Earlier, we talked a bit about Donald Trump’s waning political capital and the extent to which rising policy uncertainty in the US and declining political risk in Europe may ultimately lead to a narrowing of rate differentials, painting a bearish picture for the dollar.
Meanwhile, the yen is likely to remain bid as its fortunes are inversely correlated to the fate of the US reflation narrative (policy disappointment in Washington = stronger yen).
All of this is set against a backdrop of divergent monetary policy. Here’s what we said on Friday:
… trying to keep track of where each central bank (i.e. the Fed, the ECB, the BoJ, etc.) stands when it comes to normalizing policy is quite difficult. Unfortunately, it’s necessary. And not only because you want to know when the proverbial punch bowl is going to be taken away. You also need to be aware of the extent to which mismatches in the timing of normalization create policy divergence, drive rate differentials, and influence FX markets.
Needless to say, if things keep going the way they’re going (that is, waning political risk in Europe and reflation frustration in the US as tax reform and fiscal stimulus seem further and further away), policy divergence should dissipate as the Fed backs off and the ECB feels more comfortable with normalization. It’s the same story for the Fed versus the BoJ. Here’s Barclays:
Under our new FX forecast, we continue to expect JPY appreciation in the year ahead. While USDJPY could remain supported in the near term by the global cyclical upswing, we look for an eventual break lower as we forecast the US-Japan 10y yield differential to tighten in the H2 17 as the BoJ hikes its 10y JGB rate target in Q3 and for UST yields to remain largely flat. Extended undervaluation of the JPY despite Japan’s closing output gap, delay and scaling back of Trump policies, and large CA surplus with growing income surplus while Japanese investors turn cautious towards foreign investment, all point to a risk of JPY appreciation in the medium term. We forecast USDJPY to decline to 106 by end-2017 and 103 by Q1 18.
Well, considering all of that, we liked SocGen’s week ahead preview which touches on all of the above on the way to getting you prepped and ready for Monday. More below.
Last week, both the EUR/USD and 10Y spread (T-note – Bund) broke new year records. While growing doubts on the ability of the Trump administration to deliver on campaign promises offers one explanation, we believe firm euro area data to be as least as important. Looking ahead, we believe that Trumpflation hopes are likely to be disappointed (hence our below consensus call on the US medium-term) while euro area election fears remain true tail risks only. At the same time, we believe that any hopes of fast-track euro area reform are set once again to be disappointed. In a nutshell, that leaves the economic cycle as the main driver of the cross Atlantic gaps and we see room for further narrowing as the euro area continues to catch-up.
Last week saw new 2017 records tested with EUR/USD trading just above 1.08 and the 10Y spread close to 195bp. Euro area equities also appear to be catching up, having outperformed the US in recent weeks. Our view is that the underlying economic cycle will ultimately prove the main driver looking ahead, as the best and worst of political hopes and fears prove overdone on both sides of the Atlantic.
Trumpflation disappointment … focus on economic data
After failing to get Obamacare repealed on Friday, President Trump tweeted “Obamacare will explode and we will all get together and piece together a great healthcare plan for THE PEOPLE. Do not worry!” Speaking to reporters, President Trump said “…we will probably start going very, very strong for big tax cuts and tax reform. That will be next”. A first hurdle comes from the now absent savings after failing on health care reform ($337bn over the coming 10 years according to the CBO and JCT). The Tax Foundation estimate the cost of the House Republican tax plan over the first decade on a dynamic basis at $191bn with a cost of $1,807bn from lowering the corporate tax income rate to 25%. One of the more controversial ideas is the border adjusted tax, which alone is supposed to raise $936bn. That could mark yet another hurdle. Indeed, financial markets seen increasingly sceptical that Trump will be able to deliver on the many promises that fuelled the S&P a peak of close to 2400 in early March. This will place the emphasis on the economic data, at least until the next debate in Washington is more advanced. This week sees the release of the February personal income report and we look for only a tepid rebound in real consumption.
Inflation to justify central bank positions … for now
Turning to inflation, this is where we still see a significant cross Atlantic gap and is also where central bankers are placing emphasis. In the US this week, we expect the February headline PCE deflator to move up from 1.9% to 2.1%, marking the first time at or above the Fed’s 2.0% target in five years. The core PCE will likely hold steady, however, at 1.7%. Turning to the euro area, the flash CPI estimate for March is expected to decline on both the headline and core to, respectively, 1.7% and 0.7%. We believe the decline in the core, however, to be temporary only and look for a recovery to 1.0% over the coming quarters.
Policy uncertainty gap to narrow, albeit slowly
The ECB has also pointed to policy uncertainty as a factor in justifying its more dovish stance. Indeed, the euro area faces a very busy electoral agenda, with key elections due in France, Germany and probably also Italy over the coming year. As we head to press this evening, Chancellor Merkel faces a test in the Saarland state election. A further uncertainty for Europe stems from Brexit, set to be officially triggered by Article 50 on Wednesday by Prime Minister May. As discussed above, the US also faces policy uncertainty but admittedly to a lesser extent than Europe at present. Looking ahead, we expect to see a decline in euro area uncertainty as the elections pass and the tail risks of anti-establishment parties taking power (hopefully) fade away unrealised. At the same time, we are not optimistic either side of the Atlantic when it comes to politics delivering positive upside surprises. Last week’s developments in Washington confirmed this view. For the euro area, despite a new implicit warning from the ECB in its latest Bulletin that 90% of the country-specific recommendations saw only “some” or “limited” progress, we remain concerned that reform will come still at a too slow pace to boost the near-term outlook. In a nutshell, setting aside some potential noise linked to political developments, we look for the momentum of the economic cycle to be the main driver of the cross-Atlantic gaps and fundamentals plead for further narrowing as the euro area catches up.
In essence, justification for cross-Atlantic gaps in monetary policy can only be found in inflation. And even that justification may soon come under pressure.
We’ll close by rehashing a post from last week that touches on some of these same ideas.
With the broad dollar sinking…
…and the euro hitting six week highs (well on its way to a YTD peak)…
…and a “dovish” Fed hike having triggered a rally in rates, it’s worth connecting the dots in terms of assessing the extent to which rate differentials still support the structurally strong USD thesis.
Make no mistake, this is a pretty important point, which is why we thought the following was worth presenting.
Via Bloomberg and Macro Man
Another plank supporting U.S. dollar strength has been removed, if only temporarily.
- Since the election, 200 has been firmly grounded support in the Treasury-Bund spread, having held on several occasions. Not today, as the spread is currently 198 bps. The implication for EUR/USD is pretty clear.
- The next technical level for the spread is 191 bps, the 61.8% retracement of the move since the election. If that goes, the risk is that the spread retrenches all the way back to 164 bps, presumably taking the euro with it.
- Selling Bobls looks like the clearest bond trade out there at the moment. That probably implies more upside risk for the euro.