After receiving a number of questions regarding our USD view, we thought it might be useful to summarise the main thoughts and drivers behind our forecasts. 

In terms of our global foreign exchange forecasts we tend to the view that the USD will broadly weaken over the next two years. A number of assumptions underline this view, which are summarised below.

PPP valuations:

Our own PPP fair value models suggest that a number of the world’s major currencies are quite significantly undervalued against the USD, the most notable ones being GBP (-24%), EUR (-15%) and the Yen. Now whilst we would not envisage an immediate reversal back to ‘fair value’ levels, we would expect valuation arguments to support a gradual appreciation in these currencies against the USD over the medium term. The chart shows % under or overvaluation vs the USD:

ECB tapering:

We believe that the re-evaluation of ECB monetary policy will be a big factor in pushing the euro higher against the USD after the weakness seen in recent years. Our central euro area forecast envisages the ECB beginning to end its ultra-loose monetary policy stance in Q4 2017, with an announcement of a tapering in its asset purchase programme and a full end to it by June 2018. Markets should begin to price this in through this year as Eurozone inflation trends higher and the fundamental growth backdrop improves (note that Euro area growth has exceeded expectations in the each of the last three years). We suspect that ECB tapering might have a similar currency supportive effect to when the Fed started winding down its QE programme. Between the Fed taper announcement in Dec-13 and the halting of purchases in Oct-14 the USD strengthened 13% against the euro, although we do acknowledge the added drag on the euro from the introduction of a negative deposit rate in the period. Our end-17 eur:$ forecast of $1.14 envisages a rise of 6% from current spot ($1.075), an appreciation of half the magnitude that the USD witnessed.

Sterling to rise:

As mentioned above we think that sterling is significantly undervalued (see chart) against the USD. Our (PPP-based) model of fair value points to sterling at $1.63. Over the longer term at least, we would expect the price of tradeable goods to adjust, and for some of that adjustment to come through exchange rates (ie a stronger pound) as global demand shifts towards cheaper (than fair value) UK goods. Secondly, we see the UK economy holding up fairly well this year (only a slight slowdown in GDP growth to 1.7% from 2.0% last year) alongside a little more clarity on the direction of Brexit (we suspect that leaving the Single Market has now more or less been priced in). Overall the valuation arguments, resilience in the UK economy and a degree of clarity over the direction of Brexit should be supportive of the Pound versus the USD. Our end-17 GBP:USD forecast stands at $1.35.

Buy the rumour, sell the fact?

With the Fed moving to a path of gradual policy tightening in recent years, interest rate differentials with other economies has been a key driver of USD strength. However, we believe that the majority of FOMC tightening has been priced into the USD. For example the Fed Funds futures curve is currently pricing in around 4 hikes by the end of 2018, very similar to our own forecast of 5 hikes over the same period. An additional point that we would note, is that if you look at the last two Fed tightening cycles, the USD appreciated into the start of tightening and then weakened thereafter, suggesting that once tightening is priced into markets further USD gains are limited. See the chart below.

  • 1999- In the nine months (June 1999-Apr 2000) after the first Fed hike in June 1999 the Broad USD index fell by 2.6%. The dollar did strengthen thereafter as the Fed continued tightening, but other things may have influenced the dollar’s strength, i.e safe haven demand given the fall in the S&P 500 (it lost almost half its value between 2000 & 2002).
  • 2004- Fed started tightening in June 2004, the USD subsequently fell 5.5% over the following two years despite continued hikes. On this point it is also worth remembering this fall in the USD occurred even as the Fed tightened more aggressively than markets had expected- they tightened 25bps at 17 consecutive meetings, taking the rates from 1% to 5.25%.

Please see our FX forecasts below.

The Investec Economics Team

The opinions and views expressed are for information purposes only and are subject to change without notice. They should not be viewed as independent research, recommendations or advice of any nature.