FX in the currents of three big forces
There have been three dominant drivers in currency markets since the start of this month. Investors have taken profit on extreme long US dollar positions, with the dollar’s move higher losing momentum. This was partly on a focus on less favourable news about the US economy in the process, such as the dovish comments of some Fed officials and rare disappointing US data. Weaker economic data have triggered concerns about the state of global economic outlook, while stronger numbers have been ignored. As a result, investor sentiment has deteriorated dramatically, leading to hysteria at some points. This was reflected by sharp drops in equity markets and bond yields (especially US Treasury yields). Meanwhile, equity volatility and gold prices rose. Last but not least, the sharp sell-off in cyclical commodity prices such as oil, base metals, palladium (to a lesser extent platinum) had an immediate negative impact on currencies of commodity exporters and influenced the expectations about monetary policy of central banks. For example, the recent weaker than expected eurozone data and the drop in oil prices have resulted in a rise in expectations of further monetary stimulus by the ECB.
Meanwhile, financial markets now expect a later start of the Fed hiking cycle. For example, markets have dramatically reduced expectations of Fed rate increases in 2015 (see graph). This reflects that there has been a lot of focus on the comments of more dovish Fed officials. We think that in general the FOMC has confidence in the US economic outlook and judges that inflation will gradually move up towards the central bank’s inflation objective. We could see more commentary from officials in this direction going forward.
Safe currencies outperform while lower inflation and lower oil prices hurt others
Currency markets have been buffeted around, because none of these forces was the most dominant. For a start, the US dollar has fallen under pressure because of profit taking, but also because of a downward adjustment in expectations about US growth and the likelihood of later Fed hikes. However, the euro also has fallen out of favour because of weaker eurozone data, and the fear of deflation and recession in the eurozone. These fears are overdone, in our view. The lower than expected inflation data in the UK have also resulted in investors pushing back their view of the likely timing of BoE rate hikes, which has hurt sterling. Moreover, currencies of oil exporters such as the Norwegian krone, Canadian dollar and Russian ruble were among the weakest. Meanwhile, safe haven currencies such as the Japanese yen and the Swiss franc profited from the deterioration in investor sentiment. In addition, the Australian dollar (AUD) and New Zealand dollar (NZD) received support from market expectations that China has more room to implement targeted easing measures to stimulate its economy, as inflationary pressures have declined.
Emerging market currencies show a similar picture
The behaviour of emerging market currencies also highlighted the tug of war between these three dominant forces. On the one hand, a weaker US dollar and lower US interest rate expectations was a positive for emerging market currencies. On the other hand, risk aversion hurt currencies with vulnerable fundamentals, while lower oil prices hurt currencies of oil exporters. As a result, the currencies of commodity exporters that have weaker fundamentals/political uncertainty were hit the most. For example, the slide in oil prices had a substantial negative effect on the Russian ruble. Russia’s credit rating cut also weighed on the currency. In the meantime, the Brazilian real was mainly driven by election polls and overall investor sentiment. However, currencies of countries that import oil such as Hungary, South Africa and Turkey outperformed the US dollar.
But pessimism is overdone…
As we have noted a number of times now over the last few days, a look beneath the surface suggests that the pessimism is overdone. We still think that macro drivers are consistent with stronger global growth. This should be driven by robust growth in the US lifting other countries around the world. In addition, policymakers in weaker economies such as the eurozone and Japan are continuing to add monetary stimulus and could well step up their efforts going forward. The Chinese authorities are providing targeted support to meet their lower – but still high – growth targets. Last but not least, the sharp fall in oil prices will provide considerable support to global demand. Every USD 10 fall in oil prices increases global GDP by 0.3 percentage points according to our estimates. There is a risk that the pessimism on markets becomes self-fulfilling as financial conditions tighten and confidence in the real economy deteriorates. Though we think it is more likely that stronger economic data will instead lift the gloom and support an improvement in investor risk appetite going forward.
…resulting in a switch back to fundamentals
It is likely that safe haven currencies will sharply come under pressure again in the coming weeks, in our view. The trigger for this will be an increase in confidence about the global economic recovery, especially the strength of the US economy. As a result, cyclical commodities such as oil, base metals and palladium and platinum will variously stabilise or even recover. Therefore currencies of these oil exporters could also recover such as the Norwegian krone, Canadian dollar, Russian ruble and Mexican peso. More broadly, our view that the US economy will do well and that the Fed will eventually raise rates in 2015, suggests that the dollar will resume its uptrend. So, some of these commodity currencies could over time come under renewed pressure again if the US dollar rally resumes its uptrend. We expect emerging market currencies with weaker fundamentals and/or ongoing (geo) political risks to be the most vulnerable such as Russian ruble, Indonesian rupiah, South African rand and Turkish lira. Meanwhile, it is likely that the Mexican peso and Brazilian real will recover. Over the coming quarters we expect the Mexican peso to rise on prospects of a strong US and local economy. Moreover, the Brazilian real will likely recover after the second round of the Brazilian election on 26 October, especially if Brazilian Social Democracy Party Candidate Aécio Neves wins this election.
Growth and inflation outlook to set tone for FX this week
Several key economic data releases this week are likely drivers for the currency market. Early this week, China’s Q3 GDP will be released with market consensus expecting economic growth to decline from 7.5% to 7.2% (we are modestly more positive at 7.3%). This is followed by China’s October manufacturing flash estimate. A weaker than expected outcome would be positive for the Japanese yen, but negative for both the Australian dollar, the New Zealand dollar and other Asian currencies. In the eurozone, October composite PMI and consumer confidence will also be closely watched as market speculation that the ECB will need to ease further has increased. In the US, inflation numbers is also of importance to the market expectations on the timing and pace of Fed raising rates in 2015.