An abrupt deterioration in investor sentiment triggered by developments in emerging markets supported the Japanese yen and the Swiss franc and led to sharp declines in emerging market currencies. Given our view that the global economic recovery will remain on track and that emerging market fundamentals are generally much more healthy than in the 1990s, we think these moves will unwind going forward, though there are clearly well-known problems in a handful of specific economies. Weaker US data also hurt the USD, while the Canadian dollar was the clear underperformer among the majors on a dovish Bank of Canada.
EM fears hit investor risk appetite
Last week ended with a significant deterioration in market sentiment. This was triggered by turmoil in specific emerging markets, which led to worries in the EM universe more widely and eventually undermined investor risk appetite globally. We have seen an escalation of the political unrest in Ukraine, internal challenges in Turkey and the devaluation of the Argentine peso, while this happened against the background of weaker Chinese economic data. Emerging market currencies have been aggressively sold off. The South African rand dropped to levels not seen since 2002 and the Turkish lira fell to an all-time low despite the currency interventions by the Central Bank of the Republic of Turkey (CBRT) on Thursday. The CBRT reserves are insufficient to continue aggressive FX intervention. The market is aware of this and wants the CBRT to hike official rates. The devaluation of the Argentine peso resulted in a deterioration in sentiment for Latin American currencies. Concerns in the market about contagion of emerging markets is rising. The Japanese yen and the Swiss franc benefited from safe haven demand. Gold prices received some support as well, while equities moved lower in a typical risk off move. Given our view that the global economic recovery will remain on track and that emerging market fundamentals are generally much more healthy than in the 1990s, we think these moves will unwind going forward, though there are clearly well-known problems in a handful of specific economies.
US dollar under pressure
The USD was one of the weakest major currencies last week, only the Canadian dollar and Australian dollar underperformed the US dollar (see more on this later). US data came in weaker and eurozone data stronger resulting in pressure on the USD versus the euro. Moreover, the overall sentiment in currency markets deteriorated sharply resulting in an outperformance of the Japanese yen and the Swiss franc. This week the FOMC will decide on monetary policy and key economic data are due. We expect the Fed to further reduce its Treasury purchases by 5bn to 35bn and to reduce the MBS purchases also by 5bn to 30bn. As this is widely expected, such outcome will unlikely move financial markets. However, the statement could. Up to the FOMC decision, the market will likely be reluctant to take new positions; as a result the ranges will likely be tight unless speculation hits the market that the Fed were to take an even more decisive direction (either by keeping policy unchanged or tapering at a faster pace but both these options look like low probability events).
SNB targets the housing sector again
On Thursday morning the Swiss National Bank (SNB) submitted a proposal to the Federal Council, requesting that the sectoral countercyclical capital buffer (CCB) be increased from 1% to 2% of risk weighted positions secured by residential property situated in Switzerland. This measure is proposed because the imbalances on the Swiss residential mortgage and real estate markets have increased further. These imbalances are mainly the result of the loose monetary policy by the SNB, which has been in place to support the economy and the prevent the Swiss franc from strengthening. Since September 2011 the SNB has introduced a cap of the Swiss franc versus the euro at 1.20. As the SNB is not willing to exit this loose monetary policy, but at the same time it would like to manage the frothy real estate market, it has proposed this measure. The immediate market reaction as to buy the Swiss franc. As a result, USD/CHF and EUR/CHF dropped to below 0.90 and 1.23. The risk aversion wave triggered by developments in emerging markets further supported the Swiss franc. The Swiss economy is on a recovery path and inflation is expected to turn positive this year. The last thing the SNB wants is a stronger CHF.
Sterling rally restarted
Sterling (GBP) had a strong week mainly driven by stronger than expected UK employment report. With the UK unemployment being almost at the 7% Bank of England threshold, the market is increasingly pricing in the likelihood of early rate hikes. It must be noted that interest rate futures markets have already moved a long way to price in a relatively early rate hike cycle, so to some extent the above views on UK monetary policy are already partially reflected in the sterling exchange rate. On the other hand, we think that financial markets are still underestimating how accommodative ECB policy will likely be this year and next. We expect it to move to ease policy before long and we think that the upward trend in Euribor rates implied by next year in futures markets is unrealistic. As a result we expect further strength of the sterling versus the euro with a year-end target of 0.79 in EUR/GBP.
Canadian dollar weakest performer
The Canadian dollar was the clear underperformer among the majors. Since the start of 2013, the CAD (also a high conviction short position versus the USD) has lost more than 10% versus the USD with 4.7% since the start of this year, moving above our year-end target of 1.10. Lower than expected economic growth and, inflation data and a more dovish central bank were the main reasons behind this. Although we expect external drivers to improve, the risks have increased that the economy will reach its full potential beyond 2015 and hence any monetary tightening will be slower.
Australian dollar remains under pressure
The Australian dollar (another high conviction short position versus the USD) did fare better than the Canadian dollar, but it was still among the weakest major currencies. On the one hand, higher than expected inflation data reduced the flexibility for the RBA to increase monetary stimulus in the coming months. The bounce fell short of testing resistance at 0.90 in AUD/USD though. On the other hand, the weaker than expected Chinese PMI data and dovish comments from RBA member Ridout hurt the Australian dollar again. As we do not expect the rise in inflation seen in the previous quarter to be sustainable, we maintain our expectation of a rate cut later this year in Australia. As this is not fully priced in by the market, any rally in the AUD is unlikely to be sustainable. We continue to see downside bias towards 0.85 and possibly even lower by the end of this year.
RBNZ to pull the trigger earlier than expected
The New Zealand dollar (NZD) was supported as inflation in the fourth quarter came in higher than expected. The manufacturing sector also expanded for the 15th consecutive month in December, albeit at a slower pace. In addition, consumer confidence in January rose to the highest level since early 2007. With both Q3 GDP and Q4 CPI coming in higher than what the Reserve Bank of New Zealand (RBNZ) forecast in the December monetary policy statement, we now expect the RBNZ to raise the official cash rate from 2.50% to 2.75% later this week on 30 January, two months ahead of our March rate hike forecast. This is not fully priced in by the market and against market consensus. We expect the RBNZ to follow up with another 75bp of rate hikes to bring the cash rate to 3.5% by the end of this year.
Reality check in the Chinese yuan
Since the beginning of 2014, optimism that the onshore Chinese yuan (CNY) trading band might be widened, and seasonal investment flows into the offshore yuan (CNH) in anticipation of further appreciation in the currency, has resulted in the CNH premium over the CNY widening by more than 0.03. However such optimism waned due to increasing uncertainty surrounding a potential default in a trust fund issued by China Credit Trust and marketed by Industrial and Commercial Bank of China. We believe that the CNH premium over the CNY is likely to narrow further this week ahead of 31 January when the trust is due to mature. Market concerns are also reflected in China’s sovereign credit default swap and options market to hedge potential weakness in the yuan. Weaker economic data out of China also resulted in some profit taking in the yuan. Looking ahead, we expect any contagion effect on the yuan to be manageable and maintain our year end USD/CNY target of 6.0.