By Kathy Lien, Managing Director of FX Strategy for BK Asset Management.
It was a relatively quiet day in the foreign-exchange market with the U.S. dollar trading higher against all of the major currencies except the euro. The strength of the dollar and the lack of big moves is not a surprise during this holiday week and is in fact reinforced by Tuesday’s U.S. economic reports. According to the Conference Board, consumer confidence jumped to its highest level since 2001. Not only are investors optimistic about current conditions but they haven’t been this positive about future business conditions since February 2011. This report -- along with record highs in U.S. stocks -- tells us that investors and consumers expect Donald Trump to deliver. There’s no doubt that the President elect inherits an improving economy because aside from the Conference Board’s report, house prices are on the rise according to S&P CaseShiller and even with the stronger dollar, manufacturing activity improved significantly in Richmond and Dallas during December. Until data starts to turn negative or the headlines suggest that Trump’s stimulus program could fall short of expectations, the dips in the dollar will be shallow with the currency aiming for new highs. But at the first sign of bad news, there could be a massive correction in what is quickly becoming a crowded long dollar traded.
Meanwhile, 2017 could be a tough year for the U.K. economy and the British pound. The first few months of the year will be marked by uncertainty with Prime Minister May pledging to trigger Article 50 of the EU treaty by the end of March. U.K. lawmakers have signed off on this target date as long as the PM submits her plans for Brexit in advance. Tough discussions will be had in 2017 as the invocation of Brexit gives the U.K. 2 years to leave the European Union. So far, all of the discussions have been procedural -- in the beginning of the New Year, the Supreme Court will decide if May needs Parliament’s authority to invoke Article 50. While this decision could cause some uncertainty, the real focus in 2017 will be the issue of a hard vs. soft Brexit.
Most members of Parliament prefer a softer exit, but some hardliners want to put immigration above everything else, leaving Britain at risk of losing access to the single market. The best-case scenario for the U.K. economy and sterling would be if the U.K. remains within the single market, which allows for tariff-free movement of goods, services, money and people within the EU. This would be similar to the Norway model, which had to accept the EU’s rules for free movement of labor. The Brits are unlikely to concede to these terms as immigration was one of the main reasons for leaving the Union in the first place. In the coming year, delays in Brexit negotiations could provide temporary support to the currency but the ongoing uncertainty is negative for the economy and currency. Businesses have already delayed spending and, according to the IMF, even if EU negotiations limit political fallout next year, the U.K. economy will still grow by only 1.1% -- half of its previous forecast. Unfortunately, the Bank of England can’t provide much help as its ability to ease monetary policy in the event of slower growth is limited by the sharp rise in inflation. Sterling is down 16% year to date and policymakers expect this weakness to lead to a sharp rise in inflation in the coming year. So with the central bank’s hands tied and investment expected to remain weak, we anticipate a further decline in sterling versus the U.S. dollar and euro in the first half of 2017.
Of all the major currencies, euro was the most resilient against the U.S. dollar on Tuesday. The price action may have confused some traders since there were no Eurozone economic reports on the calendar and U.S. data was better than expected. Still, the currency’s strength stems primarily from the ECB, which paused its bond-buying program this week. Without the central bank driving yields lower, euro was able to find support above 1.04. The only news out of the region came from Italy -- Italian bank Monte dei Paschi (MI:BMPS) was told to raise €8.8b, up from Friday’s €5b request. Even though the upward revision is problematic for the world’s oldest bank, it is not in any immediate danger of collapse because the Italian government recently pledged €20b to help the embattled banking sector.
Although markets were closed in Australia, New Zealand and Canada, all 3 commodity currencies traded lower against the U.S. dollar Tuesay. USD/CAD continued to ignore the rebound in crude oil, choosing instead to take its cue from the rise in U.S. yields. Along these lines, the rebound in gold prices also failed to lift the Australian dollar. Gold spiked to $1150 as Germany increased buying. No major economic reports are scheduled for release from the 3 commodity-producing countries this week.