US dollar rallied to the highest level since September 2013 on expectations of that the Fed may increase interest rates earlier than previously expected. At the same time, the euro was hurt by expectations of more ECB monetary stimulus. In addition, sterling fell under pressure after lower inflation data, but recovered as the minutes of the BoE’s MPC meeting showed that two MPC members voted for an increase. The Japanese yen underperformed as interest rate differentials between Japan and elsewhere become less favourable and due to expectations of more outflows.
Monetary policy divergence supports US dollar
The US dollar had a strong week across the board. At the start of the week, stronger than expected US economic data gave support. This was followed by less dovish than expected FOMC minutes and comments from Fed officials. As a result, US yields and 3-month interest rate expectations rose. In turn, this pushed the US dollar to the highest level since September 2013. So ahead of the testimony of Fed Chair Yellen at the Jackson Hole Symposium, the sentiment was US dollar positive, but investors held back because of the fear that Chair Yellen would sound more dovish to counterbalance the less dovish remarks from other FOMC members. Fed Chair Yellen did not counterbalance the less dovish comments from other Fed members. As a result US yields and the US dollar continued to rise. Meanwhile, ECB President Draghi opened the door for more monetary stimulus. This resulted in more pressure on the euro versus majors and emerging market currencies after his speech. The net short positions in euro are quite large, but this state could continue for some time. Our year-end target of 1.30 in EUR/USD is in reach.
Japanese yen underperformed
The Japanese yen was the worst performer last week as investor sentiment improved. Besides a stronger US dollar and higher US yields, market expectations that an increase in outward investment from Japanese investors, including the Government Pension Investment Fund, continue to weigh on the yen. Indeed, data from the Ministry of Finance shows that since the beginning of new fiscal year in April up to 15 August, domestic investors have invested 5.82 trillion JPY in foreign bonds (compared to 3.35 trillion JPY and 4.73 trillion JPY repatriation during the same period last year and whole of fiscal year 2013/14 respectively) and 1.61 trillion JPY in foreign stocks (compared to 1.34 trillion JPY and 3.41 trillion JPY repatriation during the same period last year and whole of fiscal year 2013/14 respectively). On the domestic side, the recovery in domestic spending continued to contract yoy in July albeit at slower pace compared to the second quarter. This implies that the recovery in economic growth might be slower than the BoJ’s projections, paving the way for further monetary stimulus at a later stage.
Rate expectations dominate sterling
In the UK, headline inflation fell to 1.6% yoy from 1.9% yoy, mainly driven by a decline in the core, to 1.8% from 2% yoy. Sterling declined sharply following these UK inflation numbers. Since the start of July, GBP/USD has dropped by more than 3.5% because investors have scaled back interest rate hike expectations. In addition, some of them have taken profit on long sterling positions reflecting the view that most positive news was already reflected in sterling. Later in the week the minutes of the BoE’s August MPC meeting showed that two of the members already voted for a hike this month. This gave some support to sterling. Although we remain optimistic on sterling for the next year, we judge that current levels are not attractive enough to enter sterling longs.
Australian dollar and Norwegian krone were resilient
The Australian dollar received some support after Reserve Bank of Australia Governor Stevens acknowledged limitations for further monetary stimulus. As a result, the market priced out expectations of a 25bp cut within the next month. Nevertheless, Mr Stevens reiterated that the market is underestimating the risk that the Australian dollar will fall materially and that intervention to weaken the currency remains on the cards even though conditions do not warrant it at this stage. In Norway, the much better than expected GDP number resulted in recovery of the Norwegian Krone because the likelihood of more monetary stimulus has been reduced.
Lower emerging market currencies
Higher US yields and a higher US dollar put most emerging market currencies under pressure. There were some exceptions though such as the Indian rupee and the Indonesian rupiah. The South African rand fell the most last week. Moody’s decision to cut the rating of South Africa’s four biggest banks weighed on the currency. Moreover, inflation came in lower than expected which alleviated pressure on the central bank to raise interest rates. As a result, yields moved lower and this hurt the ZAR.
The appreciation of the Chinese yuan came to a halt last week due to profit taking after its 2% appreciation since June. Economic data releases disappointed last week with foreign direct investment in July declining to the lowest level since November 2013. In addition, the preliminary PMI estimate showed that the manufacturing sector’s growth in August has slowed. Nevertheless, we remain optimistic that policy makers will be able to cushion the short term downward pressure on economic growth. Indeed, the central government announced measures to speed up construction of rail lines and build 10 regional airports in the Northeast China to support the region.