A 'Frustrating Year' In G10 FX, So What's Next 'Medium-Term'?

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A frustrating year in G10 FX.

FX market moves have often been counterintuitive this year, with seemingly very little to do with fundamentals. Bad news is still good news, but investors we talk to are very concerned about stretched valuations in both equity and bond markets, as they have been forced to join the market rally in recent months. At the same time, investors have started questioning the sustainability of what major central banks are doing.

Thinking medium term.

Our analysis supports buying EUR/JPY, flags positive GBP risks and is bullish SEK and NOK. Given short-term uncertainties related with the Fed, the ECB, the BoJ and the US elections, these views may be more relevant for next year. In the meantime, we see some USD strength towards the end of this year if the Fed hikes.

Our baseline scenario subject to substantial risks.

Our baseline G10 FX projections assume a smooth transition back to normal. This scenario supports the USD in the rest of this year, but the outlook becomes mixed next year, with EUR and GBP strengthening and JPY weakening. However, we see substantial risks to these projections, to a large extent depending on the Fed’s tightening cycle and the credibility of the ECB, BoJ and BoE. These risks point to more upside for EUR and, potentially, GBP.

Central banks and FX.

We believe that the FED is trying to hike more than once a year, which is not what markets are pricing. We are also concerned that markets rely too much on the Fed’s policy put. Repricing of the Fed could support the USD towards the end of 2016.

The ECB could face BoJ-like challenges next year in our view, as it reaches self-imposed QE constraints. We think QE extension this year is relatively easy. We expect that extending QE again next year will be much more difficult, as the ECB may have to abandon the capital key just ahead of the German elections. Markets could challenge Draghi and the EUR could strengthen. We argue that the key to success in Japan is coordination of monetary and fiscal policies, which was the essence of Abenomics but has suffered this year.

We do not believe the BoJ can address this problem currently,, but a solution might not be far off. The next JPY rally may be a selling opportunity.

Markets could start pricing an early end of the BoE's QE if the UK data continue surprising to the upside. Markets could also become complacent about Brexit, given how long it could take. Both could lead to a stronger GBP, in our view.


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