The US employment report drastically changed the short-term sentiment on the dollar. Bad weather has increased the risk of near-term disappointment on the US data front, however we expect this to be only temporary and stick to our view that the dollar is set to strengthen in coming months. Meanwhile, the euro is likely to come under pressure because of less tight money market conditions and the likelihood of more monetary easing.
The weak US employment report delays the USD rally
The US dollar dropped across the board on the back of the weak labour market report. EUR/USD moved back above 1.3650 while USD/JPY dropped below 104.00. This weak report – and the implication that bad weather could have impacted economic activity – increases the risk of near-term disappointment on the US data front and some deterioration in overall investor sentiment. However, as noted above, we think this will be temporary and we remain optimistic on the US economy and the dollar.
Peripheral bond attractiveness supported the euro…
As noted previously, the euro has tended to be a very interest-rate sensitive currency. Not only is it sensitive to developments in the yield spread between the eurozone and other countries, but developments in the yield spreads between eurozone member states have also had an impact. Although the eurozone has one currency it has multiple sovereign bond markets with differing yields, meaning that the eurozone offers a diverse spectrum of investment opportunities for both domestic and foreign investors. This stretches from ultra-safe (and low yielding Bunds) to higher yielding peripherals. Given the search for yield, domestic investors have been playing out a carry trade within the euro without having currency risk, while foreign investors have also been shifting funds into the these eurozone bond markets. In 2013H2, EUR/USD received important support from surprisingly widening spreads between Germany and the US (see graph) – driven by monetary policy expectations and tightness in eurozone money market – and demand for higher yielding peripheral bonds. The latter manifested itself in a negative relationship (see second chart – EUR/USD is inverse scale) between Italian and-Spanish spreads over Germany and EUR/USD. Both EUR/USD and the lower spread over Germany could also be a reflection of lower eurozone systemic risks. With investors being less worried about the risks and more attracted by the yield pick-up, investors moved into peripheral bonds. EUR/USD received support as foreign investors also re-entered these markets.
…but the tide is turning
Last week, the relationship between peripheral spreads and the EUR/USD broke down. This can mean several things. For starters eurozone investors continue to move into peripheral bonds, but non-eurozone investors may have stopped doing so. Tighter spreads may have resulted in currency exposure being less desirable. In short the reward may not be enough to compensate for the currency risk anymore. A more likely explanation is that the spread between Germany and the US has fallen and this has put pressure on EUR/USD. Less tight conditions in the eurozone money market, lower inflation and dovish ECB commentary are important reasons for this. This means that the cyclical divergence between the US and eurozone is becoming the dominant driver.
We expect this development to continue this year. President Mario Draghi struck a relatively dovish tone in the press conference. He strengthened the wording of the central bank’s forward guidance, while also explicitly setting out the conditions under which it would act to ease monetary policy. Looking forward, we think further policy easing from the ECB remains a distinct possibility. A further deterioration in the central bank’s outlook for inflation in the medium term seems likely. Last but not least, the US dollar has become more cyclical reflecting the prospect of less accommodative monetary policy and strong US growth. As a result, the correlation between the US dollar and both US equities and 2-year yields have moved into strong positive territory (see graph below).
Downward revisions to EM currency forecasts
Emerging market currencies remained under pressure last week until the release of the US employment report. The weak US employment report resulted in a sharp recovery in emerging market currencies. This report more than compensated for the earlier losses. We have adjusted downwards our forecasts for the Indonesia rupiah, Thai baht, South African rand and Turkish lira. The revisions to our forecasts for the THB and IDR reflect a weaker outlook for 2014 and 2015. Domestic political uncertainty in Thailand has lasted longer than expected and is likely to drag on over the coming months potentially past the elections early next month. This has increased the risk that economic growth might be impacted. With core inflation at the lower end of the central bank’s target of 0.5-3%, the risk of further monetary stimulus has increased. In Indonesia, measures to address external and domestic imbalances have been slower than expected. In addition, inflation remains stubbornly high resulting in negative real returns for investors. The government announced that “though the trade balance improved in November, the trend might be not be sustainable in the coming months as mineral exports were banned with effect from 12 January this year.” We have adjusted downwards our forecasts for IDR and THB versus the USD (see our latest FX Monthly).
TRY under pressure
Since the start of the year, the TRY slide has continued mainly driven by domestic political uncertainty (see Turkey Watch: Under fire again and FX Monthly: Our high conviction views) and a lower probability of a rate hike following the tax increases. This year and next year Presidential and Parliamentary elections will be held. As a result, (geo) political uncertainty is unlikely to ease. The lack of transparency on the monetary policy front is also unlikely to change. Market interest rates are now already close to the O/N lending rate and FX interventions cannot be credibly sustained for long. Hence, the likelihood has risen that the CBRT will be forced to hike official rates to stem further capital outflows and lira depreciation, certainly if market pressures would continue or even intensify. We expect some improvement on the fundamental front and in overall investor sentiment. As a result of the above mentioned dynamics, the TRY sell-off will likely ease and even some recovery could be on the cards. However, we continue to stay on the sidelines. We have changed our USD/TRY forecasts for the end of 2014 and 2015 (see our latest FX monthly).
South African rand being punished
South African rand has dropped to levels not seen since 2002. Negative surprises on the economic data front, poor investor sentiment, weak fundamentals such as the twin deficit (current account and fiscal deficit), inflation pressures, weak commodity prices and a stronger USD are the key reasons for its weakness. Since March 2012 it has weakened by almost 29% in one straight line. One would be wondering if it has not weakened enough already. The drivers remain negative though and as we have above consensus USD positive view, it is difficult to see the ZAR strongly recovering. However, at some point in time the ZAR will post a large recovery. Though the visibility of the timing is low. Therefore we have adjusted our forecasts downwards for the ZAR to a flat line of 10.5 versus the USD.