The impact of the weak US employment faded quickly in currency markets, mainly driven by strong US economic data, which underlined that the economy remains on a strong footing, and the perception that this weak employment report will not change the course of the Fed. Tighter liquidity conditions continue to support the euro, but they also make ECB action to ease policy more likely, which would undermine the currency. Meanwhile, the AUD weakened even further because of weak employment data.
Impact of weak US employment report faded quickly
The currency markets have surprisingly returned to the rhythm, which was in place before the release of the US employment report, almost as if it had not been released at all. There are several reasons for this. For starters, the market realised that one weak US employment report – caused by weather related factors – will unlikely de-rail the Fed tapering of bond purchases. Moreover, investors remain convinced about the strength of the US economy, as we do. Indeed, we keep our above consensus view on the US economy and expect more rate hikes by the Fed in 2015 (which will likely be anticipated later in 2014) than currently priced into financial markets. US economic data released last week were generally robust confirming the strength of the underlying economy. As a result, the pressure on the US dollar faded. We closely track the behaviour of both USD/JPY and USD/CHF. If both pairs are aligned and move in the same direction, usually the US dollar momentum is strong. If USD/CHF breaks through the resistance levels of 0.9125 and after that 0.9250 and the upward momentum in USD/JPY remains in place then this could signal the start of a general more powerful US dollar rally.
Tighter liquidity conditions continue to support the euro
The momentum in EUR/USD faded like it did in the other USD pairs mainly driven by the stronger-than-expected US data releases. However, the euro has been relatively resilient. The main reason for this is the tighter liquidity conditions in the money market. Excess liquidity has fallen sharply since the start of this year and this has resulted in rates on the short-end of the curve moving higher supporting the euro. A further tightening of these conditions could trigger ECB action to ease liquidity conditions (see rates note earlier in this publication). This will hurt the euro across the board. With US data likely to continue to come in strongly, we could then see a substantial downward correction in EUR/USD.
AUD has plummeted to a 3-year low
The Australian dollar was the worst performer last week versus major currencies and emerging market currencies. The strong recovery versus the US dollar after the weaker US employment report on 10 January came abruptly to an end on 14 January. A combination of a stronger US dollar and weaker than expected Australian employment data have resulted in a downward adjustment in short-term interest rate expectations in Australia and a weaker Australian dollar (AUD) (see graph below). For some time we have AUD/USD on our high conviction short list. The main reasons for this are a combination of weakness in the domestic economy, the likelihood of another rate cut by the Reserve Bank of Australia, external imbalances, overvaluation and general US dollar strength. This has played out very well and the move has even been larger than we originally had envisaged. We keep it on our high conviction short list as we expect further weakness this year with 0.85 as our year-end target.
Pressure on emerging market currencies
The recovery of the US dollar last week was also a theme versus emerging market currencies. Most currencies came under pressure, in particular the South African rand, Mexican peso and Turkish lira. Weak mining production and PMI data out of South Africa hurt the ZAR. In Brazil, the COPOM hiked interest rates by 50bp to 10.5% to fight inflationary pressures. The market anticipates that the hiking cycle is coming an end. The Thai baht, Indian rupee and Indonesia Rupiah were the only currencies to modestly outperform the USD. In case of the Indian rupee, better than expected inflation data (lower) improved sentiment while in the case of the IDR and THB weakness in the recent weeks had gone too far and this resulted is some recovery.