memory and it does rather look like the ECB has been too slow to raise expectations. Credit conditions may well be tightened at precisely the wrong moment.
Investor confidence has sunk to four-year lows, inflation expectations remains anchored at a level below the ECB’s target and growth is showing signs of cooling. Meanwhile the threat of a trade war is weighing heavily on export-focused Germany. Finally, political risks are mounting with Italian government still in dispute with the European Commission over its budget, while the yellow vest movement in France highlights how populism is rising in Europe.
For the euro, we consider the growth levels but above all the ECB’s monetary policy, particularly interest rates. Markets have been banking on the central bank to start to raise rates in the back end of 2019, but those expectations may need to change. Increasingly uncertainty about when rates might rise will likely weigh on the euro. Meanwhile there is a risk that a global slowdown in 2019 results in the ECB needing to open the taps on QE again.
Whilst remaining doggedly optimistic throughout 2018, by December even Draghi had to admit that risks were starting to tilt to the downside. The Eurozone’s exposure to global export markets is important as trade tensions become tougher and slowing growth in China will affect the bloc more than the much more domestically-oriented US economy. EURUSD risks heading back to multi-year lows at 1.03 if the ECB does have to restart QE.
Brexit tightrope for sterling
Economic fundamentals and interest rates matter less for the pound than any other major currency because of Brexit. How and even if the UK leaves the EU is critical to the direction of the pound over the next few months.
The range of outcomes makes it very hard to take a long-term position on the pound. A no deal exit could bring GBP/USD down to 1985 levels around $1.05 again. If there is a second referendum and Brexit cancelled, then a return to $1.45 looks likely. Amid that massive range there is any number of potential outcomes and levels for the pound.
In that regard, the current range for sterling around the $1.26 level suggests that sterling is significantly mis-priced – but only if we get one of the extreme outcomes. The two polar extremes – no exit and no deal – seem more likely now, but you just never know what will happen.
Japan: no change
Investors have been eyeing Japan for some time as a country that could be ready to move away from extraordinary monetary stimulus. However, anyone expecting some progress on this front in 2019 could be left disappointed. Despite its vast QE programme, inflation has remained stubbornly low and growth is starting to look very weak. Indeed, Japan’s GDP contracted by an annualised 2.5 per cent in the third quarter of the year, its worst performance in four years.
Citing trade wars and US-China relations, Bank of Japan governor Haruhiko Kuroda recently warned that risks to Japan’s economy are skewed to the downside and that it is yet too early to start raising rates. He added that rates will only rise when inflation approaches the central bank’s 2 per cent target. That could take some time – core inflation in Japan is still under 1 per cent.
But the yen is enjoying significant uplift from safe haven demand as investors retreat from riskier assets. The yen’s haven status means USDJPY could retreat to 100 if the US-Sino trade war escalates.