The trade-weighted US dollar rebounded 3.4 percent over the past month amid climbing Treasury yields, but the conditions necessary for a sustained recovery have yet to materialize. The currency erased most of its late summer losses as firming domestic inflation is helping to boost the case for the Federal Reserve to raise interest rates in December.
In September, US Treasury yields widened against every G-10 nation except the UK, and futures markets are now anticipating that the Fed will hike rates twice by the end of next year. There has been some fiscal progress in Washington as lawmakers successfully avoided a debt-ceiling showdown and tax reform proposals appear to have gained momentum. Meanwhile, central banks throughout the world have either slowed or reversed some of their monetary tightening policies.
But the forces driving the dollar’s rise may soon subside. Growth across developed markets has been strong, and some of the country’s major trading partners appear poised to enact policies tightening their monetary supply. A steady pace for interest rate normalization is already priced in for the dollar, and the Fed is unlikely to further accelerate its timeline. In the coming months, developments in tax reform legislation will likely play a key role in driving the dollar.
The European Central Bank (ECB) announced on Oct. 26 that will begin tapering its quantitative easing program. It will take a gradual approach beginning in January, reducing the amount of assets it purchases every month to €30 billion from the current level of €60 billion.
Tapering expectations have overshadowed the month’s political developments, including unrest surrounding the Catalonian independence referendum. Some 90 percent of referendum voters supported leaving Spain, but the national government immediately rejected the results as illegal and invalid. The standoff has widened yield spreads between Spanish bonds and German bunds by 20 basis points, although the spread has recently begun to narrow. Markets seem to be treating the independence movement as a domestic issue for now.
German Chancellor Angela Merkel was elected to a fourth term, but her coalition suffered significant losses in parliament as the Alternative for Germany party picked up 94 seats, largely at the expense of Merkel’s Christian Democratic Union party. Plans for further European economic integration will likely be put on hold while Germany forges a new governing coalition, which may include the Greens and the Free Democrats.
Ultimately, Europe’s political developments are likely to be overwhelmed by tapering, which has historically had a pronounced effect on currency values. When the US ended its quantitative easing program, the trade-weighted dollar responded by climbing 27 percent. Tapering in the UK led to a 22 percent rise for the pound. The euro is expected to see a similar rise as the ECB gradually ends quantitative easing.
The pound rose in September following the Bank of England’s (BoE) surprise announcement that it would resume tightening in the coming months. Markets hadn’t priced in the resumption of interest rate hikes before early 2019, but the BoE left little room for ambiguity. A November hike is now priced at 75 percent, and at least one additional hike is anticipated in 2018. Bond yields rose on the news, pushing the pound up against G-10 currencies.
The BoE has offered conflicting justifications for its hawkish turn, hinting at renewed confidence in real growth, as well as a desire to prop up exchange rates. Notably, the BoE now believes that Brexit could bring an inflationary supply shock that will overwhelm the deflationary pressure from falling domestic demand.
The pound is likely still holding onto a considerable risk premium surrounding Brexit. Markets appear to have been reassured by the UK’s move toward a “soft” Brexit, but the government is still committed to achieving a clean break that could hold considerable disruptive potential for the British economy.
Over the past month, the yen tumbled approximately 3 percent against G-10 currencies as tensions on the Korean Peninsula seemed to calm a bit. Now, politics have taken center stage in Japan, with Prime Minister Shinzo Abe’s ruling coalition securing a two-thirds “super majority” following a snap election on Oct. 22.
The result indicates that the easy monetary policies of the Bank of Japan and the country’s government will remain intact. Consequently, Japanese stocks rose; and since the outcome had been expected, currency markets saw minimal effects.
Source: J.P. Morgan Global FX Strategy & Global EM Research, Key Currency Views; published October 6, 2017.
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