2016 will go down as the year when major political upsets triggered substantial moves in global currency markets as populist sentiment became more firmly entrenched.
Overview / Analysis
At the beginning of 2016, the Federal Reserve expected to raise interest rates four times in the course of the year, but their plans were continually frustrated by domestic and international factors and there was only one rate hike during the course of the year. For much of the year, the dollar also failed to meet expectations of gains before a late and dramatic twist.
The Fed’s inability to raise interest rates undermined dollar support during the first six months of 2016 as the trade-weighted index declined to lows just below 92.50 in early May from 98.65 at the beginning of the year.
The US economy was trapped in a low-growth environment while the Euro was broadly resilient even with the ECB increasing its bond-buying programme to EUR80bn per month from EUR60bn at the March meeting and cutting the deposit rate to a fresh record low of -0.40%.
Markets inevitably focussed much of their attention on economic trends and central bank policies, although it was political events and shock outcomes that had the biggest impact and caused major market turbulence with two huge set-piece events.
On June 23rd the UK held a referendum on whether to remain in the EU. Uncertainty ahead of the event had an important impact and was partially responsible for cancelling the Fed’s planned June interest rate increase, although a dismal employment report was the dominant reason for a postponement.
The UK voted to leave the EU, contrary to all the opinion polls and expert opinion leading into the event. The shock decision put severe downward pressure on Sterling and also helped fuel global populist sentiment.
In response, the Bank of England cut interest rates in August and Sterling remained under pressure throughout the second half of 2016. The UK currency hit the lowest level for over 30 years against the dollar with a slide to lows below 1.20 and also lost ground heavily on a trade-weighted basis.
The second major shock occurred in the November US presidential election with the vast majority of opinion polls suggesting that Democrat contender Clinton would secure victory. Clinton did win the popular vote, but Republican rival Trump won the Electoral College with victory in key battleground states such as Florida.
The dollar initially declined sharply, but markets staged a dramatic reversal within hours and the US currency surged higher against major currencies over the following few weeks.
There were expectations that the Trump Administration would cut taxes aggressively, potentially raising the US growth rate and put upward pressure on inflation which, in turn, would accelerate the pace of Federal Reserve tightening and increase the US yield support.
After being locked in a global deflation mindset for much of 2016, market sentiment swung sharply towards expecting higher inflation. US bond yields rose sharply and the shift in yield spreads in the dollar’s favour was a key factor boosting the dollar as support for the yen and Euro evaporated. USD/JPY rose from a test of support near 100.00 to a peak above 118.50. EUR/USD dipped to lows at 1.0350 which reignited market talk of parity.