USD Currency Forecast Until End of 2016

End-2016 US dollar outlook

End-2016 forecasts

Introduction

US growth trends and Federal Reserve policies will inevitably have a very important impact on overall dollar trends in the short term while the Presidential election will be a complicating factor and could have a major currency impact.

Given that currency rates are determined by relative economic fundamentals between two economic areas and not absolute strength, international dynamics will also be crucial with developments in the Euro-zone, Japan and China all important for overall dollar trends over the next few months. A strong Euro-zone recovery and ECB tightening, for example, would tend to strengthen the Euro against the dollar even if the US economy strengthened and the Fed increased interest rates.

Trends in risk appetite will also have important implications for the currency.

US outlook

The US economy and Federal Reserve policies will continue to have a crucial dollar impact and will be the most important factor.

The first reading of second-quarter GDP growth was much weaker than expected at an annualised rate of 1.2% compared with a consensus figure of 2.5% as inventories and investment dipped sharply for the quarter, although Federal Reserve officials have downplayed the report’s significance, especially given strong consumer spending.

Confidence was also shaken by the weak employment report for May. The last two US employment data releases have been much stronger than expected with a cumulative gain in nonfarm payrolls of close to 550,000.  There has also been a further gradual increase in average earnings with an annual gain of 2.6%.

The Fed is still uneasy surrounding external risks, but oil prices have recovered ground and the dollar is also weaker on a trade-weighted basis.  The risk of inflation staying below target with falling inflation expectations has been a key factor in deterring Fed tightening, but these concerns should continue to ease.  Financial conditions are also now much looser, especially with US equity indices trading close to record highs.

Fed officials are worried over weak investment and low productivity, although these concerns are only loosely linked to monetary policy.

There was clear evidence of divisions within the Federal Reserve Open Market Committee (FOMC) at the July meeting with the more dovish majority wanting to see more data before making a commitment to raise interest rates while a minority pushed for short-term action to raise rates.  

Over the past week, however, there has been a shift to more hawkish rhetoric from several officials, including Vice Chair Fischer, that the overall outlook has improved with the FOMC moving closer to raising rates. Stronger earnings growth appears to be a pivotal factor in Fed thinking.

There are three FOMC meetings over the remainder of 2016, with a policy change only realistic in September and December.

Overall, there is a strong case for the Fed to raise interest rates in the short term, especially as a further delay would risk having to tighten more aggressively later on. Very strong data could lead to two rate increases by the end of 2016.

Fed fund futures are indicating just over a 50% chance of a rate increase by the end of 2016. In simplistic terms, a tighter Fed policy would tend to strengthen the dollar, at least in the very short term given that an increase has not been priced in, while a dovish policy would tend to weaken the US currency.

The US presidential election is a potentially important factor. A victory for Democrat Candidate Clinton would be potentially slightly dollar positive with yields tending to move higher on expectations of a looser fiscal policy which could lead to a faster pace of Fed tightening.

The impact would be greater if the Democrats gain congressional control, if not there would be a high risk of deadlock which would tend to undermine the dollar in 2017.

Victory for Republican candidate Trump would risk major turbulence surrounding global trade policies and the huge uncertainty factor would tend to be dollar negative.

Any serious consideration of a return to the gold standard would tend to push the dollar sharply higher while any legislation to encourage capital back to the US would also boost the dollar, although legislation would of course not be enacted until well into 2017.  

Overall, there would be very high dollar vulnerability, although the working assumption is that there will be a Democrat victory.

The US is still running a significant current account deficit and there needs to be a recycling of capital from surplus countries such as Germany and Japan to support the dollar. Favourable yield spreads will, therefore, be essential to stop the US currency declining.

Euro-zone outlook

The ECB will maintain its very aggressive monetary policy in the short term with the main refi rate at zero, a deposit rate of -0.40% and monthly sovereign bond purchases of EUR80bn.

Very low interest rates will undermine the Euro directly and it will also continue to be used as a global funding currency to fund flows into higher-yield instruments which will push the Euro lower against the dollar.   

The ECB will remain committed to a very loose monetary over the next few months in order to push the inflation rate higher.  By the end of 2016, however, there will be increased speculation of a tapering in bond purchases which could trigger an aggressive covering of Euro short positions.

Japan outlook

The economy remains trapped in a low-growth environment, with the government and Bank of Japan still unable to defeat deflationary pressures.

The Bank of Japan has continually missed its 2% inflation target with the bank’s preferred rate still below 1.0% while the national CPI data remains in negative territory.

The central bank will undertake an extensive policy review for the September policy meeting with a potential shift in strategy. Comments, so far, suggest the bank will not taper bond purchases and there will be pressure for an aggressive easing to counter deflation pressures. Overall, monetary policy is likely to be eased further which will put downward pressure on the yen, especially with the bank potentially buying newly-issued 40-year government bonds.

Chinese outlook

After a major scare early in 2016, there has been some overall stabilisation in confidence with aggressive credit expansion having a significant impact in supporting second-quarter demand.

The most recent data was also disappointing with industrial production and credit growth much weaker than expected for July while the yuan has shown some signs of fresh vulnerability with the People’s Bank of China allowing the currency to decline to record lows on a trade-weighted basis.

The overall debt dynamics remains extremely worrying and fears over a destabilising hard landing are liable to return. Fresh fears surrounding the Chinese outlook would boost potential defensive dollar demand, but would also make it much more difficult for the Federal Reserve to tighten policy.

The most likely outcome is for a slight net improvement in conditions over the next few months before fresh turbulence in 2017 as underlying debt dynamics continue to deteriorate.

Global outlook

Global central banks will continue to pursue aggressive monetary policies over the next few months and money supply growth is expanding at a stronger rate which should boost the global growth outlook.

Stronger conditions would lessen demand for the dollar as a defensive asset and there would also be the potential for selling of US Treasuries, although any rise in yields would lead to offsetting capital inflows

Risk factors

• The Chinese debt position remains precarious while fresh credit injections are becoming increasingly ineffective. At best, rising defaults will increase banking-sector bad loans and government debt with the threat of a much more severe collapse in conditions which would block Fed tightening, but also boost defensive US support.
• A sharper than expected increase in US inflation would risk a sharp sell-off in US bonds and force the Federal Reserve into a much more aggressive tightening cycle to head-off inflation which would risk recession conditions during 2017.
• Further aggressive easing by the Bank of Japan could push the dollar sharply higher while and ending of quantitative in Japan or the Euro-zone would push the dollar sharply lower.
• A crisis within the Euro-zone banking sector would trigger fresh fears over the Euro’s future and potentially push the dollar stronger.

Summary

Dollar volatility levels have been generally low over the past few months, but there is an increasing risk of complacency with volatilities likely to be substantially higher over the remainder of 2016. Greater uncertainty surrounding monetary policy, fiscal policy and the US election all risk increasing volatility even without adding in the global dimension.    

The most likely outcome is a slightly tighter Fed policy and robust US outlook which would push the dollar stronger, especially with the Bank of Japan and ECB maintaining aggressive monetary policies. Overall, the dollar is unlikely to strengthen sharply on a trade-weighted basis.