Another strong week for the US dollar
At the start of last week, the US dollar showed no clear direction. There are several reasons for this. For starters, financial markets were cautious ahead of the FOMC meeting. Initially there were some expectations that the Fed would change its guidance. As the meeting approached, though, some of these expectations were scaled back. Moreover, speculative positions in the futures market in US dollar (net long), euro (net short) and Japanese yen (net short) are already quite substantial. Therefore, economic data or events are having a lower impact in accelerating the current trends of a higher US dollar and lower euro and yen. These positions will continue to loom over the market in the near term. However, it is quite likely that the current trends will continue for some time, despite these positions being large.
The US dollar rally restarted after the Fed signalled that more interest rate hikes are likely in the coming years. USD/JPY flew to levels above 108.50, while EUR/USD dropped below 1.29. What is quite remarkable is that financial markets have been rather reluctant to price in tighter monetary policy in the US next year. For example, interest rate markets continue to price in fewer rate hikes than the Fed is currently signalling. The Fed also signalled that it is data-dependent compared to being calendar-dependent. In our view, the market will ultimately adjust upwards its expectations on the path of Fed rate hikes as US economic data are likely to remain strong. This will further fuel the US dollar rally across the board. In short, we remain US dollar bullish despite the strong rally we have seen since July of this year. The crucial support area in EUR/USD is 1.2750-1.2800. If this is taken out, stop loss orders layered below this level are likely to accelerate the move. We believe that it is just a matter of time before the market will test this level and eventually break it.
Yen out of favour
The Japanese yen broke the 108 level as interest rate differentials between the US and Japan widened. What is more, stop losses above 108 and 109 exacerbated the upward move. Furthermore, the weak trade report in August imply that the export-led recovery has not yet materialised and that domestic demand remains weak. Therefore, this will increase the pressure on the Bank of Japan to ease monetary policy to stimulate the economy sooner rather than later.
Sterling outperformed other major currencies. There were two reasons for this. For starters, the Scots voted decisively to remain part of the UK. What is more, the UK labour market report underlined the strength of its economy, but also that inflation pressures are building. This resulted in an overall improvement in investor sentiment towards sterling and as a result, sterling moved higher.
Canadian dollar outperformed the US dollar
The Canadian dollar (CAD) managed to make gains against the US dollar. This was due to a more optimistic tone emanating from the Bank of Canada (BoC). For example, Governor Poloz indicated that there have been encouraging signs that exports and business investment are replacing household spending as the main engines of growth. Nevertheless, our view that the CAD will underperform the USD remains unchanged as both economic growth and monetary policy tightening in Canada will lag behind the US in 2015.
Swiss National Bank does not meet market expectations
The Swiss National Bank (SNB) left monetary policy unchanged last week. It also reiterated that it will continue to defend the cap in the Swiss franc layered at 1.20 versus the euro. The SNB has been very clear on this. It is prepared to purchase foreign currency in unlimited quantities and if necessary, will take further measures immediately. In addition, it adjusted downwards its conditional CPI forecasts and stated that the risk of deflation in Switzerland has increased again. Recently, the market had started to anticipate that the Swiss National Bank would also cut interest rates sending them into negative territory. This would be intended to halt the upward pressure on the Swiss franc versus the euro as the euro deposit rate is already negative. So the market was quite disappointed that the SNB did not deliver this. For example, a negative official rate in Switzerland could trigger outflows, pushing the Swiss franc lower. The SNB could have taken such a decision because inflation, being just above zero year-on-year represents a downside risk. It is likely that the market will test the SNB on its commitment to buy unlimited amounts of euro versus the Swiss franc. Furthermore, financial markets will probably put further pressure on the SNB to cut official interest rates to negative territory in order to weaken the Swiss franc. Therefore, we hold on to our short Swiss franc position versus the US dollar, because the US dollar will probably profit the most from such a move.
Lower emerging market currencies
Emerging market currencies were clearly on the defensive versus the US dollar last week. The Russian ruble was the most out of favour, while the Hungarian forint was able to outperform even the US dollar. The Hungarian forint profited from an improvement in investor sentiment, following a well-received bond auction.
In Asia, the Indonesian rupiah was the worst performer as investors took profits on their positions in the local market. The Indonesian government also announced that before November they will reduce the fuel subsidy by 3000 IDR/litre. According to the central bank’s estimate, this is likely to push inflation higher by around 3.3-3.5pp. Because the reduction in the fuel subsidy will increase inflation, it is likely that the central bank will be more reluctant to ease monetary policy to stimulate the economy. Early last week investor sentiment towards the Chinese yuan deteriorated as weaker economic data reignited concerns that the rebalancing in the economy remains fragile. In addition, outward direct investments surpassed net foreign direct investments for the second consecutive month in August. This was due to concerns that foreign companies are being discriminated against amid widening antitrust probes in China. The yuan recovered later in the week after the central bank injected targeted liquidity measures. In addition, the government also announced further measures to support financing and tax cuts to small businesses. We maintain our view that Chinese authorities will implement targeted stimulus if economic data continue to deteriorate. This year we still expect the yuan to appreciate a little further to 6.10. However, 2015 should see some weakness versus the US dollar as it moves towards 6.20.