A summary of our key FX forecasts as at November 2019.

A long-standing feature of our FX forecasts has been a robust US dollar uptrend. Events over the past month however have led us to revise this view. While we still see the US dollar edging higher into year end, thereafter a sustained downtrend is expected as the Yen and Euro firm.

From 98.9 (DXY index) at the time of our October Market Outlook, the US dollar fell to a low of 97.2 during the month before partially recovering to 98.1. Behind the initial move was greater confidence vis a vis US/China trade relations, reducing demand for the US dollar as a safe-haven.

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While the market’s new-found comfort on this front has grown since, partially offsetting its effect on the currency has been a reduction in rate cut expectations for the FOMC – federal funds rate expectations at December 2019 and 2020 respectively have risen from 1.47% and 0.96% on October 4 to 1.54% and 1.36% currently. While immediate expectations for other nations have moved to a similar degree, the shift in expectations a year out has been greater for the US.

As we look ahead, tensions on trade look set to (at worst) remain a ‘slow-burn’ risk, limiting any flight-to-safety flows to the US dollar. Meanwhile, on the back of a further deterioration in the US’ domestic economy (which we see as already in train), federal funds rate expectations should decline – we foresee a low for the federal funds rate of 0.875%, albeit now not until September 2020 (previously June). As outlined on page 16, this will be the result of a deceleration in consumption growth and persistent weakness in business investment, and will likely see GDP growth below trend in both 2020 and 2021. These developments will weigh on the US dollar during 2020 and their effect will be amplified by policy developments in both Europe and Japan.

First to the euro area, while market sentiment there has been buoyed by global developments, the state of the underlying economy remains poor. In Q2, annualised growth remained below trend, and inflation is a long way below target, on both a headline and core basis. This warrants further action from the ECB. However, additional easing seems unappealing politically. While we expect another cut in the deposit rate in March 2020, it will only be of 10bps (versus an expected 75bps from the FOMC). Of greater significance, in the absence of another sharp deterioration, there seems little-to-no support for a further increase in asset purchases. As a result, we now look for the Euro to decline to USD1.09 by March 2020 before rising to USD1.15 in late-2020.

For the UK, of late their currency has moved sharply higher as market optimism has grown over an eventual Brexit deal. While we continue to harbour significant doubts over the effect that Brexit will have on the UK economy over the medium-to-long term, we expect the market’s current exuberance to be sustained through early 2020 as a deal is delivered on January 31. Consequently, we look for Sterling to appreciate further to USD1.33 at March 2020. Thereafter a lengthy period of stability is anticipated as the economy and markets process the changes taking place in the UK economy. We expect a Bank Rate cut in the June quarter. This will be in the midst of other central banks easing, and will help limit Sterling buying post the smooth Brexit outcome.

Then to Asia. While the BOJ has so far sat out of the recent global easing cycle, increasingly they are taking steps in that direction. Having previously opened the possibility of further easing by stating that, if downside risks to inflation materialise, “the Bank will not hesitate to take additional easing measures”, the BOJ introduced new forward guidance at its October meeting.

The BOJ now states: “As for the policy rates, the Bank expects short- and long-term interest rates to remain at their present or lower levels as long as it is necessary”, almost exactly mirroring the ECB’s current guidance. With that in mind, it is also worth noting that, when the ECB adjusted its guidance to “present or lower levels” from simply “present” in July, they followed the adjustment in forward guidance with a stimulus package in September which included a deposit rate cut.

As for the Euro Area though, the scale of any easing in Japan is expected to be a fraction of that delivered by the FOMC. Hence, a modest appreciation of the Yen is anticipated in 2020, from JPY109 currently to JPY105 at September. Note that this move is in the absence of another bout of financial market instability. Were one to occur, USD/JPY could move lower still.

For the US dollar overall, the net effect of these anticipated developments is the taking hold of a gradual downtrend in the DXY index, from a peak of 98.7 at December 2019 to 96.4 by December 2020, and 95.0 come December 2021. The obvious risk to this view is that agreement of a deal between the US and China could materially change the US outlook and thus FOMC policy (as above, a positive influence for the US dollar). That said, a deal would also bouy market optimism over global growth and lessen concern over the risks (further reducing demand for the US dollar as a safe-haven). As a result, we consider risks to our revised view as balanced but highly dependent on the conditions and timing of any agreement reached by the US and China – which is yet to be confirmed or detailed.

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