The star performers among the G10 currencies in 2017 were the big box-office draws of the euro and the US dollar. At the beginning of the year, the US currency was enjoying a post-Trump rally, while a wave of populist electoral successes appeared to be heading for the euro.
It was soon clear that December 2016 had marked a long-term top for the greenback, however, and EURUSD ended the year up more than 13 per cent. It was an impressive turnaround, like two famous actors playing spectacularly against type. Oscars all around!
Will they be in the limelight again? Can the euro storm higher still, or the dollar force a reversal of fortune? Or could the G10’s supporting actors provide the red-carpet performances of 2018?
Euro feeds off renewed confidence
It was really the euro that caught the eye last year. Multiple positive economic surprises in Europe had already triggered unhedged portfolio flows before Emmanuel Macron’s election as President of France opened the floodgates, renewing confidence in the euro project as a whole. Today, currency-futures data indicate that short-term speculators are extremely long the single currency.
That fundamental economic recovery is real. But capital flows have already pushed EURUSD above the fair value implied by relative monetary policies and close to what is implied by purchasing power parity. In our view, we need additional good news in Europe or bad news in the US for EURUSD to rally much higher.
What might those catalysts be?
Euro and dollar forces appear balanced
There is political risk. We face coalition negotiations in Germany and an election in Italy. But trouble there seems no more likely than trouble from the special counsel investigation into the Trump administration or the US mid-term elections.
Portfolio flows could continue to support the euro, despite higher interest rates for the US dollar. This is what happened during the 2004–06 Federal Reserve rate-hike cycle.
Economic recovery, and especially the gradual unwind of structural European shorts that US investors have held since the Eurozone crisis in 2012–13, have fed these flows. It is difficult to tell what more there is to come, however, and there may be offsetting factors.
First, euro-based investors may decide to stop paying the approximately 250 basis points (bps) of carry required to hedge their dollar exposures. Second, US tax reform will likely incentivise repatriation of some of the non-dollar profits that US companies have overseas. And third, the potentially deflationary effects of a stronger euro could, in themselves, prompt the ECB to pause policy normalisation in pursuit of its inflation target.
Inflation and interest rate differentials are potentially more clear-cut catalysts, but they are likely to favour the dollar. Much of the unwinding of the ECB’s bond-purchase programme is priced in, and while the ECB could change its monetary policy faster than expected, it is more likely that inflation will rise first in the US, prompting the Fed to respond more quickly, too. If there is one conspicuous missing catalyst for a stronger euro, we believe it is Eurozone inflation.
The yen, Swiss franc and Nordics catch our eye
In short, there are many similarities between where the dollar was a year ago and where the euro is today, but the result of that switch is something close to equilibrium, with catalysts for a change either way finely balanced. EURUSD may end 2018 close to where it started it.
Investors looking for drama might turn their attention to the G10’s supporting actors.
The Japanese yen remains very cheap, in our view: The Bank of Japan rocked bond markets last week by cutting its long-dated bond purchases, so further adjustments to its yield curve-control policy could be positive for the currency. By contrast, the negative-yielding Swiss franc still looks expensive to us despite an already meaningful decline as stale safe-haven positions unwind.
Finally, asking which central banks are likely to normalise monetary policy soonest leads us to Scandinavia. The Swedish krona seems to us the strongest candidate for appreciation, with the Norwegian krone close behind in the event of a sustained bull market in energy and global growth.
Time will tell which of these end 2018 as Best Supporting Actors. We believe, however, that their performances can potentially outshine those of the G10’s superstars, the euro and the dollar.
Ugo Lancioni, head of Global Currency at Neuberger Berman.
