The crucial event last week was the US budget deal. Sentiment changed from the moment the deal was announced. The market became more nervous about a possible Fed tapering this week and this supported the US dollar versus most currencies. A December tapering is not in our base scenario, but for financial markets it would be good when the first tapering step is over and done with. The resilience of the euro continued to be driven by tighter liquidity conditions in the money market. But its fortunes should turn in before long.
Source that trigger Fed tapering expectations matter
The crucial event last week was the US budget deal. Sentiment changed from the moment the deal was announced. The market became more nervous about a possible Fed tapering this week and this supported the US dollar versus most currencies. Furthermore, there was a slight uptick in currency volatility (see graph below) and profit taking in currencies that recovered recently on a wave of risk appetite For example emerging market currencies that had recovered after the US employment report gave back some of these gains.
This market reaction differed from the reaction seen after the release of the better-than-expected US employment report on 6 December. Although widely anticipated, the budget deal in US Congress increased the risk of a Fed tapering this week. With the budget deal being announced, this removed another reason for the Fed to delay tapering. So on the one hand if tapering expectations are the result stronger US growth data the market is quite relaxed. On the other hand, if the tapering expectations are the result of less fiscal uncertainty, the market appears to be more concerned. This seems odd, as both better US data and a US fiscal budget deal lead to stronger growth in the end.
This week the Fed will decide on monetary policy. We think it will be a close call, but on balance we expect the Fed to wait until next year before tapering, likely March. Such a delay could hurt the US dollar, but communication setting out a path to tapering would likely cushion the blow. In our view, the current relatively high levels in EUR/USD and, to a lesser extent, gold are opportunities to position for a strong US dollar rally in 2014. We hold a strong US dollar view because of strong fundamentals, an above consensus US growth forecast, expectations of higher rates in 2015 (above consensus) to be anticipated in 2014 and low valuation. At the same time we are negative on the euro (see below)
Market psychology – disjunction effect: let’s get the first Fed tapering step over and done with
Currently financial markets, including currency markets, are obsessed with the idea of the Fed tapering bond purchases. Market players have the tendency to want to make decisions until the information is revealed (Fed tapering in December?). This is called the disjunction effect in Behavioural Finance. The main questions we need to ask ourselves are: Is the information really important? Would you make the same decision regardless of the information? If the answers on both of these questions are affirmative, there is no reason to wait. Fed tapering will come in the end, so why wait to make decisions. Although this may look straightforward, Fed tapering will continue to keep financial markets hostage for now. The only thing we can hope for is that Fed creates a sense of clarity in its communication when the tapering will start and end and/or start tapering this week. This way financial markets can finally start focussing on other topics.
Liquidity conditions support the euro again
The EUR/USD has been well supported by the difference in short-end yield spread across the Atlantic. This has manifested itself in a strong positive correlation between EUR/USD and the 2-Y yield spread between Germany and the US. The decreases in ECB excess liquidity, outstanding amount of the 3-Y LTROs and base money signal tighter money market conditions that have started to push up the EONIA rate and as a result the 2-Y as well. We have underestimated the impact of these forces on EUR/USD in 2013.
This year the euro trade-weighted index has risen by more than 6%. This is mainly a reflection of the above mentioned liquidity dynamics and demand for the higher yielding periphery bonds. However, the euro is overvalued versus most major currencies on the basis of purchasing power parity. For instance, against the Japanese yen (33%), US dollar (19%), Swedish krona (17%) and Norwegian krona (11). Only the New Zealand dollar, the Swiss franc and the Australian dollar are overvalued versus the EUR.
If we take the liquidity drivers into account for 2014, we would like to highlight the following. Repayments of LTROs could continue, leading to a decrease in the ECB excess liquidity as well. However, as discussed in the Rates section, we think these developments (and their impact on the euro) could trigger an ECB response. Moreover, the Fed will likely taper early in 2014 and if the US economy accelerates as we expect, rate hikes for 2015 will be anticipated in the second half of 2014. So the ECB unofficial “tapering” will come to an end, while the Fed tapering will happen. This should be a strong negative driver for EUR/USD in 2014.
RBNZ more hawkish on pace of monetary tightening
The Reserve Bank of New Zealand left monetary policy unchanged at 2.5%. It mentioned the strong currency as being a headwind for the economy, but comments were less dovish than expected. Moreover, the market (including us) now anticipates that the strength of the economy will result in the RBNZ tightening monetary policy in March 2014. We foresee a 25bp hike in each subsequent quarters, bringing the cash rate to 3.50% from current 2.5%. However, this is still below market consensus of 120bp in rate hikes by the end of year, hence we remain negative on the New Zealand dollar.
RBA continues to talk down the Australian dollar
The Australian dollar declined for the 8th consecutive week due to increased market speculation that the Reserve Bank of Australia (RBA) will need to cut the cash rate further next year to accelerate the rebalancing of the economy. RBA Governor Glenn Stevens reiterated that a lower AUD/USD towards 0.85 would be desired over further rate cuts in the cash rate. Indeed we do expect the AUD/USD to head towards 0.85 by the end of next year due to continued divergence between growth and monetary policies in Australia and the US.
SNB is in a Catch-22
The Swiss National Bank left interest rates unchanged at 0.0%. It also kept the cap in the Swiss franc versus the euro at 1.20 in place. The market continues to challenge the SNB on this cap. Even though the SNB sounded dovish, the market appears to have expected more. Comments from officials that the mortgage and real estate market are at risk of overheating were interpreted as being somewhat more hawkish. The SNB is in a Catch-22 situation. On the one hand, it wants a weaker CHF and therefore the cap is in place. On the other hand, zero interest rates have kept mortgages attractive and fuelled a real-estate boom. It has taken measures to cool the mortgage and property market, but the SNB recognises that they have not been enough. In this situation something has to give and some investors have started to anticipate that it will be the CHF, also because the market is clearly positioned for a lower CHF, which up to now has barely materialised. We continue to believe that higher global growth and a pick-up in investor appetite should be CHF bearish.
The market now expects a Riksbank rate cut
Lower inflation and employment data have hurt the Swedish krona (SEK) again. EUR/SEK has popped up above 9.0 as the result, a level not seen since May 2012. The market is now positioned for a 25bp rate cut to 0.75% at the Riksbank’s meeting this week. The SEK is a currency that profits from strong global and domestic growth and constructive investor sentiment. But 2013 was not the year of the SEK (-5% versus the EUR), because of a lack of cyclical drivers. We expect 2014 to be a strong SEK year, because of our above-consensus view on the global economy and a weakening of the euro. We expect the SEK to strengthen more than 5% versus the euro to cover the 2013 loss.
EM currencies under pressure on Fed tapering speculation
Since September when the Fed decided to delay scaling back monetary stimulus, emerging market currencies have recovered against the USD, retracing by more than half of losses seen during the May-September period. However, more recently, stronger US economic data releases led to increased market speculation that the Fed may taper as early as this week has supported the USD versus emerging market currencies. Emerging market economies with unfavourable growth inflation mix and current account deficits have taken measured steps to address these weaknesses, but the results have been mixed so far.
In Asia, the Indonesian rupiah has weakened to the lows seen during the global financial crisis in 2009 as inflationary pressures remain elevated and market concerns that populist regulations to ban mineral exports might exacerbate the trade and current account deficits in the short term. The Indian rupee moved lower last week after a strong performance since 13 November 2013. Its current account deficit has improved but inflation remains higher than desired in India. Strong economic data releases continued to support the Chinese yuan and South Korean won, currencies we favour going into 2014. The Brazilian real closed lower last week on weaker domestic data, fears of a possible downgrade and inflationary pressures and a deterioration in emerging market sentiment. The central bank announced that it will continue to intervene in currency markets next year. The Mexican peso fell under pressure as well, but losses were limited after the Congress approved the energy reform that would end Petroleos Mexicanos’75 year oil monopoly. The next step is for one-half of local congresses to ratify the approved constitutional changes.
EM currencies sell-off unlikely
In the two weeks leading up to the September FOMC meeting, emerging market currencies recovered against the USD as investors believe that the sell-off was overdone. We expect a similar reaction by emerging market currencies this time around as the Fed is likely to seek to calm market nerves that any scaling back of monetary stimulus will be slow and gradual and accompanied with stronger global growth. This will keep overall investor sentiment constructive, preventing a major emerging market currency sell-off. Emerging market economies also stand to benefit as global growth improves next year. Hence, a rapid reversal of capital flows out of emerging market economies is unlikely as the growth and inflation mix improves in most economies. In addition, emerging market central banks have also accumulated more FX reserves in the past few months as emerging market currencies rebounded, providing larger ammunition against potential currency volatility.