- We have adjusted our FX forecasts to reflect our expectation of an even stronger dollar
- EUR/USD is now seen at 1.25 at year end, while USD/JPY is forecast to rise to 115
- Eurozone sentiment lower, but in line with moderate growth; today’s inflation could be stable
US strength to continue
Since July 2014, the US dollar index has rallied strongly. The euro and the Japanese yen, which both have weakened significantly, have large weights in this index. This rally has had a mixture of different drivers. For starters, there are signals that the US Federal Reserve is gradually moving closer to the point where it will raise interest rates given encouraging signs that US economic growth has accelerated. Such a prospect makes the US dollar an unattractive currency to use as financing currency in the so-called carry trades. These trends have further to go. Interest rate markets have so far been reluctant to fully price in the rate path that currently is signalled by the Fed. This complacency has even surprised some Fed officials. We expect even slightly higher rates than the Fed is currently signalling. If markets start to catch up to the likely extent of rate rises next year, the US dollar will likely appreciate further. Given this, we have raised our US dollar forecast across the board. Our new forecasts for EUR/USD are as follow: 1.25 for year-end 2014 and 1.15 year-end 2015 (compared to 1.28 and 1.20, respectively, before – see also table).
Euro to remain under pressure
This trend is also supported by the ECB. It has finally started to react to weak economic growth and low inflation and has eased monetary policy further. As a result, financial markets have increasingly priced in the possibility of quantitative easing in terms of large scale purchases of sovereign bonds. We expect the central bank to ultimately stick to more modest monetary stimulus, but in the meantime it will likely keep the prospect of QE very much alive. A weaker euro makes a lot of sense from the ECB’s perspective, because it will not only be supportive for eurozone growth but also for inflationary pressures. In short, the ECB will do all that it can to fuel the slide in the euro. As such, we remain negative on the euro despite the recent fall. As a result, we have modestly adjusted downwards our near-term EUR/GBP forecast. We also have pulled forward sterling strength versus the euro by some quarters, because it is very likely that the BoE will hike official rates before the Fed. This is, however, mostly reflected in the price. Our new year-end forecast for EUR/GBP is 0.78 (old 0.79).
Japanese yen to weaken further
In addition, it is likely that weakness in Japanese yen has further to. This is because USD/JPY is very sensitive to developments in the interest rate spread between the countries. We not only expect the Fed to hike more than currently is anticipated by financial markets and signalled by the Fed. We also expect the BoJ to step up its monetary easing program this year, something that is not widely anticipated by investors. Therefore, the rally in USD/JPY will continue. Our new forecasts are 115 year-end 2014 (before 110) and 125 year-end 2015 (previously: 120).
Eurozone economic sentiment lower; today’s inflation stable
Economic sentiment in the eurozone declined from 100.6 in August to 99.9 in September. At its current level, sentiment is very close to the long-term average value of 100, and consistent with moderate GDP growth of around 0.3% qoq. A similar picture was painted by the eurozone composite PMI for September that was published last week. Meanwhile, early inflation data for September pointed to upside risks to today’s eurozone flash estimate for that month. German inflation was stable (at 0.8% yoy), while Spanish inflation rose (to -0/2% yoy from -0.5% yoy). This suggests that eurozone inflation may well have stabilised at 0.4% yoy, in contrast to the consensus expectation of a further decline to 0.3% yoy.