Although some emerging market currencies were supported by central bank actions, general sentiment remained weak. Safe haven currencies such as the Japanese yen, the Swiss franc and to a lesser extent the US dollar received support. We think positive fundamentals mean that the risk of contagion is relatively low and hence expect sentiment to improve. The pressure on EUR/USD is building on the back of ECB easing expectations and as a result the pair moved to below 1.35. We expect the downward trend to continue.
Some emerging market currencies were supported by central bank actions …
Last week, the sentiment on emerging market currencies remained weak, despite some support following a central bank fight back. On Monday, the Turkish lira dropped close to 2.40 versus the US dollar. But afterwards it recovered on speculation that the Central Bank of the Republic of Turkey (CBRT) would hike official rates by 225bp. In a desperate act to support the Turkish lira and to slow down capital outflows, the CBRT in the end hiked rates by 425bp from 7.75% to 12.00%. This supported the TRY and as a result the TRY ultimately moved higher over the week. In Asia, the Indian rupee was able to outperform the US dollar, because of the rate hike by the Reserve Bank of India. Confidence has also clearly increased in the RBI since governor Rajan took over last year.
…while others remained weak
However, sentiment in most other emerging market currencies deteriorated further. In the case of South Africa, fundamentals remain weak, confidence in the political situation is low and labour unrests continue to weigh on sentiment. The 50bp rate hike to 5.50% by the South Africa Reserve Bank to support the currency was not considered large enough. Investors are increasing the pressure on currencies that are not freely floating such as the Russian rubble. The Russian central bank has communicated that it will defend the currency beyond its corridor. The central bank has sufficient foreign exchange reserves to do this, however the market will likely seriously test its commitment. Moreover, investors have increased expectations that emerging market central banks, that have recently not hiked interest rates, will likely be challenged to do so soon to defend their currencies for example Hungary. On 21 January the central bank lowered interest rates from 3.00% to 2.85% (415bps of easing since mid-2012) to support growth and because of low inflation. Recently expectations have changed towards the end of the easing cycle and a start of a hiking cycle. In the case of the Polish zloty, the higher than expected GDP growth has increased speculation that also here interest rates will need to move up.
…but risk of contagion is relatively low
Fear of contagion is often on the headlines, but if we look at our risk indicators, they don’t signal a large aggressive risk aversion wave. For starters, the 1-month volatility in USD/JPY has edged higher (see chart above), but it is still far away from the peaks seen in previous risk aversion waves. In addition, the movements in major currencies has remained relatively small. USD/JPY has moved lower and we have experienced large intraday volatility, but overall the move has been moderate. Moreover, emerging market sovereign spreads (with exception of a few countries) and liquidity spreads remain at low levels, likely be a reflection of stronger fundamentals. Furthermore, gold prices and safe haven bonds have received support but not to the extent that we would experience in a major risk aversion wave.
Pressure on EUR/USD
The US dollar was generally strong last week and this manifested itself in a lower EUR/USD. For starters, demand for the US dollar versus emerging market currencies supported overall US dollar sentiment. Moreover, the fact that the Fed continued to taper gave confidence in the state of the US economy and the US dollar. Meanwhile, the euro has been undermined by lower than expected inflation data and ECB easing expectations. Indeed, EUR/USD has been negatively affected by the move lower in the 2-Y yield spread between Germany and the US. Going forward we expect sentiment on the US dollar to become increasingly positive, given our view that the economy has entered a new stronger growth phase and that the Fed will continue to taper its asset purchases. Meanwhile, we expect further ECB monetary easing. This suggests that the 2-Y yield differential between Germany and the US will decline further, which should push EUR/USD lower.
RBNZ sounds hawkish but remains on hold
The New Zealand dollar (NZD) also fell under pressure as the Reserve Bank of New Zealand decided to leave the policy rate on hold at 2.5%. Leading into the decision, the market was pricing in a 50% probability of a rate hike. We continue to expect the RBNZ to deliver a 25bp rate hike in the next monetary policy meeting in March. This is fully priced in by the market.