After beginning the month with a hawkish tone, the Federal Open Market Committee (FOMC) delivered a surprisingly dovish median forecast in the wake of the latest incremental interest rate hike. However, the FOMC hinted that it might start normalizing its balance sheet later this year, a move that would likely support a steeper yield curve and stronger dollar. If the Fed begins selling off its $2.5 trillion in excess Treasury bonds and mortgage-backed securities, long-term interest rates in the US would likely rise, widening spreads between the US, Europe and Japan. Market reaction so far has been muted, as investors seem to be awaiting a more concrete announcement.
Recent legislative developments have been mixed for the dollar. The failure to reform healthcare has complicated the picture for tax reform in Washington. While a mainstream consensus still appears to exist around lowering corporate taxes and encouraging the repatriation of “trapped” overseas earnings, any comprehensive reform bill would likely require bipartisan support to pass.
Meanwhile, the threat of trade conflict seems to be easing. The Treasury Department's Semiannual Report on International Economic and Exchange Rate Policies declined to label China, or any other country, as a currency manipulator. Recent meetings between President Donald Trump and Chinese President Xi Jinping were dominated by growing tensions on the Korean Peninsula, leaving trade issues on the back burner. Trump’s statements following the meeting struck a conciliatory tone, seemingly abandoning some of the rhetoric from his campaign.
Over the next month, key fiscal events may provide the dollar with some direction. On April 28, the federal government will reach its statutory funding limit, setting the stage for a debt ceiling showdown in the fall. Congress will also take up the 2018 budget, which should clarify the potential for back-loaded fiscal stimulus in the coming year.
In France’s highly anticipated election on April 23, centrist Emmanuel Macron topped the vote while far-right candidate Marine Le Pen finished second, setting up a May 7 runoff between the two for the presidency. The euro hit a five-month high as a result, with polls showing the EU-friendly Macron highly favored in the runoff against Le Pen.
Part of the markets’ positive reaction was due to Macron holding off far-left candidate Jean-Luc Melenchon, who had the potential to set up a runoff between two euroskeptic candidates. While Macron is now a strong favorite to win the presidency, the euro will likely remain subject to headline and polling risks in the run-up to May 7.
Barring an electoral upset, the euro should continue to receive a boost from strengthening European fundamentals. Rising inflationary pressure and solid growth has set the stage for policy normalization from the European Central Bank. Already, the euro has become the third-cheapest G10 currency on a real effective exchange rate basis, giving it an immediate modest potential for gain once the political storms have passed.
On April 18, British Prime Minister Theresa May called for an early general election to take place on June 8, seeking to unite Parliament as the UK moves forward with Brexit negotiations. Immediately following the surprise announcement, the British pound surged to its highest point since early February, with markets expecting May to extend her party’s majority, potentially making it easier for the British government to negotiate its exit from the EU.
The UK economy has proven surprisingly resilient following Brexit, with GDP expanding at a 3 percent rate through the end of 2016. Growth has slowed somewhat in the first quarter, but the economy is projected to carry momentum into the summer, with expansion downshifting to a 1.5 percent annualized pace by mid-year.
However, inflationary pressure is rising and real yields are approaching 3 percent, bringing downside risks for the pound. Markets don’t anticipate a rate hike before 2019, and consumers might soon feel the pinch from inflation. The nation’s savings rate is already at its lowest point since 1960, making consumer spending especially vulnerable to inflationary losses.
The invocation of Article 50 and the formal start of Brexit negotiations mark the beginning, not the end, of uncertainty for the UK economy, but early signs have been encouraging. British negotiators have signaled openness to a transitional deal that could delay the consequences of a hard exit. Markets are now awaiting the adoption of formal negotiating guidelines on April 29.
The Japanese yen has shown considerable strength in April, posting five-month highs against the US dollar and rising in trade-weighted terms. The currency drew strength from narrowing yield spreads in the wake of the US FOMC’s March meeting.
Political tensions may bring downside risks for the yen over the coming months. While the US Treasury declined to label Japan a currency manipulator, the yen was placed on the Treasury’s “monitoring list” for unfair practices. Foreign exchange issues may play a prominent role in upcoming bilateral trade talks between the two countries, which will also address contentious barriers to agricultural and automotive trade.
Easing trade tensions and rising growth forecasts may be sufficient to prevent Mexico’s credit rating from being downgraded later this year, supporting a stronger peso. Concerns over a looming trade conflict with the US were somewhat eased when the Trump administration circulated a draft proposal on NAFTA renegotiation that proved constructive. The proposed US negotiating position largely seeks to build upon, rather than upend, the existing free trade agreement. Mexican manufacturing data was strong in the first quarter, leading to an upward revision for annual growth forecasts. The Mexican economy is now expected to expand by 2 percent in 2017.
The peso will face political risks this summer when the nation’s most populous state holds gubernatorial elections in June. If Andres Manuel Lopez Obrador’s left-leaning National Regeneration Movement party unseats the incumbent conservative Institutional Revolutionary Party, it could raise Lopez Obrador’s chances of winning the presidential race next year. Combined with inevitable uncertainty over the outcome of NAFTA renegotiations, political turmoil may produce downward pressure on the peso this fall.
Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views; published April 7, 2017.
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