Speculation about G3 central bank policy has driven the USD, euro and the JPY. A likelihood of an earlier taper has supported the USD, while expectations of easier monetary policy have hurt the euro and the JPY. We continue to see upside risks to our year-end USD forecasts as US economic data could well come in above consensus.
The Fed, the economy and investor sentiment hold the key for the USD
At the start of last week, the USD was on the defensive, because of market expectation that the Fed would keep interest rates low for longer. In general, comments from Fed officials had pointed in this direction. However, sentiment changed after St. Louis Fed President James Bullard stated that a tapering of the bond buying program is on the table for next month. His comments surprised currency markets and resulted in a recovery of the USD. What is interesting to note is that the recovery of the USD has gone hand-in-hand with the move higher in the 10Y US Treasury yield. Higher Treasury yields have not resulted in a sharp deterioration in investor risk appetite this time, in contrast to what happened earlier this year. Sentiment has remained positive and investors are now more open to setting up carry trades with the Japanese yen and the Swiss franc as funding currencies.
The different is illustrated in the charts below. The first graph shows the relationship between the USD Index and the 10Y US Treasury yield and the second graph below between the VIX and the 10Y US Treasury yield. In the period between the end of April and 21 of June, higher US Treasury yields resulted in a deterioration in investor sentiment reflected by a rise in the VIX. Therefore, these higher yields did not support the USD.
The rally of the USD versus emerging market currencies was offset by the lower USD versus major currencies such as the EUR.
More recently, both US Treasury yields and the USD have risen driven by stronger-than-expected US data and the possibility of an earlier-than-expected tapering in an overall constructive investor climate. This combination has been positive for the USD and the correlation between the greenback and Treasury yields has turned positive (see chart on the next page). These are exactly the dynamics we expect to play out in 2014 and 2015. The combination of a US-led acceleration in global growth, higher US yields, expectations of the start of Fed rate hikes in 2015 and positive investor sentiment are likely to push the USD higher.
Speculation of a negative deposit rate modestly hurt the EUR
Last week, speculation that the ECB Governing Council is set to cut its deposit rate put the euro under pressure. However, the move over the week, has been modest as ECB officials have subsequently sounded more cautious on negative rates. In addition, the euro advanced versus most currencies at the start of the week.
The Norwegian krone rallied slightly versus the euro because of stronger GDP data. In addition, the sentiment on sterling has remained constructive. The Swiss franc also did relatively well. This comes as a surprise, because an improvement in investor sentiment is usually negative for the currency. Currently, the market is focused on how much longer the SNB will keep the CHF cap versus the EUR in place. A Bloomberg poll showed that market consensus is that the Swiss National Bank will keep the CHF capped until 2015. The OECD said that the Swiss National Bank should end this cap once inflation pressures intensify and the global economy recovers. The Australian dollar and New Zealand dollar were the most out of favour among FX majors, because the Chinese PMI came in below expectations and comments from central bank officials that they consider their currencies to be too strong.
Speculation of Bank of Japan postponing 2% inflation goal hurt the JPY
The Japanese yen came under pressure on speculation that the Bank of Japan will need to postpone the timeframe for achieving the 2% inflation forecast. The market came to this conclusion after the central bank retained its plan for a 60 to 70 trillion JPY annual rise in monetary base. The positive investor appetite and a widening yield spread between the US/eurozone and Japan have pushed up both USD/JPY and EUR/JPY. The risk has increased that USD/JPY will stay above our target for the end of this year (100) and already move towards our forecast of 103 for the end of March. The weakening of the JPY is in line with the trend we expect for 2014 and 2015. Our year-end forecasts for USD/JPY are 110 for 2014 and 120 for 2015. The main drivers for a higher USD/JPY are diverging monetary policies between the US and Japan, widening yield spreads and risk seeking investors.
Higher yielding EM FX do relatively well
Emerging market currencies had a good start to last week. However, most of them gave back gains during the week because the FOMC minutes and comments from Fed’s Bullard suggested that tapering is still on the table for the December meeting. This has resulted in higher US Treasury yields and hurt some of the more vulnerable emerging market currencies. The Brazilian real (BRL), Turkish lira (TRY), South African rand (ZAR), Indian rupee (INR), Hungarian forint and Korean won (KRW) were able to close higher for the week though. This reflects that investor sentiment has remained constructive, so investors have been attracted by these currencies’ higher yields. Moreover, the central banks of Turkey (CBRT) and South Africa (SARB) were perceived as being more hawkish than expected. The CBRT left interest rates unchanged, but terminated its one-month repo. As a result the interbank money market rate will be converging towards the overnight lending rate of 7.75%. Moreover, the statement did not mention any expectation that inflation would decline in the coming months. Meanwhile, the SARB said that the weak rand poses upside risks to inflation.
Pockets of strength and weakness in Asia
Asian currencies such as the Taiwan dollar, Indonesia rupiah and Thai baht have been under pressure on reports of equity outflows. In the case of the THB, political uncertainty also weighed. The Democratic Party in Thailand is seeking to remove Thai Prime Minister Yingluck, Deputy Prime Minister Suraswadi and Interior Minister Ruangsuwan for alleged corruption and filed a motion of no-confidence. The debate is scheduled for 26-27 November. Meanwhile, currencies in Northern Asia have had a positive performance. The KRW and INR have appreciated on the back of favourable investor sentiment.
Central banks continue to monitor inflation
This week the central banks of Brazil, Thailand and Hungary will decide on monetary policy. Despite the recent lower reading on inflation, the Copom is expected to hike interest rates by 50bp to 10%. It has signalled that it has not yet decided on the extension of the FX intervention program in 2014. The market widely expects that the central bank will continue to intervene in FX markets to avoid inflationary pressure via the foreign exchange channel. In addition, the government is currently in discussions to gradually increase the fuel price, which would also result in upward pressure on inflation. The market remains worried that a downgrade of Brazil’s credit rating is just a matter of time. A Bloomberg poll shows that the majority expect a downgrade. In contrast, we expect the central bank of Hungary to lower rates by another 20bps to 3.2% (because of lower inflation pressures), in line with market expectations The Bank of Thailand is expected to keep interest rates on hold at 2.5%. The latter may reduce GDP forecasts for this year.
China’s policymakers set scene for renminbi strength
Turning finally to China, the reforms announced after the Third Plenum are ambitious and more concrete, but the timing is still unclear. Among other policies, the reform agenda considers adjustments to the exchange rate system. An “orderly” widening of the band is proposed, but no mention was made of the timing. This approach was reiterated by the Governor of the People’s bank of China on Tuesday. A widening of the band should be supportive of further renminbi appreciation with respect to the dollar. This is not the first time this year that such a move has been announced. There could be tolerance for further strength of the renminbi as the authorities seek to rebalance the economy, but in the transition China’s growth is also reliant on exports, so we don’t expect it to be an abrupt adjustment of the trading band.