FX Convictions – Views remain in place

by: Roy Teo , Georgette Boele

FX-Convictions-31-October-2014.pdf ()
  • US dollar rally took a breather…
  • …firmer US dollar expected well into 2015
  • We keep our high conviction views in major currencies in place…
  • … being bearish on EUR, JPY, CHF, AUD against the USD…
  • … but positive on MXN against EUR and CNH against JPY

Australian and New Zealand dollar outperform…

Expectations that the Fed may slow the pace and extent of rate hikes in 2015 benefited high yield currencies like the Australian and New Zealand dollar. Both currencies managed to recover as economic growth in China, their main export partner, slowed less than expected. This was despite the fact that inflation in the third quarter in both economies declined more than market consensus. As a result it is likely that the RBNZ will delay tightening monetary policy until the middle of 2015.

…while Scandinavian currencies being out of favour

Scandinavian currencies, Norwegian krone and Swedish Krona were the most out of favour on expectations of further monetary policy easing because of low inflation. For example the Riksbank lowered interest rates to 0.0% from 0.25% which was more aggressive than expected. In addition, it lowered its rate path more than expected. It pushed out a possible start of the tightening cycle from 2015 to 2016 and stated that the zero repo rate will remain in place until inflation clearly picks up. In the case of the Norwegian krona, lower oil prices were also being felt.

 …but the US dollar was mixed

After its spectacular gains from July to early October, investors took profit on long positions in the US dollar. The slide in 10y US Treasury yields and a considerable drop in US inflation expectations (driven by the substantial drop in oil prices) were the most important reason for this profit taking. In addition, weaker than expected US data releases, more dovish FOMC minutes and the market focus on dovish FOMC comments also added pressure. However the US dollar recovered later this month as economic data remained firm and expectations that the Fed may delay the conclusion of asset purchases faded.

EM FX also mixed

Profit taking on the US dollar and lower US Treasury yields came as welcome forces for emerging market currencies. In addition, currencies of countries that import oil did also do well for example the South African rand and the Turkish lira. The South African rand rose by more than 3% also because of a slight improvement in investor sentiment. This was the result of lower than expected inflation data and expectations that actions to improve  the fiscal outlook will be implemented. The Turkish lira also gained as both the inflation and external imbalance improved.

However, currencies from countries that export oil were mostly out of favour. The Russian ruble dropped by almost 5% due to market concerns that Russia’s credit rating may be cut to junk. As a result, Russian assets were sold off. The central bank was also unable to halt the slide in the ruble despite currency intervention. In fact, the central bank said that it eventually would like to halt these interventions and to move to inflation targeting. In the case of the Brazilian real, the outcome of the presidential elections,  re-election of Dilma Rousseff, was not seen favourable by financial markets. However the currency recovered strongly after the central bank unexpectedly hiked interest rates to cool inflationary pressures.

Firmer US dollar expected

Our view that the US dollar will continue to be favoured well into 2015 has not changed. Concerns that the strong currency will weigh on economic growth and push down inflationary pressures should not be over exaggerated. In our US watch “Rising dollar a headwind” published on 14 October, we have argued that the strong currency effect on the trade balance, economic growth and inflation will be modest. We continue to expect the US economy to grow above trend rate in 2014 and 2015 and this will reduce market slack in the job market, pushing up wage growth and inflationary pressures. Furthermore, the market is significantly under-estimating the timing and pace of Fed rate hikes next year. Monetary policy divergence between the US, Eurozone, Japan and China will continue to support the US dollar.

We keep in place our long US dollar views versus the euro, the yen, the Swiss franc and the Australian dollar; long Mexican peso against the euro and Chinese yuan outperformance against the yen.

Euro to remain under pressure…

We remain negative on the euro despite the recent fall. This trend is also supported by the ECB. It has finally started to react to weak economic growth and low inflation and has started to ease monetary policy further. In short, the ECB will do all that it can to fuel the slide in the euro. Monetary policy divergence across the Atlantic will remain a major theme for the euro versus the US dollar. In addition, the contrast of higher US Treasury yields and strong US growth will also hurt the euro versus the US dollar. However, we do expect the market to become less gloomy about the eurozone economy. This could dampen the downside in EUR/USD somewhat.  However the substantial upward adjustment in US rate hike expectations will be far more negative for the euro versus the US dollar. What is important that better eurozone data will improve overall investor sentiment. As a result, investors will focus more on growth and monetary policy divergence which is in favour of the US dollar.

 BoJ easing: catalyst for weaker Japanese yen

We are of the view that the recent strength in the yen against the dollar to below 106 is a healthy transitory correction. Since 15 October, the dollar has recovered to 109 against the yen as short term yields in the US firmed and risk sentiment in financial markets improved. Furthermore, we suspect that Japanese lifers are taking advantage of periods of yen strength to purchase overseas assets as they seek to increase their portfolio returns. Indeed, most life insurers have recently announced their investment plans for the second half of FY 14 (October 2014 – March 2015) and a majority of them has indicated that they have an intension to allocate more funds to foreign bonds as domestic yields remain low. The majority of foreign debt are in US treasuries. Furthermore, some have also stated that they have reduced their currency hedge ratio in their overseas purchases. Another catalyst for further weakness in the yen is that we expect the Bank of Japan (BoJ) to further ease monetary policy later this year as it attempts to achieve its 2% inflation target by 2015. Please see our BoJ Watch “More easing on the cards” published on 30 October 2014. This is not widely priced in by the market. For example, a Bloomberg poll conducted from 26 September to 2 October showed the following. Fewer than 25% of economists expect the BoJ to embark on more easing measures in 2014. In the meantime, slightly more than 40% of those surveyed expect the BoJ to wait until early next year, while 33% do not expect more actions. Last but not least, we expect interest rate differentials between the US and Japan to widen as the US economy firms, providing further support to the dollar against the yen towards 115 by the end of this year.

 Australian dollar: weakness lies ahead after consolidation

As highlighted in our previous report, the Australian dollar (AUD) has based above 0.86 as technical indicators imply that the currency was oversold after its sharp decline in September. Sentiment in the AUD was also supported as China (Australia key export destination) slowed at a more measured pace in the third quarter. However, we are of the view that more weakness in the AUD lies ahead after the current consolidation phase ends. On the domestic economy, we continue to expect lower inflationary pressures in the fourth quarter. Moreover, the rebalancing in the non-mining sectors  remains slow and the Reserve Bank of Australia continues jawboning the currency lower. Furthermore, the only bright spot in the economy, the housing and construction sectors, are likely to experience slower growth. This is because it is likely that macro prudential tools and tighter bank lending practices will be implemented later this year. The 50% decline in iron ore prices since the beginning of this year is also expected to weigh on the terms of trade and economy’s income effect. This will occur during the coming months where further significant declines in mining investment are expected. In short, we are of the view that the economic and inflationary divergence between Australia and the US will widen in the coming months. This is negative for the AUD/USD. We maintain our view that upside in the AUD/USD is likely to be limited towards 0.89-0.90. Our 2014 and 2015 year end targets of 0.86 and 0.80 remain unchanged.

CNH outperformance against JPY has resumed

The Japanese yen outperformed the Chinese yuan in the past month due to safe haven demand on the back of softer global growth outlook. We expect such support for the yen to fade as we remain optimistic on the global economy. In addition, the slowdown in the Chinese economy in the third quarter was less than market expectations, reinforcing our view that authorities in China have the tools to engineer a gradual rebalancing in the economy. Furthermore, we are of the view that any stimulus from China is likely to be specific while in the case of Japan an extension of current qualitative and quantitative easing programme is expected. As a result, monetary divergence between both economies are likely to favour the yuan over the yen. Last but not least, we maintain our view that the yuan will be more resilient than the yen to tighter monetary conditions in the US. We expect an upside potential of about 5% in CNH/JPY by the end of this year.

MXN long versus EUR

Long Mexican peso view has often been challenged by market performance. It has been very reluctant to move in our direction. The wave of profit taking on US dollar longs combined with lower oil prices and risk aversion did not support the Mexican peso versus the euro. However, we continue to like the Mexican peso.  For starters, we remain positive about its prospects for the economy and its strong ties with the US economy. In addition, oil prices will likely recover in the near term taking away this headwind.  We expect large capital inflows because of the energy overhaul.  In addition, the central bank will also start tightening in the course of 2015 to fight inflationary pressures. Last but not least, speculative long positions have been reduced so there is room to enter new long positions.  To conclude, we continue to favour Mexican peso versus euro.