Weekly FX – Monetary policy in focus

by: Roy Teo

A slew of weak economic data across the globe has renewed market expectations that monetary policies will remain accommodative for a while longer. This was the main driver for currency markets last week as geopolitical concerns stabilised. Emerging market currencies mostly recovered as investor sentiment improved. Speeches from US Federal Reserve Chair Yellen, European Central Bank President Draghi and Reserve Bank of Australia Governor Stevens this week are likely drivers for currency markets.

Easier for even longer?

Weaker than expected retail sales and jobless claims have renewed market speculation that the Fed will remain cautious and not tighten monetary policy at a faster pace. That weighed on the US dollar last week. However, the US dollar managed to outperform the euro as economic growth in the eurozone stalled in the second quarter, disappointing market expectations. This has led to renewed market speculation that the ECB might need to increase monetary stimulus later this year should the slow recovery in the eurozone and low inflation persist longer than expected. Sterling also came under pressure after BoE Governor Mark Carney hinted that an early rate hike was not imminent as wage growth has been weaker than expected. As a result, financial markets scaled back rate hike expectations within the next one year by 15bp. Consequently, sterling broke below key support level at 1.67 against the US dollar, exposing downside risk towards the next support at 1.6460. However, technical indicators imply that sterling is in oversold territory and hence some relief rally is likely in the short term. This is also reinforced by the options market, which is pricing in little downside risks in the currency.

Safe haven flows into the Japanese yen eased as geopolitical tensions subsided. The yen was also hurt by market speculation that the BoJ might need to extend monetary stimulus (its existing quantitative and qualitative easing program is due to end this year) after the economy contracted in the first half of 2014 relative to the last quarter of 2013. Though the BoJ minutes continue to reflect an optimistic view that the economy will recover and core inflation excluding the effects of consumption tax hike will rise to 2%, there was some sense of caution. A few members noted that structural factors could continue to restrain an increase in exports and noted that the continued moderate disinflationary trend warranted attention. Indeed the inflation swap curve shows that investors do not share with the central bank’s optimistic view that inflation will be sustained at the central bank’s target.

 

On the other hand, the Norwegian Krona rose by more than 1% as inflation and retail sales surprised on the upside. A resilient consumer sentiment report and narrower Western Canada crude oil discount to WTI oil supported the Canadian dollar. The slide in the Australian dollar came to a halt last week as business and consumer confidence rose. House prices also rose at a stronger pace in the second quarter.

 

Emerging market currencies recover

The Mexican peso recovered last week due to market expectations that foreign investment flows into the economy will increase after the government opened up its energy sector. However, the upside in the currency was capped after the central bank lowered its economic growth forecast for 2014. The South African rand also gained after the central bank hinted that further rate hikes are on the horizon due to strong underlying inflation pressures. In Asia, despite China’s economic data disappointing market expectations, sentiment in

Asian currencies and the Chinese yuan remained positive. This is due to market expectations that further targeted stimulus is likely as policy makers seek to prevent deleveraging from becoming disorderly. Indeed, the People’s Bank of China reassured markets that the direction of monetary policy is not changing and money supply and aggregate financing are expected to maintain stable growth in the future. Policy makers also announced measures to lower borrowing costs for enterprises and ensure that new loans flow into the real economy. The Indonesian rupiah rebounded last week as consumer confidence rose in July. The South Korean won was also supported after the central bank cut interest rates to boost economic growth.

 

On the other hand, the Turkish lira extended its third consecutive week of decline after Fitch Ratings warned that political risk was expected to remain a sovereign credit weakness. Late last week, Chile’s central bank stated that it will consider further rate cuts as the economy is slowing faster than expected. This weighed on the Chilean peso.

Monetary policy directions from key central bankers

The highlight of this week will no doubt be US Federal Reserve Chair Yellen’s speech on the US labour market on 22 August during the Jackson Hole symposium. This will give further insights on the timing and pace of monetary tightening in the US. We think financial markets are underestimating the pace of rate hikes next year as the US economy and labour market looks set to continue improve strongly. However, we do not expect the Fed Chair to change her dovish tone as early as this week’s Jackson Hole event. Later this week, US inflation and FOMC minutes will also be of importance to the direction of the US dollar.

 

ECB President Draghi’s speech during the symposium will be of similar importance to the euro especially after economic growth in the eurozone stalled in the second quarter. Taken together with an uncomfortably low inflation outlook, the market will be closely watching for hints of future monetary policy direction. Speculative short futures positions in the euro have been building as investors use the euro as a funding currency (due to negative deposit rates) and continued market speculation that a full blown quantitative easing programme will be set up later this year.

 

Before the Jackson Hole symposium on 21-23 August, the Reserve Bank of Australia Governor Stevens will give his semi-annual testimony before the Economics Committee of the House of Representatives. We do not expect any material change in the central bank’s economic and monetary outlook given that earlier this month it downgraded its forecasts for this year. On the currency, it is highly likely that Stevens will reiterate that a weaker exchange rate is expected due to lower commodity prices and narrower interest rate differentials between Australia and other advanced economies.