Sentiment on the Forex Market - the US Election, Brexit and the Fed
The past year was one of considerable volatility on financial markets. Surprise outcomes in the UK referendum on leaving the European Union and the presidential election in the United States contributed to that volatile trading in foreign exchange,commodities and global stocks. In 2017 these factors and the pace of interest rate hikes by the US Federal Reserve will have an important impact on market sentiment.
How these events and policy decisions affect the foreign exchange market will be the focus of this article. The intent is also to examine how they might impact the trading of key currencies in the year ahead.
The victory of the "leave" camp in the UK referendum in June and the election of political outsider Donald Trump in the US presidential vote in November showed the depth of dissatisfaction with the status quo in both countries. Both votes were seen as a popular backlash against the perceived interests and influence of "elites." Both produced considerable uncertainty in terms of policies and capital flows.
In the UK,the so-called Brexit vote resulted in an immediate 12% slump in the pound sterling against the greenback amid a broader flight to safe haven assets. Most yen cross rates dropped significantly as the yen appreciated. The dollar/yen (USD/JPY) fell to a three-year low and briefly broke below the 100 level. Gold prices advanced smartly,topping US$1,355 an ounce,a high for the year at the time.
In any market,understanding the flow of capital is of utmost importance,for it greatly enhances our ability to judge market direction. What could be even more important in the foreign exchange market,is identifying the relationship between the different forex pairs. From a volatility perspective,by buying the strongest currency (capital flowing in) and at the same time,selling the weakest currency (capital flowing out),investors could take the path of least resistance,assuming the general gauge of direction was correct.
Market Sentiment – Immediate Effects
In the long run,appreciation or depreciation in prices of any commodity or currency pairs should be governed largely by supply and demand or national monetary and fiscal policies. However,one could also argue that a shift in market sentiment,if significant enough,might be the initial driver in any reversal of medium to long term trends. It could also be the force behind the creation of a new driver,as illustrated by the recent market conditions following the US presidential election.
Risk adverse assets such as yen and gold both displayed a deep V-shaped price pattern on the day of the US presidential election. Retracements of an initial advance were readily identified as the outcome of the election became clearer.
In that one trading day,USD/JPY rebounded from its day low of approximately 101.20 to above 105.50. Similarly,gold retraced its US$50 upswing and at one point broke below US$1,280. Both examples were indicative of the fact that the market demonstrated a shift from risk averse to risk-on,from post-Brexit to post-US election.
The markets in the weeks after the US election confirmed these assessments as the USD/JPY traded above 115.00,and gold prices broke below US$1,175 dollars per ounce,just before the FOMC meeting on December 14th. Clearly,the markets demonstrated their continued appetite for risk following the US election.
The outcome of these events indicates that market sentiment governs immediate capital flow and a significant shift in market sentiment can be a force to be reckoned with. Such reversals of sentiment usually are accompanied by volatile market conditions.
Long Term Direction and the FOMC
As mentioned above,changes in market sentiment might propel trading in the early stages of a trend but the consolidation of the trend may depend on factors such as monetary and fiscal policies and the market's expectations for these polices. In the capital markets,either spot,future or otherwise,the greenback is one of the most frequently traded instruments while some of the most heavily traded commodities are also priced in dollars. Therefore,it is no surprise that the market closely follows the Federal Open Market Committee's monetary policy deliberations or the fiscal policies of the US government.
With Donald Trump capturing the presidency,the Chicago Mercantile Exchange (CME) simultaneously calculated a greater than 80% likelihood (based on fed funds future pricing),that the FOMC would move to increase interest rates at the December meeting. Fixed income and equities markets also reacted to an expected rise in the dollar. Financial intelligence provider EPFR Global recorded the second highest outflow of capital from the bond market,with 10-year US treasury bills showing an increase of 20% in yields following the US election.
The initial assessment of 80% later climbed to 90%,one week prior to the meeting,and was proved accurate as the Fed made its second rate increase in a decade,boosting the benchmark rate by 25 basis points. The greenback continued to strengthen,gaining momentum on the growing prospects of higher interest rates in 2017,as a result,the US dollar index (DXY) has been seen trading at levels above 103,a 13-year high record.
Fiscal and Monetary Policy Interaction
Another inevitable factor affecting the strength of the greenback - or other currencies - is the underlying strength of the economy,and data on unemployment,inflation,and GDP growth are focal points for determining market direction. Such economic figures might be largely affected by the government fiscal policies.
In president-elect Trump's first television interview after the vote,the businessman-turned-politician once again emphasized that roads,bridges,tunnels and airports were badly in need of repair and upgrading. A big dose of fiscal spending was required,and the need for stepped up infrastructure spending was one of his key themes during the campaign. Trump's policy pronouncements are widely seen as likely to win congressional backing as his Republican Party controls the Senate and the House of Representatives. This suggests,however,that a Trump presidency could bring higher inflation. The following factors need to be considered:
-- Increased government spending to rebuild key infrastructure is a key part of the Trump agenda and this stimulus has the added benefit of creating more jobs. But unemployment in the United States has been relatively low at an average of below 4.9% over the last 12 months with employment growth averaging at 180,00 per month in 2016. A large-scale stimulus policy could push up wages in a tight labor market and give inflation a boost.
-- Tax reforms are also on the table,with substantial tax cuts for individuals and corporate tax payers. A lowering of the ceiling for ordinary income tax rates might trigger higher consumer spending. Personal consumption expenditure accounts for over 66% of the US gross domestic product,and an increase in personal consumption should lead to faster GDP growth as well as higher inflation.
-- Prospects for the Trans-Pacific Partnership (TPP) are not looking good. Trump has said he will scrap the agreement,a move that could convince some of the governments that had signed on to the major trade treaty to pursue alternatives - such as China's own version of a regional arrangement. That could put US goods at a disadvantage in some markets over the medium and longer term,affecting economic growth and employment.
--The Federal Reserve,under the leadership of Chair Janet Yellen,has taken a rather dovish stance toward raising interest rates - until now. The Fed now sees three rate hikes in 2017 - a slightly more aggressive pace than expected. That could mean an even stronger US dollar might be on the horizon,perhaps with a dollar rally similar to the size and scale experienced from July 2014 to March 2015.
Divergent Monetary Policies – EUR/USD
As discussed earlier,it is more likely that the Fed will move ahead with a tighter monetary policy coupled with an expansionary government fiscal policy. At the same time,the European Central Bank (ECB),might continue to adhere to monetary expansion,resulting in a further divergence of monetary policies.
Mario Draghi,president of the European Central Bank,speaking after the bank's December meeting,said the bank's quantitative easing policy would be reduced in size but would be extended over a longer period of time. Given that the monthly euro area core inflation rate showed only an average of about 0.85% (year-on-year) over the last 12 months,a continuation of quantitative easing on a significant scale is still likely for a while. With the euro-dollar (EUR/USD) trading below 1.0500 after the recent FOMC December rate hike,a further increase in divergence in monetary policy in 2017 might pave the way for the euro and the dollar to trade at par.
Convergence of Monetary Policies – GBP/USD
The Bank of England (BOE),from a monetary policy perspective,is currently looking much like the ECB. However,the economic data of both areas suggests otherwise. In comparing data such as unemployment,the UK figures have been