US: Policy destination and FX valuation are the keys for FX outlook - SocGen

Kit Juckes, Research Analyst at Societe Generale, suggests that the importance of the destination of monetary policy, rather than the exact path that central banks take to get there, has been a constant bug bear of ours this year.

Key Quotes

“So too, have valuations, in particular crude ‘PPP’-based ones. These are famously useless guides to shortterm FX moves, but there are limits to how over or undervalued a currency can get, in real terms; and there is a tendency for moves back towards ‘fair value’ to be quick.” 

“Ten years ago, the US market was pricing short-term rates above 5% around now. That does not mean everyone thought that’s where they would be; in broad terms, expectations were closer to estimates of a 4% neutral fed funds rate, based on a 2% ‘r*’ rate and 2% inflation, with 1% or so on top in terms of term premium. Since the financial crisis, that term premium has fallen sharply and estimates of ‘r*’ have fallen as well. By 2012, five years ago, the market was pricing short-term rates at around 2% by now, rising above 3% in the next few years.  Since then, the market has moved less.”

“Two years ago, pricing of short rates in 2022, five years from now, was 2½%. It was only marginally higher this time last year and now it’s marginally below 2½%. In other words, with the rethink on r* behind us and the term premium mostly vanished, expectations about where the Fed is heading have stabilised.”

“House prices, equity prices, corporate and emerging market bonds, ETFs, Bitcoin and authors of books about wealth inequality have all benefitted from this adjustment, which probably won’t be substantially reversed any time soon because we are now, collectively, addicted to cheap money. The 2018 FX outlook will mostly be determined by whether the market pricing of the US long-term interest rate path changes, and by whether the implied long-term paths in other key economies move.”