The euro has surprisingly recovered in the aftermath of the ECB’s rate cut earlier this month. The EUR/USD has been very resilient reflecting expectations that the Fed will not taper its asset purchases until next year and will keep interest rates low for longer. We expect the EUR/USD to decline as US data continue to improve and the ECB takes further action to push down expectations of eurozone short-term interest rates. Therefore, the balance of risks to our year-end forecast for the EUR/USD (1.35) is titled to the downside.
Why has the EUR been resilient?
The euro has surprisingly recovered in the aftermath of the ECB’s rate cut earlier this month. This reflects a number of factors. For starters, the EUR/USD pair is very sensitive to expectations on the monetary policy front and the German-US yield spread has bounced higher (see yellow line in chart above). Whereas after the non-farm payrolls, expectations of a widening divergence in monetary policies across the Atlantic was market consensus, the recent dovish comments from Fed members, most noticeably Yellen, suggest that the Fed’s policy will remain accommodative as long as growth is not ‘very strong’. Moreover, economic data in other countries such as Sweden, Australia and Japan (except GDP) have surprised on the downside while eurozone data have come in around expectations. For example, Swedish inflation has moved into negative territory again and this has resulted in a substantial weakening of the Swedish krona (SEK) versus the EUR, mainly because of a lower likelihood of rate hikes in 2014. As a result, EUR/SEK even touched 9.0. The current situation of weak domestic growth and low inflation will not justify a start of a rate hike cycle in the foreseeable future (before H1 2014). But Sweden has a very open economy and its currency (SEK) is in fact the European growth currency. We expect strong global growth in 2014 in an environment of constructive investor sentiment. This is the ideal environment for the SEK. Therefore, we believe that the current SEK weakness represents an opportunity. In addition, investor sentiment has improved and this has put downward pressure on central banks that are expected to exit loose monetary policy at an even later stage than the ECB. The Swiss National Bank and the BoJ fall into this category. As a result, these currencies have been on the defensive.
The options market has given short-term EUR support
Another reason for the resilience of the EUR has been demand from the options market. The sell-off after the ECB resulted in a sharp spike lower in the bias in the EUR/USD options. This bias, however, recovered quickly afterwards. This behaviour of the bias can be explained by the fact that short-term players get frustrated that a sell-off in EUR/USD is not accelerated by larger stop loss orders. Therefore, these investors buy EUR/USD on dips. We believe that this is a short-term phenomenon. If we take into account the overall behaviour in the options market, there are strong signs pointing to a lower EUR/USD. The overall tendency is for a lower EUR/USD (negative bias). Even though this bias has edged higher over the recent days, it will soon run out of steam close to previous peaks. The buy-on-dips behaviour could quickly change in case of a substantial improvement in USD sentiment. Overall, investors still hold net EUR longs, which will likely be abandoned in case of a change in sentiment.
Mixed USD versus majors for now…
The US dollar (USD) has partly given back post-US employment gains, mainly driven by expectations of a dovish Fed. As a result the USD fell modestly under pressure versus the EUR, NZD and GBP. The NZD and the GBP also stood out the week before. Domestic data have been strong and they have fuelled expectations of earlier rate hikes. The USD, however, has gained versus countries where the market has adjusted downwards growth and monetary policy expectations such as the SEK and AUD (see graph below).
In addition, it also gained versus currencies on a widening interest rate differential such as the Japanese yen (JPY). The JPY has been under pressure because improved investor sentiment has made the market more receptive to re-instating carry-trades with the JPY as funding currency. Usually, the Swiss franc (CHF) would also suffer. However, the time around the CHF merely weakened versus the EUR. The SNB reiterated that the ceiling on the Swiss franc is a vital policy tool to protect its economy.
…but more upside this week
We believe that most of the low rates for longer scenario for the Fed is priced into the USD. Therefore, there will not be much room to weaken going forward barring negative surprises on the US economic data front this week. If these data come in somewhat stronger as we expect, they will provide support to the USD. However, the moves will unlikely be substantial unless the market starts to anticipate that these better data will materially alter the path of the Fed. Moreover, this week quite a number of Fed officials will speak and also the FOMC minutes will be released. With most of the low rate scenario for longer being in the price, there is a good chance that the USD will receive support from these events.
Less dovish inflation report supports GBP
At the start of the week lower inflation data hurt GBP. Later during the week, however, GBP had a comeback after the BoE released a less dovish Inflation Report. The BoE became more optimistic on growth, unemployment and inflation. The most eye-catching change was a major shift in its view of how long it would take unemployment to reach its 7% threshold. On an unchanged interest rate scenario, it expects the magic number to be reached at the end of next year. At the time of the August report, it projected that the threshold would not be reached before 2016Q3. At the time, there was widespread incredulity at that forecast. So with this revision, the central bank is actually coming back down to planet earth. Nevertheless, Governor Mark Carney was quick to point out that reaching the threshold would not trigger a rate hike, but rather would mark the time when the MPC would consider whether one was necessary, taking into account the momentum in the economy and the outlook for inflation. This gives the central bank a lot of flexibility. Our view is that the unemployment rate will reach the 7% threshold in Q3 of next year, and that the policy rate will likely be moved up early in 2015. As a result we expect an outperformance of the GBP versus the EUR in 2014.
EM FX mixed for now
The rise in US Treasury yields together with weaker domestic economic data hurt some emerging market currencies such as INR and IDR. But the IDR modestly recovered after the central bank unexpectedly tightened monetary policy to cool inflationary pressures. The USD, however, underperformed other emerging market currencies because domestic data was on the strong side of expectations and/or most weak news is already reflected in the price. The PLN, HUF fall into the former category and the ZAR and MXN into the latter one. Earlier this month in Mexico the fiscal reform program for 2014 was approved in the Senate. The vote to change the constitution to allow full private sector participation in the energy sector and the vote in Senate on political reform will also take place before the end of this year. The market anticipates that both votes will pass. The market is neutrally positioned in in the MXN, and therefore it has room to set up longs again. The CNY remained stable against the USD. The market was disappointed by the lack of reform details from China’s plenum and this limited the upside in the CNY.