The risks to our year-end forecast for EUR/USD of 1.35 are tilted to the downside and have clearly increased over recent days. This reflects that the differences between the likely paths of monetary policy on either side of the Atlantic have become more stark given the ECB’s rate cut and the strong US economic data. We largely expect this move to play out in 2014, hence we are forecasting a EUR/USD of 1.20 by the end of that year.
ECB rate cut pressures euro, dollar performance mixed
The ECB’s surprise rate cut resulted in an aggressive sell-off of the euro (EUR) across the board as financial markets adjusted their view on the outlook for interest rates in the future downwards. The performance of the US dollar (USD) was mixed against the major currencies up to the US employment report. But the USD outperformed most major currencies at the end of last week. What was surprising though is that the better-than-expected US economic data, including the very encouraging US employment report did not result in a really strong rally versus most major currencies. This was partly because Fed officials continue to sound cautious about slowing the pace of the monetary stimulus that has been such a negative factor for the USD in recent years. However, as explained above, we do think that the risks have risen of earlier easing of stimulus follow the jobs data.
The USD showed the largest gains versus European currencies, because of weaker economic data in these countries and the expectations that monetary policy will remain easy for longer to support growth. The USD modestly rallied versus commodity currencies, where the Canadian and Australian dollars were the weaker ones. The AUD fell under some pressure because the RBA downgraded its 2014 growth outlook, motivated by a weaker than expected mining sector and the stronger AUD. The New Zealand dollar was very resilient, because of stronger domestic data and expectations that the central bank will raise rates next year. The pound sterling, however, outperformed the USD driven by stronger domestic economic data, which fuelled interest rate hike expectations
Dollar rally could start earlier than expected
Recent market movements suggest that the downside risks for the EUR/USD, AUD/USD, NZD/USD and GBP/USD exchange rate are building. The options market is signalling further downside potential. This year the bias in these pairs was generally negative. However, the bias rose strongly over the summer and the underlying currency pairs followed as well. The move even accelerated from September onwards. This move run out of steam at the end of October and the picture in these crosses has deteriorated. As the market has tested the upside and failed to push prices and the bias higher, it is now vulnerable for a strong correction in the other direction. This could play out at around the turn of the year. A possible trigger for this could be better US economic data. Moreover, dovish central banks (ECB, BoC, BoJ, SNB) or verbal intervention by central banks (RBA, RBNZ) to limit currency appreciation could also act as a catalyst to push these currencies lower versus the USD.
Downside risks to EUR/USD in near term
The risks to our year-end forecast for EUR/USD of 1.35 are tilted to the downside and have clearly increased over recent days. This reflects that the differences between the likely paths of monetary policy on either side of the Atlantic have become more stark given the ECB’s rate cut and the strong US economic data. We largely expect this move to play out in 2014, hence we are forecasting a EUR/USD of 1.20 by the end of that year. However, recent events, as well as positioning signals from the options market, signal that the downward trend may already start this year. Meanwhile, we continue to expect the euro to weaken modestly against sterling, given that the UK economy is outperforming that of the eurozone. However, quite some good news is priced into the currency, and this week’s Inflation Report is likely to show that the BoE is reluctant to start raising rates any time soon.
Emerging markets underperform
Most emerging market currencies underperformed against the USD last week, partly due to higher US Treasury yields. Weaker economic data in Mexico have hurt the MXN while the BRL was sold off due to market concerns about the budget deficit. This reflects the market perception that the fiscal deterioration could result in a sovereign ratings downgrade. In Turkey, investors did not appreciate the upside surprise in inflation at the start of the week. Moreover, the higher US yields also added pressure during the week. In South Africa, mining production was reported to have been very weak and, with labour negotiations ongoing, the sentiment will likely remain negative. The National Bank of Poland left rates unchanged at 2.5% and committed to keep interest rates on hold until at least June 2014. this did not hurt the PLN versus the EUR because the ECB was more dovish. In the Czech Republic, the central bank decided to leave official rates unchanged at 0.05%. However, it surprised the market by announcing that it would intervene in currency markets to keep EUR/CZK around 27. EUR/CZK spiked higher as the result from 25.80 to 26.97 (or more than 4.5%). In Asia, most currencies were mostly flat against the USD. The INR declined by more than 1% due to oil companies’ demand for the USD and concerns that India’s rating might be lowered to speculative grade next year.