Volatility in currency markets also rose on the intensifying geopolitical tensions. The resulting deterioration in risk sentiment supported safe haven currencies like the Japanese yen and the US dollar. The latter was also supported as US data releases generally came in better than expected. The euro eased lower due to worries about the economic outlook and comments from ECB President Draghi. Meanwhile, emerging market currencies extended their decline last week, with the exception of the Chinese Yuan.
Volatility rose as geopolitical tensions intensified
Market concerns about early Fed monetary tightening eased last week after the softer than expected US payrolls numbers on 1 August. However, geopolitical tensions in Ukraine and Iraq intensified last week. As a result, volatility in currency markets rose again after easing off early last week. This led to demand for safe haven currencies such as the Japanese yen and US dollar. The latter also benefited as US data releases generally came in better than expected. Against its trade weighted partners, the US dollar is now trading at the highest level since February this year.
The euro extended its slide against the US dollar for the sixth consecutive week. As expected the ECB left monetary policy unchanged last week. However, ECB President Draghi did not rule out unconventional measures like ABS purchases and quantitative easing if their medium term outlook for inflation changed. Draghi also talked down the euro by stating that market fundamentals for a weaker euro were much better and that real interest rates would remain negative in the eurozone for a much longer time than in the US. We think that monetary policy differentials suggest that the euro has further downside, with EUR/USD likely to fall to 1.30 by year end.
The Australian and New Zealand dollars also came under pressure as employment data in both countries disappointed. Late last week, pressure on the Australian dollar increased after the Reserve Bank of Australia lowered its 2014/15 economic growth and inflation forecasts. We maintain our view that the Australian dollar will decline towards 0.85 and 0.80 in 2014 and 2015, respectively due narrowing interest rate differentials between Australia and the US.
Emerging market currencies lower as investor risk appetite deteriorates
A worsening of investor sentiment generally weighed on emerging market currencies. The Turkish lira and Russian ruble extended their declines last week as tensions in Syria and Ukraine continued. The Mexican and Chilean pesos also eased lower as consumer confidence and economic activity unexpectedly declined in Mexico and Chile, respectively. The Indian rupee was also not spared even though inflationary pressures have shown encouraging signs of declines. The Reserve Bank of India has warned that uncertainty surrounding the path of the monsoon, possible higher oil prices stemming from geopolitical concerns and strengthening domestic growth demand in the face of supply constraints could hinder the central bank’s efforts to leave inflation on a sustainably lower path. The Thai baht also succumbed to external uncertainty despite the central bank’s optimistic view that the economy showed signs of improvement in the second quarter and will continue to recover in the second half of this year supported by firmer domestic demand and fiscal policy. On the other hand, the Chinese yuan strengthened for the seventh consecutive week as investor sentiment in the currency improved. This was supported by the central bank raising the yuan fixing rate against the US dollar to the highest level in the past two weeks.
Outlook this week
This week, several key economic data releases are worth watching. In Europe advance estimates for second quarter GDP for the eurozone and UK will be released. We expect economic growth in the eurozone to slow to 0.1%, while GDP growth in the UK should firm to 0.9%. This could see some euro weakness versus sterling and the dollar. Japan’s second quarter GDP print will also be an importer driver for the Japanese yen. A sharper than expected contraction (market consensus -1.8% qoq) could renew market speculation that the BoJ needs to take further steps to stimulate the economy. Indeed the BoJ acknowledged in last week’s monetary policy meeting that the recovery in exports and industrial production has been weaker than expected. Furthermore, the rise in wages have continued to lag inflation. Last but not least the resilient yen is expected to weigh on imported inflation. We maintain our view that the BoJ’s optimistic view that it will achieve its 2% inflation target by the middle of FY 15 will be challenged in the coming months. As such, we think further yen weakness lies ahead.
Other important data releases which will be crucial for risk sentiment and currencies’ direction are China’s July industrial production and retail sales. Leading indicators imply that China’s economic growth has likely troughed in the first quarter and the outlook for the second half of this year is more positive. The trade balance has also improved providing more flexibility for a stronger currency. As such the sentiment in the Chinese yuan will remain supportive, paving the way for the currency to appreciate towards our year-end target of 6.10.