US dollar: healthy correction
From the start of July up until 3 October, the dollar index rallied strongly in almost a straight line. This was reflected by an 8.5% drop in EUR/USD and a 7.7% rally in USD/JPY. These strong directional moves were mainly the result of diverging monetary policies among the three major central banks. As a result, speculative positions were pushed into excessive territory. For example, net-long positions in the US dollar were at a record high, while net-short positions in the euro and the yen were also substantial (see graph).
Although excessive positions will usually not indicate when a trend is about to change – as such a state could continue for quite some time – movements could become more erratic or volatile. For example if a certain technical level halts the move, a part of the market could be motivated to take profit on open positions. This played out on Friday afternoon and on Monday. For example the 1.2500 level in EUR/USD proved to be a too hard a nut to crack. After investors tried several times to take out this level, they decided to take profit, which pushed EUR/USD up from 1.2501 (low on Friday) to 1.2675 (Monday evening). Afterwards, investors mainly focussed on the dovish remarks from some Fed officials in the FOMC minutes to take further profit. We judge that this was just a healthy profit taking wave after the recent strong rally seen. The move in EUR/USD ran out of steam close to 1.28. Since then, the market has become more positive on the US dollar again. This support seems to have come from a deterioration in investor sentiment given that investors have become concerned about the global growth outlook and the worry that a larger equity market correction may be around the corner. We expect this deterioration in sentiment to be temporary. It is likely that the US dollar will rally strongly again in coming months. We think the key driver will be an upward adjustment in expectations about the path of the Fed’s policy rates in 2015.
Safe have currencies outperform…
The deterioration in investor sentiment gave support to the Swiss franc and the Japanese yen last week. Lower equity markets, higher equity volatility and lower government bond yields also highlighted this deterioration in sentiment. As stated above, financial markets are mainly worried about the prospects for global growth driven by the recent weaker than expected eurozone data. We remain relatively positive the eurozone growth front and expect a modest recovery. If the eurozone economy were to substantially deteriorate then the ECB will ease monetary policy even further.
The Japanese yen also benefited from a decline in US yields. The BoJ maintained its outlook that inflationary pressures will pick up in the second half of this year and hence any adjustments in monetary stimulus are not warranted anytime soon. Nevertheless, the BoJ reiterated that there are still many options available to expand the central bank’s asset purchases which include domestic government and corporate bonds, JREITs and commercial papers. On the currency, Governor Kuroda said that on balance a weak currency is positive for the economy as a whole and that a weaker currency should support exports. We expect the BoJ to lower its GDP and inflation outlook in the next monetary policy review on 31 October, followed by more stimulus later this year. This is against market consensus and not priced in by the market. Therefore, it should provide a strong catalyst for the yen to decline further towards our year-end target of 115 against the USD. In the short term, we see upside in the yen to fade around 107.
…and high yield currencies also rebound
The beneficiaries of a weaker USD were also high yield currencies which had underperformed sharply in the past few weeks. The Australian and New Zealand dollar benefited, despite mixed domestic data releases. In Australia, inflation gauge in September declined for the third consecutive month, reinforcing our view that inflation is likely to trend lower from 3% in the second quarter towards 2% in the second half of this year. Furthermore, employment indicators suggest that there is still sufficient slack in the job market despite tentative signs that the deterioration has slowed. On the bright side, the construction sector continues to expand at a faster pace, though the pace of expansion may slow later this year when the government implement tougher measures to cool the housing market. Overall, we judge that the current relief rally is now behind us and that downside risks are building again. Our year-end target of 0.86 remains unchanged. In New Zealand, the number of optimists among businesses surveyed declined in the third quarter. Nevertheless, economic growth is expected to remain above trend rate of 2.8% in the second half of this year and inflation to rebound from 1.6% in the second quarter to 2.5% in early 2015. Our forecast that the RBNZ will resume its monetary tightening bias in early 2015 and the NZD to decline towards 0.77 against the USD remains on track.
Bank of Canada to remain cautious
The Canadian dollar was also supported due to market speculation that the central bank may sound more optimistic in next week’s monetary policy meeting. This was triggered by a strong jump in September Ivey PMI to the highest level since October 2013. Though we acknowledge that this bodes well for the economic and inflation outlook, we think it will be premature for the Bank of Canada to become hawkish given that job growth in the first 8 months of this year is slower than last year. Furthermore, the trade surplus in August has reversed. Last but not least, oil prices have slumped to the lowest level since early 2013. We expect the CAD to ease towards 1.15 against the USD by the end of this year.
Emerging market currencies
In general, most emerging market currencies were able to profit from a weaker US dollar. The deterioration in sentiment in financial markets did not hurt emerging market currencies so far. The Brazilian real rallied strongly as the sentiment remains positive. The latest Ibope poll, which was published by Globo, showed Aécio Neves being ahead of Dilma Rousseff within margin. Currently Aécio Neves has a strong momentum and financial markets favour him. In Asia, the Indian rupee was supported on expectations that economic growth will be stronger in the second half of this year. Lower oil prices should also benefit India’s oil trade deficit and support a narrowing of current account deficit.
The Russian ruble was the most out of favour. This is mainly because of reports of capital outflows and a lower oil price. Moreover, the central bank allowed the ruble to depreciate, despite the central bank intervening in currency market to prevent a sharp fall (see our Russia Watch: A deteriorating outlook). Expectations that the Bank of Korea will cut the 7-day repo rate by 25bp to 2.0% this week weighed on the won (see our Emerging Asia Watch: Still in the lead).