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What is the outlook for forex in 2016?

Last updated: May 3rd, 2017 at 09:58 pm

With the Federal Reserve having engaged a first increase in interest rates in nine years, 2016 is set up to be the “Year of Divergence” with interest rate differentials back at the forefront for traders. As the Fed is now tightening and other central banks remain loose, what is the outlook for forex markets in 2016? I take a look at the key factors to watch for and what I believe could be in store for major forex pairs.


With interest rate differentials again en vogue in the wake of the Fed decision, the result is likely to be much greater volatility in 2016. Volatility in forex markets was extremely subdued during 2013 and 2014 as central banks around the world closely shadowed one another. However as we move into 2016 the Fed has broken ranks and hiked interest rates. The 25 basis points move in itself is not the big new story, more that the Fed is now on a different path to other major central banks. This should help to be a source of volatility among major currencies in 2016.

Factors to Watch

How will the market react to the Fed tightening? This is a really intriguing question as the Fed will have little idea of exactly how the US economy will respond to the first hike in 9 years. Will nascent inflation growth begin to fail again? Will the recessionary industrial sector act as a drag on the wider US economy? How will the China shift to a basket of currencies for its peg impact on the US economy (it is likely to be deflationary)? Look at the US 10 year Treasury yield which is 15 basis points below the November high and almost 30 basis points below the June high. The yield has fallen since the Fed announcement of a rate hike. The market is clearly questioning the future growth prospects amidst a Fed tightening cycle. This move is a function of the continued economic slowdown in China in addition to the market’s concerns over the strength of the United States’ own recovery.

10 year yield

These are all aspects that drives me to expect the Fed will be extremely cautious in any tightening next year. The FOMC dot plots suggest 4 hikes, but I foresee a maximum of two or maybe even one. The Fed funds futures are priced at a hike around the June meeting and possibly another again in December 2016. I believe that global economic shocks will and subsequent impact on the US economy will mean that the Fed will be more cautious through 2016. This will mean that the US dollar will struggle to gain the same sort of traction it gained in 2015.

Another key factor is the European Central Bank’s monetary policy. The disappointment of the December ECB meeting suggested that the hawks are still a strong voice within the Governing Council. The European economy is gradually improving (inflation upward revision to +0.2% in December) and with the fanfare that preceded the ECB decision, it would be a surprise if Draghi was able to extend easing too much further. At the press conference he repeatedly refused to answer questions about the limit of the deposit rate, my take away from this is that he does not want to admit that he has. I think that therefore the euro downside is limited in 2016. The mixed recent economic data (positive PMIs and disappointing inflation) is likely to mean the euro remains choppy in the coming months but I do not see parity against the dollar, just as I do not see any significant rally either.

The Bank of England is concerned about the lack of wage growth. The December employment data revealed that ex-bonus average wages fell to 2.0%. In 2016 the energy price declines are expected to start dropping out of the CPI calculation. This will mean that CPI will start to rise again, with some forecasts around 1% CPI by the year-end. If this comes as average wages are falling, then REAL wages will come under pressure. This is not what the Bank of England would want to see as it contemplates a rate hike. MPC member Shafik has already said that she needs to see sustainable wage growth before she can vote for a hike. Shafik is seen as a centrist on the committee and is a decent gauge for the committee. Historically, the Bank of England is normally around 3 months behind the FOMC in a tightening cycle. However the way the economic data in the UK has begun to slide, the Short Sterling Interest Rate futures that show a 25 basis points rate hike in late summer 2016 is likely to be pushed back. Furthermore, the uncertainty over the EU referendum (which could easily be in June 2016) is also likely to be a significant weight on the shoulders of the sterling bulls.

uk wages

Other issues to impact on forex markets:

The PBoC changing its peg to a basket rather than the dollar should act as a tacit depreciation for the Yuan. The currency pair against the dollar has been accelerating higher (i.e. Yuan weakness) over the past few weeks as this depreciation continues. This is likely to have a deflationary impact on the US and could also lead to a less aggressive monetary tightening from the Fed. Since the devaluation by the PBoC in August the yuan has depreciated by 8% against the dollar.  This will also have a knock on impact across exporting emerging market countries, due to its deflationary impact and the fact that Chinese goods will be cheaper.


How will the Bank of Japan react this year? The economy only just avoided moving into technical recession on a revision, but inflation is back around zero once more. Although Governor Kuroda is confident of the improvement in inflation as the energy price falls drop out, the economy is still struggling to get going. The yen has been strengthening in recent weeks and this may encourage the BoJ into further action, even though the December meeting contained little to appease the market that seemed to be wanting more action on easing measures. With the ECB extending easing, will the BoJ follow suit in 2016?

The further weakness of commodity markets will acting as a drag on the higher risk major currencies, the Aussie, Kiwi and Canadian Loonie. The falling oil price will also impact on currencies such as the Norwegian Krone and Russian Rouble. The big question is where will the floor in the oil price be? Also, if the oil price does start to find support, can it engage in a recovery? Furthermore, with the ongoing China slowdown and issues regarding oversupply, metals prices remain under huge pressure and there seems to be now end in sight.

Summary outlook

In 2016 I expect that much of the dollar strength from the beginning of the tightening has been priced in. Perhaps the risk will be for dollar weakness on the disappointment of fewer rate hikes? I see the euro as finding support and I do not believe that there is any great downside potential now. The move may be choppy but substantial further ECB easing measures are unlikely. I think that it could be a tough year also for Sterling, what with deteriorating wage and PMI data, in addition to the prospect of an EU referendum. The yen tends to weaken significantly on the announcement of decisive further BoJ easing measures. Therefore, I expect the yen to broadly trade sideways in the absence of any extension of the QQE program.

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At Hantec Markets Ltd we provide an execution only service. Any opinions expressed by analyst Richard Perry should not be construed as investment advice or an investment recommendation. This report does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. Forex and CFDs are leveraged products which can result in losses greater than your initial deposit. Therefore you should only speculate with money that you can afford to lose. Please ensure you fully understand the risks involved, seeking independent advice if necessary prior to entering into such transactions.