Weekly FX – Carry and oil key drivers for currency markets

door: Roy Teo

Better than expected US data supported the dollar early last week. However, gains were erased after the sharper than expected contraction in the first quarter of this year. Low volatility in currency markets and higher oil prices continue to support currencies with attractive carry and currencies of net oil exporters. Historically, volatility in the currency markets has tended to remain low during the summer, while the Fed and ECB are likely to remain dovish in the near term. Hence carry trades could remain in vogue in the coming months.


US dollar weighed by sharper US contraction in Q1

Better than expected US data early last week supported the dollar. However, gains were erased after economic growth came in weaker than expected. We judge that the US economy will gather momentum in the coming months and this should support the USD later this year. The upside in sterling was limited after Bank of England governor Carney stated that there is more scope to absorb slack before monetary policy is tightened. The euro was also supported as several ECB officials stated that quantitative easing might be problematic as financial markets in the eurozone remain fragmented. Japan Prime Minister Abe announced his ‘third arrow’ of ‘Abenomics’ last week. Though lacking details, his broad framework did not disappoint the market with the Japanese yen (JPY) largely unchanged. The JPY strengthened late last week after the labour market improved and CPI remained on an upward trajectory. In addition, retail sales in May also rebounded at a stronger pace reflecting that the negative impact due to sales tax on consumer spending might be less than envisaged. This reduced market expectations that the Bank of Japan might need to increase stimulus alter this year.

However, we continue to expect that the Bank of Japan to increase stimulus in October 2014 as underlying inflation pressures are actually fading, stripping out the effects of sales tax, energy & food inflation has even been easing over the recent months. .

Carry trades continue to be in vogue

Volatility in currency markets has tended to remain low during the summer period with the exceptions of 2007, 2008 and 2011. We attribute these exceptions due to the oil price shock, global financial crisis and eurozone debt crisis respectively. More fundamentally the Fed has anchored short rate expectations, while speculation about ECB QE has also been supportive. Though tail risks remain a distinct possibility (escalation of Iraq crisis leading to elevated oil prices) we judge that the low currency volatility environment might persist well into the third quarter of this year. Hence the carry theme might remain in vogue in the coming weeks or months.


However, given that implied volatility is at the lowest level since late 2007 we judge that further declines in volatility are limited. In addition, the current low volatility priced in by the market does not necessarily imply that risks are low.

Positive carry remains the key driver for the New Zealand dollar (NZD) despite lower dairy prices. In addition, the market is increasingly pricing in our expectations that the Reserve Bank of New Zealand will hike rates by 25bp on 24 July. This has supported any dips in the NZD.


Bank of Canada to become hawkish?

Higher oil prices have supported the Canadian dollar (CAD) since the beginning of this month. However, in the past week rising market expectations that the Bank of Canada (BoC) may be less dovish because of inflationary pressures have also benefited the CAD. We believe that the central bank will be wary that any change in tone towards the hawkish side will result in further strength in the currency. The latter has already appreciated by almost 2% since the beginning of this month and further gains would hinder the non-energy export sectors. Though headline inflation has risen for three consecutive months and is now above the central bank’s 2% target, core inflation remains below target. In addition, leading indicators imply that the recent rise in inflationary pressures is unlikely to be sustainable.


Furthermore, the job market remains fragile. Though concerns in the housing market remain, house price gains have slowed and household debt to disposable income has also edged lower in the last six months. We do not expect the divergence between the currency market and interest rate differentials between the US and Canada (implying a weaker CAD against the USD) to be sustainable. We maintain our view that the CAD will underperform the USD later this year and upside in the CAD will be limited towards 1.0650 given our view that there will not be an escalation in oil prices on a sustainable basis.

…while emerging market currencies were mixed

Higher oil prices and fading political uncertainty supported the Russian ruble (RUB) last week. Moreover, the central bank of Brazil said that it will extend daily intervention for at least another six months as part of an effort to curb inflation.
This supported the Brazilian real. On the other hand, the Indonesian rupiah (IDR) underperformed due to market concerns that higher oil prices would result in a deterioration in the trade balance, inflation and the fiscal deficit. A recent poll also showed that Presidential candidate favourite Widodo lead over opposition Prabowo has narrowed. This has increased market uncertainty that a new strong government might not be formed after the elections on 9 July. In addition, less than half of planned infrastructure projects in Indonesia will start due to difficulties in land acquisition and higher fuel subsidy costs limiting budget spending. We judge that the IDR will fare worse than the Indian rupee, another oil deficit currency for several reasons. First, the Reserve Bank of India has been more successful in lowering inflation since the beginning of this year. Second, energy subsidies account for larger part of fiscal deficit in Indonesia. Third, India’s current account deficit has narrowed more resulting in less vulnerability to the currency.