2017 was a disappointing year for currency investors. The consensus view of a stronger US dollar after the US elections did not materialise. The US dollar peaked at the start of the year at 1.04 against the euro and at 118 against the Japanese yen and finished the year as the worst-performing currency.
The euro was the best performer, outperforming both the US dollar and the Japanese yen by more than 10% on the back of stronger economic growth in the eurozone. Emerging market currencies did even better, with the Polish zloty and the Czech koruna outperforming the US dollar by more than 20%. Even the Turkish lira, despite all the political turmoil, outperformed the greenback.
Expectations for 2018
In terms of expectations, investors are starting 2018 with the opposite US dollar view compared to last year. The US dollar is expected to weaken. The arguments are
- US asset valuations are at record highs, so capital will flow out of the US to other countries (and boost their currencies)
- US twin deficits are widening driven by the fiscal stimulus
- the US is re-engaging with a weak dollar policy similarly to the 1994-1995 period.
Is this view going to suffer in the same way as in 2017, i.e. will the US dollar be stronger, or are most of the commentators right this time?
In particular, the EUR/USD exchange rate remains in focus, with USD 1.30 to the euro being a popular target.
In our view, focusing on EUR/USD is similar to Kylo fighting Luke Skywalker in the movie “Star Wars: The Last Jedi”. In the eighth main installment of the Star War franchise, Luke appears to confront the First Order to enable surviving Resistance members to escape. Kylo orders the First Order’s forces to fire on Luke, but to no effect. He then engages Luke in a lightsaber duel and strikes the jedi only to realise that he has been fighting Luke’s Force projection. Kylo wasted precious time, which enabled the surviving resistance members to escape. Investors might be wasting precious time focusing entirely on EUR/USD.
This is because even the most bullish projections are calling for euro at only USD 1.30 by the end of the year. Given that euro was at 1.25 just recently and that the one-year forward rate was at 1.28, this implies an appreciation of less than 2%. Why? The implied interest-rate differential in EUR/USD is at almost 3% – this is a pretty big hurdle for long euro positions vs. the greenback. In fact, this differential has almost never been so attractive relative to the volatility of the exchange rate (see Exhibit 1).
Exhibit 1: EUR/USD implied interest-rate differential relative to volatility
Source: Bloomberg, as of 09/02/2018
What should investors be focusing on in 2018?
In our view, the Japanese yen could easily be the top performer among the G-10 currencies and could do better than both the euro and the US dollar.
First, for the past two years, Japan’s economy has been expanding at above its potential growth rate. Wage growth remains lacklustre and the BoJ is dovish for now, but this means the next policy shift can only be in a hawkish direction.
Second, the Japanese yen is one of the cheapest currencies in the world (see Exhibit 2).
Exhibit 2: G-10 purchasing power parity (PPP) valuations
Source: Bloomberg, as of 31/01/2018
Third, the return of financial market uncertainty is supportive of the yen, which traditionally rises in periods of equity stress. After five years of falling volatility, rising stock markets and falling global bond yields, the recent market turmoil might persist for longer than expected.