Weekly FX – Dollar the clear winner, as outlook improves

by: Roy Teo

The US dollar was the clear winner last week as confidence in the US economy built reflecting that GDP rebounded at a strong pace in the second quarter. Emerging market currencies generally underperformed, but the Chinese yuan was supported by more optimism about the economic outlook. Carry trades are at risk as volatility expectations in currency markets have risen. Major central banks are widely expected to leave monetary policy unchanged this week.

US dollar favoured as US economy rebounds

The US dollar (USD) was the clear outperformer last week as economic growth in the second quarter surprised on the upside. On a trade weighted basis, the US dollar is now trading at the highest level since March this year and has erased the losses incurred due to sharper than expected economic contraction in the first quarter. We judge that as the US economy gathers momentum in the second half of this year, the Fed will have less flexibility to maintain its current dovish monetary policy communication. This was already evident last week when Fed Plosser dissented against the forward guidance that interest rates will remain low for a considerable time after quantitative easing concludes. We expect financial markets to adjust their expectations for US short-term interest rates for 2015 upwards. We maintain our view that the USD will strengthen in the coming months.

 

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The Swedish Krona declined by more than 1% as economic data continues to disappoint. The Norwegian Krona also underperformed due to fears of terrorist attacks. Profit taking in the New Zealand dollar (NZD) continued last week as investors continue to price in a slower pace of rate hikes and after Fonterra announced a lower dairy pay-out forecast. We expect the NZD/USD to find some support above 0.84 as technical indicators imply that prices are near oversold territory. The Canadian dollar extended its loss as oil prices stabilised and consumer confidence declined. Though economic growth gathered momentum in May, wage growth remains lacklustre. Our view that the Canadian economy will underperform the US in the next two years remains unchanged. Further declines in the CAD towards 1.1053 are expected in the coming weeks. The Japanese yen eased to 103 against the USD due to market speculation that the BoJ might need to further step up monetary stimulus and due to widening interest rate differentials between US and Japan.

 

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Emerging market currencies mostly lower

Emerging market currencies were mostly lower due to a stronger US dollar and unfavourable domestic drivers. Geopolitical tensions weighed on the Turkish Lira (TRY) and Russian ruble. Renewed concerns that monetary stimulus in the US may reverse sooner than expected also pressured the TRY, Indonesian rupiah, South African rand and Brazilian real. However the Chinese yuan was supported by more optimism about the economic outlook. The Chinese yuan strengthened to below our Q3 target of 6.18 against the USD as investors’ sentiment towards the currency improved. Indeed the currency is trading at the smallest discount to the daily fix since March this year. In addition the options market demand to hedge weakness in the currency has also declined to the lowest level this year. We judge that given progress in the rebalancing in the economy and firming growth, the central bank will be more tolerant of capital inflows and allow a stronger currency towards our year-end target of 6.10.

Carry trades are at risk as volatility rises

In the past month, volatility expectations in currency markets have started to increase. Some would argue that this is due to rising geopolitical tensions. However this is debatable as we have not seen support in safe haven currencies like the Swiss franc and Japanese yen both of which have underperformed. We believe that investors have realized that the options market has been under-pricing potential volatility in the currency market as uncertainty surrounding monetary policies in advanced economies remain. Furthermore several currencies have also broken out of their recent trading range resulting in an increase in demand to hedge directional movements. We expect carry trades to be at risk as volatility heads higher.

 

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No surprises from the ECB, BoE and BoJ…

This week the ECB, BoE and BoJ are expected to keep monetary policies unchanged. Market expectations that the ECB will embark on further monetary easing measures have been increasing due to the fragile economic outlook and low inflation. We think that the ECB will adopt a wait and see approach after announcing its stimulus package in June, which is still to be fully implemented. In addition, the ECB is likely to welcome the decline in the euro and improvement in bank credit conditions to households and companies. The euro has reached our Q3 target of 1.35 earlier than expected. However a relief rally in the euro in the short term cannot be ruled out as technical indicators imply that the currency is oversold. In addition the options demand to hedge downside risks in the euro has faded in the past two weeks. We maintain our year end EUR/USD target of 1.30.

 

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We do not expect any surprises from the BoE this week and maintain our view that the BoE will tighten monetary policy in November. The BoJ is likely to acknowledge that the export led recovery has been slower than expected. On the domestic side recent industrial production and retail sales figures have also disappointed. However we believe that the BoJ is unlikely to alter their optimistic view that their inflation target of 2% will be achieved in FY 15 until later this year. We see further weakness in the yen towards 104 in the coming weeks. Our view is reinforced by the options market which is pricing in the highest premium to hedge weakness in the yen since late November last year.

…but perhaps a more dovish RBA?

On the other hand, the market will be closely watching for signals of the RBA’s future policy direction. On 3 July RBA Governor Stevens stated that the central bank still has ‘ammunition’ on interest rates and that investors are under-estimating the likelihood of a significant decline in the Australian dollar. We judge that the RBA is likely to indicate that the strong inflation print in the second quarter is unlikely to be sustainable and reiterate that the less than desired decline in the currency will slow the rebalancing in the economy. On the bright side, surveys show that consumer confidence has rebounded. In addition the decline in iron ore prices have also stabilised. However the job market remains fragile. Though we do not rule out a more dovish RBA statement this week, we judge that the bar remains high for the RBA to further ease monetary policy as the full effects of previous monetary stimulus have yet to fully filter through. On the currency, the technical outlook is deteriorating with prices likely to test key support level at 0.92 in the coming month.