Forex: In 2017 populism and reflation will be the key drivers
The year 2016 was one for the populists: the UK voted to leave the EU, the US voted for Donald Trump to be President and the Italians voted against constitutional reform to get rid of their President Matteo Renzi and it looks like the populists are going to be shaping the economic and political agenda going forward and therefore exchange rates.
Indeed, 2017 could see faster economic growth with Trump aiming to pursue aggressive stimulus polices. His victory has already been a game changer for the markets, and before even getting into power, USD and stocks surged and bonds tanked as traders and investors anticipated a great reflation and tighter monetary policy.
However, it could take a while before Trump’s stimulus policies, possibly 2018 at the earliest, to take hold in the US economy, especially those relating to infrastructure. However, it seems unlikely Trump will be able to push the US economy to 4% growth for any sustainable period with 2-3% looking more realistic. This could see the USD rally plateau at some point during Q1 2017 and maybe even reverse, especially if Japan and the Eurozone grow more strongly, which will raise questions over their ongoing central bank stimulus programmes.
Among the big risks is that the US could start a trade war with China and raise tensions with the EU and other countries such as Mexico, which would be damaging for the global economy. Though Trump may have an appetite for such confrontations, it’s not entirely clear that those sentiments are reflected in congress – hopefully they can water down his trade policies.
The Fed will probably get it wrong - again
The US Federal Reserve is guiding three rate rises for 2017 from two. The thing is, its forecasts on interest rates have been notoriously unreliable, the original forecast of two might be more realistic. But in 2018 and beyond rates could rise faster if Trump gets many of his policies through Congress.
With the US economy doing relatively well, the big driver of monetary policy is likely to be inflation. Therefore, the wages component of the Non-Farm Payrolls numbers is likely to be closely followed by the markets and so far, wage rises have remained moderate, but over 2017 they could start accelerating as the unemployment rate keeps falling. Also, commodity prices seem to have had a bit of a resurgence, if that’s sustained that will also increase inflationary pressures and help banish the spectre of deflation.
UK economy could surprise
In Britain, the fiscal reins are being loosened, though nothing like to the extent Trump is proposing to do in the US, to help shield the economy from Brexit. Nonetheless with a weak GBP and an accommodative monetary policy, GDP growth could continue to surprise on the upside, though the triggering of article 50 of the Lisbon Treaty, will be a test as it starts the clock on the two-year leaving process from the EU.
Potential brakes on UK economic growth are inflation, which could really start to show in 2017, and will erode disposal income and the other is a possible fall in private-sector investment due to Brexit uncertainty.
Likely trading range for GBP/USD: 1.1500-1.2500
Eurozone politicians to become more populist
The year 2017 will be a crucial one for the Eurozone with a series of national elections taking place.
However, the establishment will probably just scrape through giving the Eurozone a bit more time. But the risk is that eventually a populist anti-EU party will one day win an election in a Eurozone country and that could spell the beginning of the end of the whole project, which looks increasingly out of touch with the lives of ordinary people. And stopping that from happening will be beyond the capabilities of the European Central Bank.
Elections are taking place in the Netherlands, France, Germany and probably Italy with populist parties gaining traction. The establishment parties will probably just cling on, but it could see a growing rebellion against EU / German economic orthodoxy in the form of austerity measures as those old parties seek to become more populist to stay in power. Ironically, this could be good for growth, but will be accompanied by rising bond yields making financing large deficits more expensive, especially for the peripheral states. Fortunately for them, the European Central Bank’s bond buying programme is set to continue, albeit at EUR 60bn a month from April from EUR 80bn currently.
Nonetheless, the Eurozone is expected to continue growing, partly helped by the weaker EUR and faster US growth and a likely stabilisation in the Chinese economy.
Likely trading range for EUR/USD: 0.9500-1.1500
A good year for Japan
For 2017, Japan is also likely to see GDP growth of above 1%, thanks to a combination of very aggressive monetary policy and fiscal stimulus. Like the US, Japan has a very low unemployment rate, so it’s possible that wage inflation will come to the forth while commodity prices are looking more bullish and the weak JPY will likely banish deflation. From 2018 there will be a big increase in the minimum wage.
However, according to various purchasing power parity calculations, JPY is undervalued and should probably be around USD/JPY 90 – a level the Bank of Japan is determined to avoid. However, if inflation and growth take hold in Japan over 2017, there is a possibility that the BoJ will start to rein in some of its aggressive monetary policies, such as negative interest rates – damaging for banks – and targeting the 10-year Japanese government bond yield at 0% could start to look counter-productive in a world of generally rising bond yields.
However, the chances of Japan growing sustainably along with moderate inflation seem unlikely over the long-term due to the country’s chronic demographic position, which will see the population shrink. In other words, slow growth and deflationary pressures are structural and the same can be said for many Eurozone countries and will be back to haunt the country at some point.
Likely trading range for USD/JPY: 105.00-120.00.