FX Trading in 2017: Plenty of Surprises to Come

Last year the FX market was highly event driven, with periods of
sustained low volatility occasionally punctuated by large but episodic market
moves.

Looking ahead to 2017 and there are already clearly some events set to
take place that have the potential to drive further bursts of volatility,
namely the invocation of Article 50 by Britain to begin its exit from the
European Union and the scheduled political elections in France, Holland and
Germany.

In addition, the change of policy direction expected under US
Presidential-elect, Donald Trump, and the US Federal Reserve’s indication at
the end of 2016 that it currently plans to raise rates three times this year
are expected to be major drivers of the currency markets in the coming year.

“The most prominent theme in our 2017 FX blueprint is that a Trump
presidency changes everything. The US economy is the 800-pound gorilla in the
room – policy shifts are too important to not matter for global FX. Our overall
assessment is that Trump will be highly supportive of the dollar,” say researchers
at Deutsche Bank.

But with the aforementioned factors occupying trading firms’ attention
and eating up all the headlines, what are the major risks that are currently
being under-rated and under priced by the FX markets?

The Deutsche researchers also predict further GBP weakness, observing
that a heavy political calendar in Europe will lead the EU towards a tough
negotiation position once Article 50 is invoked, causing the market to price
towards a “hard” Brexit.

“Past sterling weakness will hit UK incomes via inflation, the current
account deficit is at record wides, London commercial real estate looks
vulnerable to bank departures and more fiscal tightening is coming. We expect
GBP/USD to break through 1.10 and like selling GBP/CHF helped by the SNB giving
up on preventing CHF strength,” they add.

This, together with the prediction of USD strength in 2017, represents
a major market consensus, and therefore also a major potential risk.

Or as Paul Chappell, founder and CIO of C-View, explains: “One interesting
thing about this year is that everyone is expecting the US dollar to go up and
everyone is expecting the pound to go down. The level of anticipation this year
into one direction in the currency markets is pretty surprising and pretty
overwhelming, and so if there’s going to be shocks in the market it’s going to
be the reversal of this expectation.”

Talking to a number of researchers, economists and strategists, there
appear to be a number of factors that could challenge this consensus regarding
USD strength.

Market Disappointment 

Callum Henderson, the head of global markets research at Eurasia Group,
points out that the USD rally witnessed since Trump’s surprise election victory
in November has been on the back of a consensus expectation that when the Trump
administration is in office that it will announce massive fiscal easing.

The assumption is that this will be pro-growth, pro-inflation, negative
for bond markets and will boost the US economy on an absolute and relative
basis, increasing the difference between the US economy and the rest of the
world. Embedded in this expectation, he says, is the idea that the Fed will
seek to offset this through its policies.

Yet Henderson says that the decline in USD that occurred during Trump’s
press conference last week – during which the US dollar index fell by just over
1.5% – is significant with regards to expectations of USD strength going
forward.

“The market reaction to the press conference showed the extent of the
consensus trade. There was a distinct lack of detail with regards to the
details of the incoming Trump administration’s policies, and the reaction from
the market shows the disappointment at this lack of detail given the positions
that have been built up from November ninth and extended from January first,”
he comments.

He adds: “So if there is a risk then this price action shows that it is
clearly that the massive fiscal easing that is widely expected across the
markets will be, one, later than expected and, two, less than expected.”

Henderson also points out that Congress might not let Trump immediately
get exactly what he wants with regards to fiscal reform, something that he says
has not been fully appreciated by the market.

“Our base case scenario is that this fiscal reform package, which includes
issues like corporate tax reform, is likely to go through in the latter part of
H2, and if this is correct then we’re not going to get a lot of fiscal reform –
if any – in the first half of the year and the market is not necessarily
pricing this in,” he says.

Meanwhile, Bob Savage, CEO of CCTrack, argues that the sheer amount of
uncertainty caused Trump’s proposed economic and foreign policies isn’t being
factored in by market participants, adding that “the market is over-pricing
de-regulation and tax cuts”.

Strategists at JP Morgan are also slightly wary about the
sustainability of the USD strength story, stating :“we are circumspect about
how much fiscal upside the Trump administration can deliver, we are concerned
that the rise of trade tensions turn the broad dollar story more messy and
differentiated, and because we believe other forces that might drive
outperformance elsewhere outside the dollar will become important later this
year.”

Boom and Bust

But Savage notes that, even if the fiscal stimulus expected from a
Trump administration does occur, this is not without risks of its own.

“For FX, I don’t want to depreciate the mood swing in the global growth
outlook, and the PMIs and confidence measures are robust, but the
under-appreciated risk is that we’re forced into a boom and bust cycle that we
haven’t really trade in for eight years. I’m optimistic about 2017, but if the
Fed has to tighten more because we have a boom from fiscal stimulus and tighter
labour markets then by the end of the year we could suddenly be worrying about
a recession,” he says.

Simon Derrick, chief currency strategist at BNY Mellon, says that while
the focus on the fiscal spending story will keep the yield curve relatively
steep and give the Fed space to hike rates, history teaches us that FX market
participants should keep a close eye on the comments being made by the Trump
administration with regards to USD.

He points out that following Bill Clinton’s election victory in 1992
there was plenty of talk in the market about the incoming President wanting to
target Japan for currency manipulation and drive the yen higher. Derrick
explains that the market ignored this entirely and the USD climbed until
Clinton’s inauguration, after which the Treasury started targeting Japan and 12
months later named China as a currency manipulator, causing USD to decline from
February 1993 until April 1995.

“So there’s a history of the market ignoring fairly clear signs about
USD strength. We can’t necessarily assume that a Trump administration is automatically
in favour of a strong US dollar, we have to listen to what is being said,”
claims Derrick.

A similar observation is made by the JP Morgan strategists, who state:
“Given that the incoming administration sees large trade deficits as one
indicator of currency manipulation, and that currency manipulation is something
to be remediated by negotiation with the threat of potential countervailing
tariffs, there is a potential scenario where the US in fact achieves
devaluation against “manipulator currencies” as a negotiated outcome, which
would obviously not be currency-positive.”

Regardless of how his policies turn out, the source any major surprises
to the FX markets this year are likely to come from the new US President.

Speaking about unexpected potential risks to the FX market at a media
briefing in New York last week Amir Sufi, professor or economics and public
policy at University of Chicago Booth School of Business, commented: “At the end of the day, it’s all going to
be about Trump, that’s the major game in town.”

He adds: “We saw some pretty sharp moves in the dollar during Trump’s
press conference, and I was actually surprised that of all the financial
indicators that moved during the conference that the dollar saw some of the
biggest moves. I think that this indicates that if people lose confidence in
Trump’s ability to manage the political system then we could see some dollar
weakness.”

Protectionist Policies

Outside of the US, sources identify a number of other potential trends
that they argue are not currently being sufficiently recognised by FX market
participants.

“One theme that will represent itself this year, and to some extent has
already started, is this: everyone is transfixed by Trump and the prospect of
US protectionism and its impact on USD and the prospect of US interest rates,
but the other side of the coin is that there’s a strong likelihood that the
rest of the world could fairly readily organise around a protectionist US,”
says Chappell.

“What people aren’t focusing on right now is what the Asian economies
will do when they reconcile themselves to the fact that the US will not be a
prime driver of their export programme. This could lead to much more economic
activity domestically and between countries in Asia, which could in turn have a
profound effect on their development, and if they do organise around a
protectionist US then those currencies could do very well under those
circumstances.”

But Savage claims that such a scenario could prove difficult due to the
complexity of global supply chains. “It’s not as simple as building your own
trading bracket,” he says.

Savage describes the trade goals articulated by Trump thus far as
“completely unclear” but points out that, amongst all the concern about trade
protectionism being part of US policy, the currency that hasn’t priced in any
of this risk is CAD.

JP Morgan strategists note that CAD was the one G10 currency did not
actually succumb to US exceptionalism after the US presidential election,
appreciating by 1.2% by January 6.

“The performance of CAD is surprising not because it is unwarranted by
fundamentals, rather that it ignores the risk of any protectionist fall-out to
Canada. This strikes us as unreasonable seeing as the US takes three quarters
of Canada’s exports and the manner in which Trump has already demonstrated a
willingness to co-opt individual companies to restrict their NAFTA activities,”
they say.

Eyes on Europe

Despite the negative sentiment around GBP at the moment, Savage says
that the political situation in Europe means that he is more bearish on the
euro as a currency right now.

“I would say that in the next three months the political risks in
Europe are much higher than people are willing to entertain, and I actually like
being short the euro more than I like being short the pound because of that. The ECB has less room to move policy and will lean on the FX market to help
them because that’s the one non-controversial place it can go, whereas the UK
has more room to maneuver,” he says.

Henderson, meanwhile, claims that the market “hasn’t even begun to
price in the European elections” taking place this year.

“If you look at implied volatility in options markets, across FX rates
and equities, you would be hard pressed to say that any risk of surprising
outcomes is being anticipated ahead of the Dutch, French or German elections,”
he says.

Henderson adds that this risk has not been priced in because to do so
would mean that firms would have to hedge, and hedging costs money.

“It costs corporates and investors to hedge and of course if a surprise
result doesn’t occur then they’ve paid a lot of money for a hedge that they
didn’t need,” he says. “Unless there is evidence to suggest that there is a
higher risk than is currently anticipated in the polls then they won’t want to
pay that hedge.”

But there is another side to this European story, as Javier Corominas, director, head of research and FX strategy at Record Currency Management, points out.

“The market is potentially not pricing in what looks to be an incipient
return to trend economic growth in the Eurozone. Obviously this needs to be
confirmed by the hard data, but soft indicators right now suggest that there
could be a potential upside surprise that markets aren’t pricing in.

“Of course, that has implications for the speed and extent of QE
tapering, the re-pricing of the euro rates curve as a whole, and it might mean
that the hawks in the ECB will have a greater preponderance going forward. By
the middle of this year we could be in a different spot with regards to
perceptions of the Eurozone and the euro as a currency,” he says.

Another issue not making the headlines right now that Corominas plans
to keep a watchful eye on is the extent to which there is actually some slack
in the US labour market, despite strong official statistics.

“On paper, unemployment is quite low and it looks like we’re in a
goldilocks type scenario, where growth is steady and the Fed will steadily
raise rates. However, if you count the number of people that could work but are
not working or currently looking for work in the US and add them to the official
count then the unemployment rate ticks up almost 1%.

“We also know the labour force participation rate is at very low levels
compared to history, which means that there’s still some room for growth to
accelerate without triggering damaging wage and price inflation. Thus, to what
extent the labour market is tight in the US or not is a key question and the
success of the new administration in Washington could depend on whether there
is more labour slack than anticipated,” he explains.

AUD to Finally Crack?

The Australian dollar has appreciated over the past year, courtesy of
Chinese devaluation, but analysts warn that the market could be surprised by
the reversal of this trend.

“I fear that the market is underpricing an AUD fall,” says David
Campbell, partner and CEO at Hunter Burton Capital, a trading firm in Australia. “I expect the interest rate differential between AUS/USD to invert soon. Any subsequent
loss of the AAA rating will cause a major AUD drop.”

He adds: “I think that the risk for AUD probably lies in the AUD
crosses, they look overpriced to me. The market appears to be positioning risk
on, but I think that is erroneous. AUD/EUR above 0.7000 and AUD/JPY above 85
seem expensive, for example.”

The researchers at Deutsche Bank paint a similar picture for Aussie in
the coming year. “We think AUD finally cracks in 2017. Low productivity and
wage growth should mean more RBA cuts and accelerating bond outflows
aggravating an already weak basic balance. Last year’s commodity rally is
providing only limited FX lift and is bound to reverse,” they say.

China’s growing influence on the world economy means that FX market
participants need to be increasingly watchful for big moves in its currency and
2017 started with what one analyst in China describes as some “pretty wild” moves
in the offshore CNH market.

The People’s Bank of China (PBoC) has been using its vast FX reserves
to maintain the value of the RMB but, having already depleted these reserves by
one trillion in the past year, there are questions surfacing about how long it
will continue to do so. This would clearly have significant implications for
the Chinese currency.

“I think that there is a possibility that China could move towards
something that could look like a floating exchange rate,” says Derrick. “The
debate is whether the pressure on the RMB will continue and then how much
further the PBoC would be prepared to use its FX reserves to mute the decline. That’s
a risk that has to be considered.

“It’s also worth noting that if you look at the US Treasury TIC data,
mainland China has been reducing its holdings in US Treasuries since November
2013, and in the second half of last year we saw an acceleration in the pace of
the reduction of these Treasury holdings. That’s a story that perhaps isn’t
getting as much attention as it should.”
 

Short-term
Volatility to Continue

Finally, it’s worth noting that FX market participants hoping that last
year’s event-driven market might give way to some clear trends, leading to
firms broadly re-balancing their portfolios, might be disappointed in 2017.

“I think the idea that volatility remains episodic stays in place,
although I think that the average volatility will go up and so the risk factors
will move to the levels that we were used to ten years ago,” says Derrick. “I
think that means firms have to become more mindful of short-term risks, and in
this environment trading FX almost becomes like set pieces where there is a
known risk event and firms need to do their risk analysis around it.”

Certainly, market participants should expect plenty of short-term
volatility around the sterling for the beginning of the year, says Corominas.

“In the past week we’ve seen sterling move two to three big figures on
the back of various political announcements, and I think that this probably
shows us what the early part of 2017 will look like,” he predicts.

Could sterling throw some surprises at the market this year? At this
moment in time the currency’s trajectory is too path dependent to predict this
with any accuracy.

The noises coming from senior UK politicians suggests that Britain
could be heading for a “hard” brexit, and, in the absence of any indicators to
prove the market wrong, it is therefore trading off sterling in the easiest way
that it thinks appropriate, which appears to be pretty much selling GBP across
the board.

“The path of least resistance is to sell sterling,” observes Henderson.

And yet, he also notes that the economic data might not actually
support this position, with Mark Carney, Governor of the Bank of England,
stating last week that the UK economy was outperforming expectations. However,
the value of sterling in 2017 will ultimately be decided by the triggering of
Article 50 and what form of Brexit the government will pursue and the terms that it eventually agrees to.

Linked to this idea of short-term risk and episodic volatility, is the
concern that there could be more flash events in the FX market in 2017. Last
week the Bank for International Settlements (BIS) released its
report on the sterling flash event that took place in October 2016. The report blamed the
event on a confluence of factors, but some of those factors were structural
issues within the FX market that Campbell says could mean that such events become
more frequent in the future.

“I continually worry about liquidity vacuums. As risk is removed from
the market as banks de-risk themselves the ability for the overall market to
absorb needs by the clients to offload risk. Events like the 2010 flash crash
and the sterling gap move last year and the EUR spike last month will become
commonplace,” he says.

2016 sprung some surprises on the FX market, most notably via political
events such as the Brexit referendum, the US election and the Italian
referendum. It seems that 2017 may have even more surprises in store for the
markets.

galen@profit-loss.com

Twitter @Galen_Stops

Twitter @Profit_and_Loss    

Colin Lambert

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