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CURRENCIES - Geopolitical risks will continue to play a key role

THE ESSENTIAL

Central banks’ ongoing policy normalisation, trade tensions and political issues will be the key drivers to watch in the FX market.

Brexit and political noise in the Eurozone might weigh on GBP and EUR for some time.

We expect the USD to remain strong in the short term, and weaken with a medium-term horizon as in addition to other factors, the economy might reach the mature phase of its cycle, a situation that has historically coincided with a weaker US dollar.

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November 2018

Novembre 2018

The Article

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EUR/USD: short-term headwinds, more positive medium-term outlook

Diverging financial conditions with respect to the US, mild (albeit increasing) growth, concerns over the impact of a trade war on European exports and rising political risks have weighed on the EUR during the year. More recently, headwinds from the Italian budget announcement put a cap on the EUR in light of the many uncertainties that remain and might be in place for some time to come as, for instance, negotiations with the EU Commission might take a while to reach a resolution. With the renewed rise in German political uncertainties and with Italian political risks tilted to the upside, we could see some short-term pressures that could prevent the EUR/USD from appreciating from current levels. European elections also pose additional risks to the currency – as the Bavarian elections recently showed, increased political fragmentation may be expected in addition to the risks of breakthrough of populists. Despite the fragile sentiment, elevated speculative short positioning indicates the negatives are very much priced in and, thus, further EUR selling seems unlikely, especially in the context of strong fundamentals. While growth for the Eurozone should remain above potential, external sector figures are also supportive to the currency (very high current account surplus). Moreover, we expect the ECB to keep moving towards normalisation and increase interest rates in H2 2019, thus lowering the policy divergence with the Fed. Hence, we remain EUR bullish in the medium term. 

 

 

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USD/JPY: downward trend for the year ahead

While we believe the USD/JPY might keep trading around the current levels (our forecast is 112 by the year-end), we expect the Japanese yen to be on an upward trend in 2019, driven by monetary policy and persistent trade protectionism talks. While recent communication from the Bank of Japan (BoJ) points to the continuation of the ongoing ultra-accommodative monetary policy for some time to come, we expect the BoJ to allow further flexibility on its long-term yield policy next year, thus moving (albeit at a very gradual pace) towards the normalisation of its monetary policy stance. Moreover, global trade friction risks might persist or could further escalate in the medium term. This provides further support to the currency, due to its traditional safe haven status. Its extremely cheap valuation (the lowest among the G10 space) and the resumption of a medium-term USD downtrend could also provide support for the currency’s appreciation. In addition, past experience has shown that the JPY tends to appreciate further on the back of rising US bond volatility, due to the effect of positions rebalancing and capital repatriation back to Japan. We note that hedge ratios on Japanese investments in US assets have indeed decreased substantially due to the high cost of hedging and any repatriation is not likely to be FX neutral.

GBP/USD: it is all about politics

Brexit negotiations are entering a critical period and, as such, the pound has reacted to political developments. As many uncertainties remain over the future of the British economy, we expect the currency volatility to remain high in the short/middle run. Even though in our baseline scenario (70% probability): i) the UK and the EU will reach a deal late in 2018 or early in 2019; and ii) the UK is going to exit the EU in March 2019 or soon afterwards to start a transition period, we expect that such a deal will only be reached through a “rock path”. This means that initial deadlines are mostly likely to be bypassed, the deal is likely going to be reached at the last moment and the parliamentary approval process is going to be very difficult. But we note that this is something that seems to be very much priced in as investors remain short the currency and option market participants remain tilted to the downside, even looking at a 1Y time horizon. Thus, we expect temporary market stress regarding Brexit would certainly give some relief to the currency. In our view, the potential upside should remain quite contained as markets might start looking at the country’s ability to finance its large current account deficit under the new framework, thus putting a cap on the GBP. We also note that support from monetary policy is not clear as further rate hikes from the Bank of England will very much depend on the final Brexit outcome and, especially, on how resilient the economy will (still) be next year.

 

 

Amundi Research & Investment Insights Unit
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