Policy divergence drives currencies
In the past month, the US dollar rally that started at the end of June has gained momentum on the back of stronger than expected economic data releases and monetary easing in other countries. Financial markets made an upward adjustment to their view on the path of Fed rate hikes for 2015. This was driven by strong US economic data and less dovish commentary from Fed officials. Meanwhile, the pound and the euro were under heavy pressure. The pound was the worst performing major currency, because financial markets scaled back their expectations about future rate hikes and started to price in the risk of a Yes vote in the Scottish independence vote. The euro, in the meantime, suffered because of expectations about monetary policy easing. Moreover, the ECB surprised financial markets by announcing a more aggressive easing package including a rate cut.
Weakness in emerging market (EM) currencies ahead…but no EM FX crisis
In general, we expect emerging market currencies to come under some pressure in the light of a higher US dollar and higher US rates following expectations that the Fed will start a hiking cycle in 2015. The currencies that will suffer the most are those of the countries that depend on large capital inflows due to a current account deficit and at the same time have some weak fundamentals like for instance a fiscal deficit, inflationary pressures, relatively low FX reserves and/or high foreign debt levels and less than vigilant central banks. (Geo) political developments can also make a currency vulnerable. We judge the South African Rand, the Russian ruble, the Brazilian real, the Turkish lira and the Indonesian rupiah to be the most vulnerable. However, a general emerging market currency crisis is unlikely in our view, because domestic fundamentals have improved and global growth will continue. We have modified most of our emerging market currency forecasts. These adjustments are technical in nature.
Our high conviction views broadly unchanged, with the exception of the PLN
Most of our high conviction views have remained in place. We remain negative on the euro, the Japanese yen, the Swiss franc and the Australian dollar, while we are positive on the US dollar, the Mexican peso (one of the few currencies we expect to strengthen against the USD) and the Chinese yuan (versus the yen). At the start of last month, we removed our long conviction view on the Polish zloty due to the Ukraine crisis and a deterioration in the economic outlook