Fixed Income Outlook  |  Q2 2017

Currency: The dollar may neither lead nor lag

Fixed Income Team

Within currency, the U.S. dollar outlook has become more clouded given the uncertainty associated with President Trump's policies, in particular, the ability of Congress to repeal and replace the ACA and repercussions this has for tax reform. As such, the more relevant driver of the dollar has been and remains the Fed. After ramping up its rhetoric and encouraging the market to price in a rate hike in March, the Fed released very subtle changes in the Statement of Economic Projection (SEP) "dots," helping to subsequently weaken the U.S. dollar. The Fed will continue to hike rates, but economic data and financial conditions will play a larger role in determining the pace, leaving the dollar as neither the leader nor laggard among currencies.

The outlook for the euro is dominated by relative monetary policy and the issue of political risk. The ECB left policy unchanged at its March meeting but signs of dissent among the hawks and doves seem to be occurring earlier than the market had expected. It is highly likely that during 2017 the ECB will need to reduce the exceptional degree of policy accommodation in place, albeit at a cautious pace, barring an exceptional outcome in the French elections that could add to instability. This should put a floor under the euro and ultimately help it rise.

The United Kingdom has invoked Article 50 of the EU treaty and initiated the long legal process of leaving the EU. In this negotiation, the EU has incentive to discourage other member countries from thinking that leaving the union is more attractive than staying in it. And while some agreement will be reached that is not catastrophic, negotiations are likely to begin on a discouraging note and become more practical over subsequent quarters. Also, as U.K. inflation has climbed due to a weaker currency and higher energy and food prices, the Bank of England saw its first dissenter calling for a rate hike. However, growth data is once again rolling over as real incomes and real spending are getting hit, and this will likely keep the Bank of England on the sidelines. This should keep the pound weak.

The Bank of Japan (BOJ) kept its "yield curve control" settings unchanged, and Governor Haruhiko Kuroda gave no signal the bank would consider exiting its extremely loose monetary policy this year, which leaves the yen as the G4 funding currency of choice. Supporting this thesis are signs that a wage-price spiral remains absent in Japan. Without any upturn in wage growth, Japan's national CPI is likely to keep undershooting the BOJ's target. In the short run, the dollar-yen rate has traded in a range, and it is likely to remain range-bound.

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