US dollar: strongest level in since 2010
The impressive rally of the US dollar continued last week with US dollar index being up almost 7% since July. Meanwhile, the EUR/USD broke below barrier level 1.28 and key support level of 1.2750, but then the move slowed down somewhat. The US dollar rose despite dovish comments from Fed official William Dudley (dovish stance). He warned that ‘a strong dollar will make it harder to achieve the Fed’s two main objectives, of full employment and inflation around the 2% target’. This is because ‘a strong currency will have consequences for growth and inflation. As such greater patience is required before interest rates are raised’. He also stated that the economy needs to run a little hot for at least some time to push inflation back to the target’.
So why did the US dollar continue to rally? For starters, it profited from weakness in other currencies. The weakness in the euro was to a large extent driven by an increase in market expectations of more monetary easing by the ECB. On top of this, fears that the Reserve Bank of New Zealand has been intervening in currency markets to weaken the New Zealand dollar resulted in a sharp depreciation. In addition, economic data in some countries disappointed, as was the case of Japan, while US data met expectations. This provided support to the US dollar. In contrast, the Pound Sterling has been resilient against the US dollar mainly as sentiment remained positive. The US dollar strength also left its mark on emerging market currencies which moved lower. Against its trade weighted basket of currencies, the US dollar is now trading at the strongest level since 2010. There are upward risks to our US dollar forecasts for the following reasons. For starters, the market has not yet fully priced in Fed rate hikes in 2015. Furthermore, we even expect the Fed to turn more hawkish. In addition, monetary policy divergence will probably widen further going forward, supporting the US dollar versus other major currencies.
Euro breaks below 1.28
The euro consolidated above 1.28 early last week before financial markets priced in the possibility of further monetary stimulus from the ECB. Remarks from ECB President Mario Draghi added fuel to this process.In remarks similar to those before the European Parliament he said that ‘we remain fully determined to counter risks to the medium-term outlook for inflation… we stand ready to use additional unconventional instruments within our mandate, and alter the size or composition of our unconventional interventions should it become necessary’. In addition, he noted that ‘economic conditions have been somewhat weaker than expected…however, we expect modest growth in the second half of the year’. His comments and weaker than expected German Ifo resulted in extra pressure on the euro. Recent data and ECB commentary suggest there is a risk of more easing over above the policy measures announced. However, the ECB is likely to first assess the impact of the TLTRO policies. Although the take-up of the September TLTRO was relatively low, Mr Draghi noted earlier this week that ‘the September and December operations should be assessed in combination’. In addition, we do expect economic data to improve going forward helped by the fall in the euro, better bank lending conditions, and a US-led rise in global demand.
EUR/USD has moved below our year-end target of 1.2800. In the near term the momentum remains negative. Indeed, the EUR/USD barely recovers on weaker US data releases. However, there is a risk that investors close some euro short positions after the ECB meeting this week, if the ECB does not live up to expectations of more monetary stimulus to come.
RBNZ selling the NZD?
The New Zealand dollar (NZD) was the worst performer last week triggered by a decline in consumer confidence and lower dairy pay-out forecast from Fonterra. Comments from Reserve Bank of New Zealand (RBNZ) governor Wheeler also triggered fears that the RBNZ is intervening in the currency market to weaken the NZD in the current bearish sentiment. Though the technical outlook in the NZD remains weak and the downward price momentum could be accelerated by stop losses, we doubt this will persist for long for the following reasons. First, the interest rate differential between New Zealand and the US does not justify the level in NZD/USD. Second, the RBNZ has limited FX reserves to push the currency down on a sustainable basis. As such, we remain cautiously optimistic that the NZD could recover later this year.
Other commodity currencies were not spared
Other commodity currencies like the Canadian dollar (CAD), Australian dollar (AUD) and Norwegian Krona (NOK) also underperformed last week. The Canadian dollar (CAD) reversed its previous week’s gains as retail sales in July recorded the first month-on-month contraction this year. Furthermore the Bank of Canada senior deputy governor Wilkins implied that monetary policy will remain accommodative for long given weak employment growth and slack in the economy. Lower iron ore prices continue to weigh on the AUD. The Reserve Bank of Australia has also stated that sounder bank lending practices are favoured to cool the housing market rather than blunt tools like interest rate hikes. The technical outlook for the AUD remains weak and this increases downside risk for prices towards this year’s low of 0.8660. We expect this support to hold given that the options demand to hedge downside risks in the AUD has not increased substantially.
Japanese yen – awaiting further catalysts
Wider interest rate differentials between the US and Japan weighed on the Japanese yen last week. In addition, Japan Economy Minister Amari also fuelled current market speculation that the BoJ may need to ease more by stating that if the economy needed more support, the main measures would come from the central bank rather than fiscal stimulus. However, the market seems reluctant to add more short positions given its recent sharp sell-off while technical indicators continue to imply that the currency is oversold. Furthermore, the debate on whether a weak currency is good or bad for the economy is heating up. Indeed, Prime Minister Abe has stated that they are closely monitoring if a weak yen would adversely impact small companies. We think that such concerns should not be exaggerated given that small companies have historically been able to pass on higher import prices to end customers. Nevertheless, we agree that sharp movements in the currency as we have seen in the past month are not desired as companies have little time to adjust and hedge their currency exposures.