The US dollar came under heavy pressure as financial markets adjusted their expectations for US interest rates downwards. It fell versus majors and most emerging market currencies. Safe haven currencies – the Japanese yen and the Swiss franc – outperformed because of weakness in equities, less dovish expectations on these central banks and diversification flows from Russia in the case of the Swiss franc. Expectations of QE by the ECB barely hurt the euro because of market scepticism, though it softened over the weekend as President Draghi warned that further euro strength could trigger monetary easing.
Adjustment in interest rate expectations hit USD
Since 4 April, the US dollar has been out of favour (see graph above and the graph below). The main reason behind is the downward adjustment in interest rate hike expectations in the US (see Rates section). This reflected a more dovish tone in a speech from Fed Chair Yellen and the March FOMC minutes. Both signalled that they view policy rate hikes as being some way off. Her comments were aimed to counter balance market expectations after the upward adjustment following the relatively hawkish press conference after the FOMC meeting of 18 March. US economic data – although starting to improve as the economy shakes off the bad weather – have not been strong enough to change this market perception. Data have gone from being weaker than expected to being broadly in line with market expectations. Therefore, they have failed to change the sentiment on the US dollar. We continue to think that the US economy will rebound with more force going forward, and this should start to provide support to the greenback.
Safe haven currencies outperform
Last week, we experienced the interesting combination of the US dollar being out of favour because of interest rate dynamics, safe haven currencies outperforming on equity market weakness and uncertainty about China, but nevertheless most emerging market currencies recovering versus the US dollar. In the case of the Japanese yen (JPY), the BoJ also had an important contribution to the JPY performance. The JPY strengthened after BoJ Governor Kuroda said that additional easing is not being considered currently as the economic recovery trend remains intact albeit with some fluctuations due to the consumption tax hike. The BoJ showed little concern about the decline in the Tankan outlook and judged that jobs and income will keep improving. In addition, Mr Kuroda remains optimistic that there is a high chance that CPI will reach 2% between the end of fiscal year 2014 to fiscal year 2015. As economic growth is set to contract sharply in Q2 and recover only gradually in the following quarters, we believe the BoJ is likely to further increase monetary stimulus at around the middle of this year in order to achieve its inflation target within the set time frame. We maintain our USD/JPY year-end target of 110.
The Swiss franc and to a lesser extent the euro profited from tensions between Russia and Ukraine, because of diversification flows. Moreover, the Swiss franc also received support from a higher than expected inflation print. If this were to continue – something we do not expect – the Swiss National Bank may be pressured to abandon the cap on the Swiss franc versus the euro at 1.20. For now this is not an issue and the market is aware of the SNB’s delicate balancing act between preventing the Swiss franc from rising and at the same time cooling the housing market. We remain negative on the Swiss franc, because we expect the central bank to remain on hold for the coming years. Moreover, we expect investors to move out of the CHF driven by more attractive investments elsewhere and lower selective safe-haven flows.
The Swedish krona showed only limited outperformance versus the US dollar, because the Riksbank surprised with a more dovish tone at the monetary policy meeting. The risks of another rate cut have increased and this hurt the SEK.
QE talk barely hurt the euro
At the start of last week, the euro faced some headwinds on speculation of QE by the ECB. The impact was very muted though, because the market has become rather sceptical if the ECB will further ease monetary policy. This scepticism and expectations of less rates hikes in the US manifested itself in interest rate spreads supporting EUR/USD (see graph below). However, the euro softened over the weekend as President Draghi warned that further euro strength could trigger monetary easing. Going forward, we expect interest rate expectations to remain a crucial driver for EUR/USD, pushing the pair lower because our high conviction of above consensus monetary tightening in 2015 by the Fed and lower diversification flows towards the euro as a result of Ukraine/Russia tensions.
EM currencies rally
Most emerging market currencies rallied last week as investors warmed to the possibility that monetary tightening in the US will come later rather than sooner. The BRL gained due to renewed market speculation that further rate hikes are imminent as inflationary pressures increased. In Asia, the KRW was the star performer as the Bank of Korea (BoK) raised its economic growth outlook and also signalled that it expects inflation to rise later this year. However, the BoK has warned that it is monitoring potential signs of speculative behaviour. On the other hand profit taking weighed on the RUB, IDR and INR. The RUB relief rally reversed last week as the government lowered its economic growth and currency outlook this year. Moreover, the tensions between Russia and Ukraine also hurt the RUB. Profit taking in the IDR also took place after elections favourite PDI-P party received less votes than expected. Investors also took cue by taking profit in the INR which has rallied by 3% since March on pre-election optimism. This week China’s economic growth is widely expected to decline from 7.7% to 7.4% in the first quarter of this year. A weaker than expected outcome is likely to result in a deterioration in risk sentiment in emerging market currencies.