Given the likelihood of ample ECB liquidity and the possibility of further policy action, we do not expect the strength of the euro over the last few weeks to last. Indeed, there are already signs that the market is turning. Meanwhile, the Fed decision to taper bond purchases accompanied by a dovish statement accelerated the sell-off of the yen, a trend we expect to continue. EM currencies have been only moderately on the defensive. Underperformers in the EM universe have specific domestic factors at play, rather than being just the usual list of suspects that have sold off in the past when tapering worries flared up.
The strong euro is an opportunity
The last days of 2013 were characterized by euro strength. Comments from ECB Governing Council member Jens Weidman that keeping interest rates low may endanger political reform on 27 December pushed EUR/USD in illiquid markets to 1.3868 and EUR/JPY to 145.48. Since then the market calmed and the euro has edged lower. Liquidity conditions in the eurozone have eased, which is reflected by higher excess liquidity in the system and a lower 2-year spread between Germany and the US. One factor is that he ECB has failed to sterilize the amount of SMP bond purchases. On 30 December the ECB communicated that it absorbed only EUR 104.8 bn from financial markets far below the amount of the 178.5 bn of the SMP program. This directly adds liquidity into the system and is mainly responsible for the easing of liquidity conditions and the sharp increase in ECB excess liquidity. For 2014 we expect ample ECB liquidity – possibly helped by further policy actions if necessary – which should push down short term interest rate expectations and the euro. The bottom line is that we do not expect euro strength to last.
Yen weakness all the way…
The main trend in currency markets over the last two weeks was the sell-off of the Japanese yen across the board. The surprise decision by the Fed to taper bond purchases on 18 December only temporary hurt sentiment. In fact sentiment sharply improved afterwards. It was a kind of relief that the start of the Fed tapering is now over and done with without causing a major market disruption. The dovish Fed statement – which confirmed that rate hikes are a long way off – helped to sugar the taper pill. The improvement in investor sentiment was reflected by a drop in equity market volatility, relatively resilient emerging market currencies and yen weakness. The yen has been out of favour because of expectations that Japan’s monetary policy will remain even more accommodative for even longer than in other advanced economies resulting in increased prospect of investment flows leaving Japan searching for better returns.
Yen weakness has been one of our main themes last year, but the recent weakness has been more pronounced than expected. USD/JPY and EUR/JPY tested the 105 and 145 level. However, profit taking in short yen positions late last week triggered by weaker than expected data releases out of China pushed USD/JPY towards 104. Yen weakness versus the euro has now gone too far because the ECB is also likely to keep monetary policy accommodative and further measures to ease policy further remain very much on the table. Therefore the risk is increasing for a move lower in EUR/JPY driven by general euro weakness.
… and Swiss franc finally falls under pressure as well
In the case of the Swiss franc the market appears to have accepted the idea that the cap remains in place versus the euro for the foreseeable future. Whereas the yen gave back some of its gains since the start of the year, the pressure on the CHF just increased. We expect 2014 to be a year of weakness for the Swiss franc mainly driven by the view that positive investor sentiment will result in the CHF being used as a funding currency in carry trades.
NZD more resilient going forward
Meanwhile, we have become less bearish on the New Zealand dollar (NZD) now as we expect the RBNZ to raise the cash rate by 100bp to 3.5% in 2014 compared to our earlier expectation of 50bp of rate hikes. This is due to stronger than expected economic growth and a more hawkish RBNZ monetary policy outlook. Our NZD/USD forecasts in 2014 and 2015 have been revised higher to 0.78 (from 0.76) and 0.76 (from 0.72) respectively. The NZD outperformance against the Australian dollar (AUD) is expected to continue though the trend against the Canadian dollar (CAD) is likely to fade as the latter benefits from a stronger US economy.
EM currencies only moderately on the defensive
Since the Fed decision to gradually scale back monetary stimulus on 18 December 2013, our emerging market currency index shows that emerging market currencies as a bloc have underperformed, but by less than 1% against the USD. As expected LatAm currencies which are more exposed to capital flight declined by almost 2% while Asian currencies edged 0.2% lower.
Underperformers reflect domestic factors
Looking at individual currencies’ performance, the Turkish Lira (TRY) fell by more than 5%, but that was mostly due to a domestic political crisis and shifting market expectations on monetary policy due to increases in consumption taxes. As a result the TRY has underperformed any other currency in our coverage. The Brazilian real (BRL) also eased lower by 2% due to widening current account balance and expectations of a lower amount of FX interventions in 2014 could put pressure on the BRL (lower support). In Asia, the Thai baht (THB) was the worst performing currency due to continued domestic political uncertainty resulting in the market’s downward adjustment on economic growth this year. The Thai Finance Ministry has revised lower its 2014 GDP forecast from 5.1% to 4%. Foreign investors have also pulled out more than USD1.2b of funds from the domestic equity market in December 2013. Overall then underperformers in the EM universe have specific domestic factors at play, rather than being just the usual list of suspects that have sold off in the past when tapering worries have come to the fore. This is in line with other evidence that suggests markets are now more positioned for a reduction in the pace of the Fed’s asset purchases.
Chinese Yuan resilient
On the bright side, the Chinese yuan (CNY) our top Asian currency pick for 2013 and 2014 edged higher by 0.3% against the USD with prices trading around 6.05. We continue to expect the CNY to strengthen towards 6.0 against the USD later this year as the allowing of a stronger currency will encourage consumption and boost domestic demand, which is in line with the government’s long term strategy. China’s large current account surplus and foreign exchange reserves are other positive attributes.