Last week emerging market currencies recovered and this resulted in an overall improvement in sentiment on currency markets. Although volatility might continue, positive fundamentals in emerging markets suggest a crisis is unlikely. The US dollar weakened due to lower safe haven demand and weaker economic data, while the ECB’s inaction supported the euro. We expect US economic data to gain traction, while the ECB should eventually ease policy, so EUR/USD will ultimately likely head lower.
Emerging market currencies recover
Worries about emerging markets eased and investor sentiment in financial markets improved last week. This manifested itself in a recovery in emerging market currencies (see graph below), lower equity volatility and the Japanese yen falling under pressure later in the week. The Polish zloty (PLN) was the best performing emerging market currency followed by the Hungarian forint and the Turkish lira. The central bank of Poland left interest rates unchanged at 2.5%, with the high level of confidence that investors have in this central bank supporting the currency. Hungary managed to sell more bonds than planned, which was seen as positive.
The US dollar came under pressure last week driven by weaker than expected US economic data releases and lower safe-haven demand. The Australian and New Zealand dollars each rallied by around 2% as domestic data came in better than expected. In addition, the Reserve Bank of Australia (RBA) unexpectedly shifted its monetary easing bias to neutral. Indeed, we now think it is more likely that monetary policy will remain unchanged this year, with the policy rate sticking at 2.5% before gradually rising to 3% by the end of 2015. Nevertheless, we do not expect the recent rebound in the AUD/USD to persist as the rebalancing in the economy remains slow. In addition, one of the main assumptions for the RBA to shift its monetary bias to neutral is that the decline in the exchange rate will be sustainable. However, if the AUD were to rally (which is not our main scenario), this would increase the likelihood that the RBA will cut rates to stimulate the economy. We maintain our year end AUD/USD forecast of 0.85. Meanwhile, sterling lost some shine last week on weaker than expected UK data and dovish Bank of England talk.
EUR rallies on ECB disappointment
At the start of the week, the euro was under pressure reflecting expectations that the ECB would further ease monetary policy. The ECB surprised financial markets by keeping its policy unchanged and failing to introduce new non-standard measures (see chapter Rates). This resulted in sharply higher eurozone bond yields and a higher euro. The lower-than-expected rise in non-farm payrolls kept the US dollar under pressure. We remain of the view that there is a powerful case for the ECB to ease monetary policy further and that this will push the euro lower. We expect US economic data to gain traction, while the ECB should eventually ease policy, so EUR/USD will ultimately likely head lower.