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Foreign Exchange

Uncertainty Continues to Pervade Markets

As one election in Europe heads to a runoff, another is unexpectedly called for the summer, both with the potential to bring new policy agendas. Meanwhile, the tax reform agenda in the US remains in doubt following Washington’s failure to reform healthcare.
J.P. Morgan Global FX Strategy & Global EM Research
April 26, 2017

Executive Summary

  • USD: There appears to be a lot of uncertainty in the market, which has yet to react to the Federal Reserve’s announcement it will begin normalizing its balance sheet later this year. Uncertainty also surrounds Washington, as no one is sure how tax reform will play out following the failure to reform healthcare. With geopolitical complications also a factor, the market appears to be taking a wait-and-see approach for now.
  • EUR: The euro reached a five-month high immediately following France’s presidential election on April 23, when Emmanuel Macron topped the vote to set up a May 7 runoff, in which he’s heavily favored to defeat Marine Le Pen.
  • GBP: The British pound surged following British Prime Minister Theresa May’s surprising call for a general election this summer, suggesting the markets expect May’s party to add seats in Parliament and help the UK in its Brexit negotiations.
  • JPY: While political tensions may bring future downside risks for the Japanese yen, narrowing yield spreads helped it reach five-month highs in April against the US dollar and trade-weighted terms.
  • MXN: Trade tensions appear to be easing between Mexico and the US with the Trump administration indicating it will seek to build upon the terms of the North American Free Trade Agreement (NAFTA), rather than starting from scratch. That news, coupled with rising growth forecasts, may prevent Mexico’s credit rating from being downgraded later in 2017, and thus supports a stronger peso.

USD: Uncertainty in US Market

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.

EUR: Europe Reacts to French Elections

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.

GBP: Pound Surges Following Surprise Announcement

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.

JPY: Yen Hits Five-Month High

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.

MXN: Peso Rises on Falling Trade Risks

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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