Top Forex Themes for 2016

Top Forex Themes for 2016

Since the next two weeks are generally the quietest periods in the financial markets, we want to take this opportunity to think longer term and share with you our currency forecasts for 2016. We’ll start with an initial review of the top themes and explore them in further detail as the week progresses in our outlook for each of the major currencies.

But first – 2015 has been a big year for the foreign exchange market. Divergences in monetary policies led to strong moves in currencies with the U.S. dollar as the best performer. The U.S. saw its first rate hike in nearly a decade while other major central banks in the Eurozone, China, Canada, Australia, New Zealand and Japan eased. In response, the greenback climbed to multiyear highs and this strength translated into significant weakness for many major currencies along with a collapse for commodities. These are some of the milestones reached in currencies this year:

The greatest risk for the financial markets and the global economy in the coming year is the feedback loop from the dollar and Fed policy.

While the quarter point hike in December represents only a nominal increase in U.S. rates, the Federal Reserve expects to tighten 4 additional times next year which will have broad ramifications for currencies, equities and commodities. In mid-December, we published a piece outlining the Consequences of a Strong Dollar and a lot of these issues will return to focus in 2016.

The first few months of the year should be good for the dollar as long as Fed officials don’t backtrack on their hawkish views.

There will be more hawks voting on the FOMC in 2016 than 2015 so the balance swings in favor of continued tightening. Between the warm El Nino weather and gas prices below $2.00 a gallon in some states, consumer spending should also rise in the first quarter. So while the dollar is rich, the path of least resistance is still in higher. However our outlook changes in the second half of 2016 as we believe rate hikes and the strong dollar will force the Fed to slow tightening makring the top for the greenback and the bottom for other major currencies.

Here are some of the themes that we are looking for in 2016:

Monetary policy gaps will expand in the first half and narrow in the second – The Federal Reserve’s rate hike ushers in a new phase of monetary divergence.

In the coming year, the Fed will continue to reduce accommodation at a time when other central banks maintain and even expand their stimulus programs. While the Fed will be the only major central bank raising interest rates for most if not the entire year, in the first few months, investors will be actively thinking about who needs to move next. This speculation could accelerate as the strains of low commodity prices, slow growth and weak external demand hits many economies. But at the end of the day for most countries, the bar is high for additional easing. The global easing cycle is nearing an end as long as the Fed raises interest rates responsibility and avoids wrecking havoc on the financial markets. As such we believe that this past year’s dominant trends should continue in the first few months and reverse as the year progresses and monetary policy divergences stop widening. Another way to look at this is that while we expect dollar strength to continue, it should abate through the year.

Commodity prices will find a bottom in 2016.

A strong dollar, weak global demand and high inventories have caused oil prices to collapse this year and while prices could fall further in the near term as the U.S. ends its 40 year ban on oil exports and sanctions are lifted on Iran, when the dollar peaks, commodities will bottom. The price of oil could fall below $30 a barrel but we do not see much weakness beyond that and by the end of the year we expect prices to settle closer to $40. In the long run, China’s focus on domestic demand should be positive for energy prices. We expect further easing and a lower currency in the coming year. A bottom in commodity prices would not only affect the outlook for commodity currencies but could also mark a shift in G7 monetary policies as inflation starts to stabilize and turn upwards. Lifting inflation is the greatest challenge for many central banks and while a strong dollar lowers the value of local currencies, it also adds to disinflationary pressure by lowering prices and the question then becomes which has greater impact on growth and inflation – right now its lower commodities and not a lower currency.

2016 should also be a year of diminishing stock market returns. The era of easy money is coming to an end and the strong dollar along with Fed tightening will take a big bite out of corporate profitability. Single digit gains are the best that investors should expect in earnings growth. The prospect of a persistently strong dollar, sluggish global growth and lower commodity prices in the first half of the year means that earnings and stocks could suffer. We are looking for a correction in equities in early 2016 that could trigger a flight to safety in the currency market.

At many points in the year politics will overshadow economics.

We have the U.S. election, the U.K. referendum, ongoing Eurozone refugee crisis, possible showdown with Russia and risk of more aggression by ISIS. The U.S. election is definitely a second half story and while there are a lot of different factors at play this year according to our study, the EUR/USD has a lower bias during U.S. election years. In the 10 elections going back to the 1970s the EUR/USD weakened in 8 out of the 10 periods. The U.K. referendum poses a major risk that we will explore in our sterling outlook while the risk of more aggression by ISIS, possible show down with Russia and the ongoing refugee crisis has the greatest impact on the euro.

There’s a lot more to explore and we will do that in the individual currency outlooks but for now, these are some of the most important themes that we believe will dominate trading in the coming year.