Morgan Stanley: Updated FX Forecasts for 2017/18

Change will remain a continuing theme as far as G10 currencies go in 2018, or so Morgan Stanley forecasts appear to suggest. 

At the tail end of an action-packed year for currency markets, US investment bank Morgan Stanley has released its foreign exchange forecasts for the year ahead.

Once constant theme for currency markets in 2017 has been change, in both fundamentals and politics, as well as the peripheral narratives that drive occasional volatility in currency prices.

During this time world markets have gone from fretting about a possible “hard landing” in China to cheering a “synchronised global upturn”.

Eurozone facing investors are no longer fearing a breakup of the currency bloc and are, instead, looking closely at the prospect of further integration, or federalisation on the continent.

Investors have learned not to fear the presidency of Donald Trump and are now focused overwhelmingly on the potential positive effects of the administration’s plan for tax cuts and reforms.

In the UK the economy has continued to muddle on through the perpetual noise around the Brexit talks and the Bank of England has raised interest rates for the first time in more than a decade, underlining the economy’s relatively succesful navigation of the post-referendum waters to date.

For fundamentals at least, change will remain a continuing theme as far as G10 currencies go in 2018, or so Morgan Stanley forecasts appear to suggest.

Summaries:

Pound Sterling

"Beyond balance sheet vulnerabilities, GBP will likely be weighed down by the consequences of Brexit on the political and economic outlook."

"Weakness in investment should result if Britain leaves the EU without alternative arrangements in place."

"Keeping EU access for an interim period may be the best outcome for now, but will likely come with a high exit bill price tag which could exceed the tolerance levels of certain Conservative party members."

"Political uncertainty potentially leading to early elections is not yet in the GBP price."

US Dollar 

"Low US rates keep USD weak against high growth and carry currencies: Powell is likely to continue Chair Yellen's policy of gradual normalization."

"The Fed's accommodative policy stance leads to higher nominal GDP growth and a tighter labor market."

"This supports US capex that, when it rises sufficiently, leads to productivity gains and gets wage growth going."

"Stronger wages are inflationary, which ultimately keeps US real yields low and USD upside limited."

Euro

"We are long-term bulls on EUR though we view 2018 as likely to see more volatility in performance."

"The short-term EUR is torn between two factors. The growth outlook in EUR remains robust, particularly when contrasted with that of the UK, and a weaker USD in the early part of next year should keep EUR supported."

"Indeed, we view EUR as increasingly trading as an asset currency, and thus it should appreciate when risk appetite is strong but weaken in 2H18 as USD rallies amid waning risk sentiment."

Japanese Yen

"We see USD/JPY upside as limited and use any rallies to sell. Any JPY weakness would be driven by global risk staying supported, but JPY’s undervaluation means that any moves should be limited. We think that JPY strength in 2018 comes from two key sources."

"First, global reflation could push Japan’s inflation rates sufficiently high that the BoJ may finally decide to turn away from its current aggressive easing policy of yield curve management, allowing long-dated JGB yields to rise fairly quickly."

"This could convince Japan’s real money investment community to reduce its outflows and external investment and keep more funds at home."

"Then, later in the year, these forces are bolstered by a potential turn in global risk appetite, which could in turn drive repatriation-related JPY demand up."

Above: Morgan Stanley forecasts for major exchange rates. Source: Morgan Stanley 2018 Strategy Guide.

Australian, New Zealand and Canadian Dollars 

"High real returns and balance sheet clean-up make EM attractive – the opposite is true of our 'canaries in the coal mine', a club of the DM economies with stretched balance sheets, high leverage and waning asset quality. Top of the list here include CAD, AUD and NZD."

"The 'canaries' have seen years of economic growth outpacing income growth. The dominance of US rates in determining global funding costs resulted in local funding costs remaining inappropriately low, given the local needs of these economies, leading to a leverage boom."

"Now, as these economies are running out of balance sheet leverage space, which reduces their growth potential, the US is pushing nominal rates gradually higher, creating further headwinds."

"High real returns in EM and rising US rates mean that the yield advantage offered by these economies relative to G10 counterparts may no longer be sufficient to compensate investors for these growing risks."

Above: Morgan Stanley forecasts for major exchange rates. Source: Morgan Stanley 2018 Strategy Guide.

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