US dollar index highest level since the middle 2010
Speculation that the Fed could become less dovish continued to support the US dollar (USD) last week. Against its trade weighted basket of currencies, the USD has risen to the highest level in four years.
As the market’s expectation for the fed funds rate at the end of 2015 is still below what is being signalled by FOMC members, there is room for further adjustment in rate expectations and the dollar. The FOMC meets this week and its rate projection could move up a bit further. However, we expect it to stick to its guidance that rates will stay low for a ‘considerable period’.
Market positioned short euro
The euro consolidated around 1.29 after its sharp fall from 1.37 since July. With short speculative futures positions in euro excessive, stronger catalysts (downside surprises in the eurozone and/or more hawkish Fed) will be needed to push the euro below the important support zone around 1.2750.
Sterling captivated by referendum
Selling interest in sterling continued as preliminary polls showed a relatively tight race in this week’s Scottish independence referendum. Meanwhile, the Swiss franc’s (CHF) strength against the euro reversed after the SNB said that further measures such as negative interest rates might be implemented should the strength in the CHF intensify.
Commodity currencies under pressure
The Australian dollar (AUD) slumped by more than 3% as the key support level at 0.92 was breached. Stop loss selling exacerbated the downward move. The negative sentiment was due to a combination of factors: broad USD strength, a deterioration in Australian business and consumer confidence, lower iron ore prices, weaker than expected economic data in China and scepticism that the improvement in employment figures in August will prove sustainable. The NZD also came under pressure after the Reserve Bank of New Zealand (RBNZ) signalled that monetary policy will remain on hold for a while. Furthermore the central bank reiterated its discomfort on the strong exchange rate and that current levels remain unjustified and unsustainable. We now expect the RBNZ to keep monetary policy unchanged at 3.50% for the rest of 2014 before resuming its tightening cycle in early 2015, with the official cash rate rising to 4.25% by the end of 2015. Our NZD/USD forecasts in 2014 and 2015 remain unchanged at 0.82 and 0.80 as our view is not materially different to what is priced in by the market. Furthermore the central bank expects the terms of trade to improve in 2015 as New Zealand’s key commodity export prices recover after falling considerably recently. This should provide some support to the NZD as the Fed tightens monetary policy next year. Lower oil prices and expectations that both economic growth and monetary policy tightening in Canada will lag the US weighed on the Canadian dollar (CAD). Indeed, the Ivey PMI price subcomponent suggests that core inflation is likely to trend lower in the coming months. Our view that the CAD will ease towards 1.15 against the USD this year remains unchanged.
Yen: too fast and furious?
The Japanese yen (JPY) continued to slide last week, with USD/JPY rising to above 107 as interest rate differentials between the US and Japan widened. Economic data releases in Japan disappointed which increased market speculation that the Bank of Japan (BoJ) may need to ease monetary policy further in the months ahead. Economic growth in the second quarter was revised lower from -6.8% to -7.1% qoq annualized driven by sharper decline in consumer and business spending. In addition the trade deficit in July widened. Surveys also showed that households have become more pessimistic, while businesses remain optimistic. However it is worth noting that the Ministry of Finance’s third quarter business outlook survey showed that large firms expect business conditions to rebound in the third quarter before easing lower in the next two quarters. Late last week, BoJ Governor Kuroda said that as inflation remains on track, further monetary actions are not considered at this point. However the central bank stands ready to adjust policy if the 2% price target is at risk. With respect to the yen, the Governor stated that current levels are reflecting fundamentals and are not a negative for the economy. Meanwhile, domestic investors outward investment in foreign assets accelerated in the week ending 5 September. Our view that the yen will decline towards 110 by the end of the year remains unchanged. However given that technical indicators imply that the yen is oversold and speculative short positions in the yen are increasingly overcrowded, we expect 108 to cap the weakness in the yen in the near term.
Volatility expectation in currency markets spikes higher
Since the beginning of this month, volatility expectation in currency markets have spiked by around 40%. With major currencies breaking out of their summer lull trading range, the demand to hedge against larger price movements in the options market have increased. Indeed, volatility expectation in the euro has surged by 30% (within the next one month) as psychological support at 1.30 was breached. Uncertainty surrounding the Scottish independence referendum also pushed up volatility expectations in the GBP by almost one fold. The demand to hedge downside risks also surged as the AUD/USD broke below the key support level of 0.92.
GBP and NZD: what happens after the elections?
In the past month, the GBP and the NZD have underperformed by about 4% and 3% respectively due to uncertainty surrounding Scottish independence referendum (18 September) and elections in New Zealand (20 September), respectively. The NZD could recover to above 0.82 after elections given that the ruling National party in New Zealand has about 50% support based on Herald-DigiPoll survey on 5 September. On the other hand the fate of the GBP seems more uncertain as a recent opinion poll shows a relatively tight race between the ‘Yes’ and ‘No’ Scottish independence camps. In the event of a ‘Yes’ outcome, the GBP could drop by 5% and test the 1.54 level versus the USD. On the other hand a GBP recovery towards 1.65 cannot be ruled out should the pro-independence camp lose.
Lower emerging market currencies
Higher yields in the US pressured emerging market currencies last week. The Brazilian real was the worst performer due to uncertainty surrounding Presidential elections on 5 October and a sovereign credit rating outlook downgrade by Moody’s (from stable to negative). The South African rand declined by 3% as the current account deficit in the second quarter widened and inflationary pressures intensified. The Turkish Lira also declined by more than 2% as the economy contracted by 0.5% qoq, much worse than market expectations of a 0.4% expansion. That triggered market speculation that the central bank may need to continue loosening monetary policy to stimulate domestic demand. In Asia, the South Korean won was the worst performer, declining for the second consecutive week due to concerns that the weak yen and euro would affect South Korea’s export competitiveness. Furthermore the Finance Minister and the central bank continued to express caution on the economic recovery, raising market speculation that interest rates could be cut further. On the other hand, the Chinese yuan was resilient as the trade balance in August widened. However, the decline in import growth in August raised concerns about domestic demand. Furthermore consumer price inflation also eased. The acceleration in producer price deflation suggest that overcapacity in the industrial sector persists. Weaker than expected industrial production and fixed assets investments in August also reflect economic challenges remain. We continue to see a modest 1% upside in the yuan towards 6.10 by the end of this year. We expect 6.1550 – 6.1625 to provide some support to the current short term weakness in the yuan.