Sterling outperformed other major currencies last week driven by a less dovish BoE Inflation Report and an upward revision in the central bank’s GDP forecast. Our end of March target of 0.82 in EUR/GBP was reached. The US dollar remained out of favour, because of weaker than expected US data, while the euro was resilient, as the stronger eurozone GDP data reduced ECB easing expectations. We expect a combination of recovering US data and ECB easing to drive the euro lower against the dollar. Meanwhile, emerging market currencies recovered further, as sentiment improved.
Sterling outperforms the major currencies
Sterling strengthened significantly against the euro last week. Our end-of-March target of 0.82 was reached in EUR/GBP and we expect further strength during the course of this year. The main reason for last week’s rally in sterling was a less dovish Bank of England quarterly Inflation Report. The BoE upgraded its UK GDP forecast for this year (to 3.4% from 2.8%). In addition, it admitted that unemployment has fallen much more rapidly than expected. The unemployment rate is likely to reach the MPC’s 7% threshold by the spring of this year. As a result, it dropped its guidance based on the unemployment rate and moved to one based more vaguely on broader measures of slack. BoE Governor Carney made a valiant attempt to stress that rate hikes were some way off but given the momentum in the economy, it seems increasingly likely that rates will start to go up early next year.
USD continues to underperform
Meanwhile, the US dollar remained out of favour versus major currencies. Weaker than expected US data and stronger eurozone GDP supported EUR/USD. Moreover, for most of the week, the US dollar moved lower because of the anticipation that Fed Chair Janet Yellen’s testimony would sound more dovish, because of the recent uncertainty in emerging markets and weaker US data. In fact, she struck a relatively positive tone and suggested that tapering will continue. This gave only temporary support to the US dollar, because US data continued to disappoint. The rise in EUR/USD was only temporarily offset by dovish ECB comments. ECB Executive Board member Benoit Coeure told Reuters that the ECB is “very seriously” considering moving the deposit rate into negative territory. These comments suggest that the ECB is closer to a negative interest rate policy than previously suggested. News that in Italy Prime Minister Letta stood down and will likely be replaced by Mr Renzi was received positively by financial markets. Both the AUD and the NZD outperformed the USD because of better than expected data out of China, but their upside was limited because of weaker domestic data releases. We judge that USD sentiment will turn positive as US data are likely to start surprising on the upside.
SEK rally halted by Riksbank
Last week, the Swedish krona started the week strongly versus the euro. EUR/SEK almost reached our target for the end of March of 8.75. The move came to a halt on Thursday after the Riksbank monetary policy decision and after the release of the much higher than expected unemployment rate. The Riksbank signalled that rates won’t increase until early 2015 to allow for inflation to pick up amid a tepid recovery. This forward guidance provides the same message as given after the December meeting. The market mainly sold Swedish krona because of the combination of a dovish Riksbank and weak employment data. EUR/SEK has now bounced off the 8.75 level a few times. If the market does not clear this level in the near-term, a move back towards 9.0 is a risk. Next week Swedish inflation data will be released. Higher than expected numbers could force such break, because it could alter expectations on monetary policy. We remain confident of a higher SEK versus the euro this year (year-end target of 8.25) because we expect the economy to improve and inflation to rise triggering an earlier rate hike (Q4 2014) than now is anticipated.
Emerging market currencies recover further
The overall performance of emerging market currencies was positive with a few exceptions. Most Asian currencies rebounded last week as domestic data generally surprised on the upside. The trade balance in China and Taiwan came in better than expected. The Indonesia rupiah (IDR) was the star performer rallying more than 2% as the central bank stated that the current account deficit narrowed from 3.8% of GDP in Q3 2013 to 1.98% in Q4. The market interpreted this as positive for the IDR and as a result USD/IDR dropped below 12,000, a level not seen since early December 2013. We remain sceptical that the sharp improvement in the trade and current account balance in the fourth quarter of last year will be sustainable as we suspect that exporters were front loading their mineral exports ahead of the ban last month. The latter is also expected to weigh on the trade balance going forward. Hence we maintain our bearish view on the IDR.
Though the inflation and trade balance outlook improved in India, the upside in the Indian rupee (INR) was capped as the Reserve Bank of India implied that the priority of monetary policy in the short term is to contain inflation rather than to stimulate economic growth. Sentiment in the offshore Chinese yuan (CNH) remains fragile as uncertainty surrounding potential defaults in wealth management trusts in China continue to weigh on the currency. We believe that there is more potential for the CNH to ease lower towards 6.05 against the USD in the coming week. Nevertheless we do not expect a sharp depreciation in the CNH as the options demand to hedge further weakness in the currency has eased.
Sentiment towards the Turkish lira further recovered last week despite the larger than expected current account deficit, which signals that the market is currently giving Turkey the benefit of the doubt after the aggressive rate hikes on 28 January. Next week the central bank will decide on monetary policy again and no change is expected. The Russian rouble and the Ukrainian Hryvnia fell under pressure as they felt the ripples of the 19% devaluation of the Kazakh Tenge on 11 February. The Brazilian real also remained under pressure, because of market concerns about the government’s fiscal policy, especially as the drought could make it even more difficult for it to deliver a credible fiscal adjustment.