Goldman Sachs FX overview

The recent bounce in the US dollar should continue. Although Hurricanes Harvey, Irma, and Maria will likely weigh on some upcoming data (including payrolls on Friday), the US economy otherwise looks in good shape: our current activity indicator has averaged growth of 3% over the last three months. Moreover, while there is still plenty of uncertainty, our US economics team sees firmer inflation reports in the coming months, and thinks investor concerns about the “Amazon effect” on goods prices are overdone. Separately, the prevailing market view that President Trump plans to nominate a relatively dovish successor to Janet Yellen as Fed Chair no longer looks clear: recent press reports indicate the White House has interviewed candidates from across the spectrum of monetary policy views. Markets are discounting fairly high odds that the FOMC will raise rates in December (a 65-70% chance). However, conditional on a December rate increase, markets are not even pricing a full 25bp rate hike for all of 2018. This seems much too conservative, especially in light of recent progress in Congress on tax reform.

Some drivers of EUR appreciation are also reversing and, as a result, EURUSD downside is our preferred expression of USD strength in the near-term. First, European equity markets have underperformed in recent months: our systematic equity-based positioning rule has been sending neutral or short signals for EUR for some time. Second, perceptions about the European political landscape—arguably too rosy since the French election—seem to be resetting lower. The German election looks likely to result in a “Jamaica coalition”—a first at the federal level—which has dimmed hopes for EU governance reform, along the lines advocated by French President Macron and EU Commission President Juncker. With political risk front of mind again, markets may begin to focus a bit more on the recent turmoil in Catalonia, next week’s legislative election in Austria, and the Italian election due by May of next year. Third, subdued inflation trends should mean the ECB lays out a relatively dovish taper timeline, continuing bond purchases throughout 2018. Lastly, the much-discussed bid for EUR from FX reserve managers did not in fact materialize in Q2: according the IMF’s latest COFER report, released Friday, reserve managers sold a small amount of EUR during the quarter. For each of these reasons, we continue to forecast that EURUSD will fall back to 1.15 by the end of the year.

USDJPY has closely tracked real rates, but may have more idiosyncratic risk in the weeks ahead. Through most of the recent bounce in the USD, the JPY has depreciated like an ‘EM high-yielder’, proving an effective hedge for a core rates selloff. And we continue to think that it makes sense to diversify the mix of funders for any EM long position, and to include JPY in the current environment. However, idiosyncratic risk may return as a result of the snap election called by PM Abe. The political situation remains fluid, but early indications are that the LDP will not sail to an easy victory. In brief, the popular governor of Tokyo, Yuriko Koike, has created a new national party, Kibo no To (Party of Hope), to contend the election. To make things interesting, late last week the largest opposition party, the DP, effectively disbanded and threw its support behind Hope. Combined, Hope and DP poll at around 20-25%, compared to roughly 30% for the LDP. While an Abe/LDP victory still seems the most likely outcome, with gains over the coming weeks, Hope may yet have a fighting chance of making substantial inroads (over the next week focus will be on fielding candidates, with formal campaigning starting around October 10; Koike herself must also decide whether to run as a candidate in the national election, at the end of the current session for the Tokyo assembly on October 5). Neither Koike nor other Hope leaders have expressed detailed views on monetary (or fiscal) policy, but given their change/reset campaign message, we believe a victory would call into question the sustainability of the BOJ’s easy stance, and open the field of candidates for Governor Kuroda’s replacement. So even though some aspects of Hope's agenda may be pro-growth, the bottom line for FX markets is that USDJPY should tend to be negatively correlated with polling results for Hope, at least until the party’s views on monetary policy become clearer.

Policy (BOE) and politics (Brexit negotiations) pulling the Pound in opposite directions. The BOE is set to hike in November despite lacklustre data—Governor Carney said Friday a rate rise was likely coming in the “relatively near term”. When central banks change direction they tend to express some degree of conviction about their decision—likely in an effort to head off outside criticism. So while our UK economics team does not forecast another rate rise until late 2018, we would be surprised if policymakers signalled “one and done” immediately after the first move. At the same time, we continue to see a very bumpy path ahead for Brexit negotiations and UK politics. Put simply, the best outcome for financial markets—a lengthy status quo transition deal—is not compatible with the views of a segment of the Conservative party, which includes Foreign Secretary Johnson (in particular his second “red line” regarding EU and ECJ rules). At the Tory party conference this week PM May will probably walk a fine line in the keynote speech on Wednesday, in which case markets could focus on BOE policy for the near-term; this would imply downside risk to our EURGBP forecast. But until the political fissures are resolved we will have a hard time seeing sustained sterling strength.

02 Oct 2017 - 16:04- Fixed IncomeBank Speaker- Source: Goldman Sachs

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