Olivier Desbarres

Olivier Desbarres FX Update: Dollar, Sterling and EM

• I maintain my view expressed in January that “dollar appreciation will extend to a third consecutive year (in 2016) even if it’s gains are likely to be more modest”.

• Modest USD rally between now and end-year including vs Sterling, premised on i) Clinton winning 8 November US elections, decent US data and my longstanding expectation of a 25bp Fed hike at 14 December meeting.

• Currencies of EM economies reliant on trade with US, including Mexican Peso and Brazilian Real, would likely benefit from post US election bounce, given concerns that Trump would opt for less open US economy. But looming Fed hike may ultimately cap any EM currency and equity gains.

• If Fed hiked in December, I would expect i) broad-based USD appreciation, ii) other major central banks (including ECB) to be more inclined to maintain their current stance on monetary policy and iii) policy rate cuts to be less frequent than in the past.

• EM currencies and global equities may struggle to hold onto post-US election gains while majors would underperform. Fed would want to avoid repeat of Q1 2016 when global risk appetite collapsed.

• Sterling Nominal Effective Exchange Rate (NEER) has depreciated about 21% since November and recently touched a 168-year low.

• Estimates of Sterling fair value suggest that Sterling is now undervalued and weaker than needs be for UK to run balanced current account like it did in mid-1990s and briefly in mid-2011.

• Conceivable that Sterling’s collapse may attract FX inflows into the UK (looking for cheap valuations) and bargain-hunting investors, stabilising Sterling or at least slowing the pace of depreciation.

• But there’s a risk of further Sterling weakness in next 3-6 months due to the persistence of a large current account deficit and withdrawal of foreign capital spooked by the government’s stance on EU membership and the speed of Sterling’s collapse.