FX Weekly – The cyclical dollar

by: Georgette Boele , Roy Teo

FX-Weekly-10-November.pdf ()
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A strong US economy, positive investor sentiment and some upward adjustment in US interest rate expectations for 2015 are the golden triangle for the US dollar. In addition, monetary easing in other big economies has also supported the US dollar. We expect this environment to remain in place in the coming months. Therefore, more US dollar strength is likely in our view. Weakness in the euro and Japanese yen continued on expectations of further monetary policy easing. This weakness hurt Asian currencies. Meanwhile, the central banks of Brazil and Russia appear to be more hands off in terms of currency intervention. We closed our long CNY/JPY position, because we think that Chinese yuan versus the US dollar has peaked and additional yen weakness is more likely versus the US dollar.

Triple boost for the US dollar

Quite some time ago we shared our view that the US dollar would start behaving like a cyclical currency leading to its ascent. What does a cyclical currency mean? This means that:

  • a currency profits when global/domestic growth improve,
  • when investor sentiment is positive and
  • its central bank pursues a relatively less accommodative monetary policy

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In such an environment domestic stock markets rally, equity volatility (VIX) moves lower and interest rate expectations rise. We call this a triple boost for a currency. It is counterintuitive to have the US dollar behaving like a cyclical currency, because the US dollar is often seen as a safe-haven currency. Currently it is clearly behaving as a cyclical currency. This manifests itself in a positive relationship between the US dollar and the Dow Jones and 3M interest rate expectations for  2015 (ED Dec 2015, see first graph). In addition, the US dollar is currently experiencing a negative relationship with equity market volatility or the VIX (second graph).

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Why is this? For starters, US economic growth is going from strength to strength. This results in an increase in confidence in US assets and a rally of US equity markets. The strong US economic background is also resulting in more positive investor sentiment. Last, but not least, the US Federal Reserve has ended asset purchases. Indeed, the stance within the FOMC is increasingly becoming more hawkish. It is likely that it will start the tightening cycle in June 2015, something that is in line with our view but is barely priced into financial markets. The triple boost for the US dollar results that it is behaving like a cyclical currency. We expect this theme to remain a major positive driver for the US dollar in the near term and in 2015. The US dollar has already strengthened above our year-end target. The risks are for a further strength of the US dollar in the months ahead. Our year-end 2015 forecasts for EUR/USD and USD/JPY are 1.15 and 125 respectively.

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Dovish ECB keeps euro under pressure

ECB President Draghi signalled that additional monetary easing was in the pipeline. We think further action could already be announced as soon as next month’s meeting. The key line in the press conference was that the Governing Council has ‘tasked relevant euro system committees with the timely preparation of further measures’.  Although he added ‘if needed’, one of the key contingencies to further action appears to have already been met. Indeed, Mr Draghi admitted that the Council saw ‘indications’ for downward revisions to its forecasts. It seems very likely to us that the ECB will reduce both its growth and inflation forecasts next month.

The ECB President also stressed that size matters when it comes to its balance sheet. He clarified that the ‘early 2012’ expectation for the balance sheet referred to the March level, which implies an expansion of EUR 1 trillion. The TLRTOs are an important measure in this respect. He also talked up the potential size of the covered bond and ABS purchase programmes, saying that these markets would grow, further increasing the universe of assets the ECB could buy. All the talk leading up to the Governing Council meeting was of a clash between President Draghi and the more dovish members on the one side, and the more hawkish officials led by the Bundesbank on the other. Mr Draghi obviously played these stories down, stressing that the statement was unanimously agreed by the Council. However, it seems that the doves have come out on top given that the central bank has both signalled further easing and underlined the importance of balance sheet expansion. The price of this in terms of compromising with the hawks seems to be that further easing will not be in the form of government bond buys. As a result of a more dovish than expected ECB, the euro dropped below 1.24 before stabilising. The US Employment report came in strong but not as strong as financial markets had hoped for. After this report EUR/USD stayed close to 1.24.

Japanese yen remains out of favour…

Monetary policy divergence remains the main driver for USD/JPY. The strong rally has mainly been driven by more monetary stimulus by the Bank of Japan, while some upward adjustment in US interest rate expectations for 2015 also helped. It is likely that further strength in USD/JPY will be driven by expectations of higher US interest rates. Our year-end target in USD/JPY at 115 has been reached. Though technical and sentiment indicators continue to imply that the rise in USD/JPY is overdone, the trend could continue for now. This is because it is likely that investors positioned for a recovery in the yen throw in the towel and outward investments from local investors could continue. The weakness in the yen could extend to 118 before profit taking and consolidation process takes place.

… but we close our long CNY/JPY position.

The Chinese yuan was resilient due to market speculation that authorities in China will lower borrowing costs to support the economy. We remain sceptical that Chinese authorities will tolerate further gains in the currency given declining inflationary pressures. Indeed, since the end of October, given the weakness in other currencies, the People’s Bank of China has raised the USD/CNY fixing rate from 6.14 to 6.16 as they attempt to signal a stronger yuan does not reflect economic fundamentals. We think that the yuan (CNH) has peaked around 6.11 against the USD with prices likely to head lower towards our year-end target of 6.17. In addition, although we remain negative on the yen, we expect that additional weakness is more likely versus the US dollar than versus the Chinese yuan. As such we have closed our long CNH/JPY high conviction call with a total return of 12.75%.

Australian dollar weakness not far behind the yen

The Australian dollar (AUD/USD) was also out of favour, by sliding more than 2%. The main reason for its performance was market disappointment in economic data. Not only did the contraction in the service sector accelerate in October, the trade deficit in September widened to the highest level since November 2012. The strong growth in the construction sector has also slowed. When AUD/USD moved below 0.8650, stop losses were triggered, which exacerbated the downward movement. The risk has increased that the Reserve Bank of Australia will tighten monetary policy later than we currently expect (Q4 2015). This is because lower commodity prices will dampen the effect of a weaker Australian dollar on higher inflation and on economic growth. We expect any relief rally in the AUD/USD towards 0.8650 to be faced with renewed selling interest with prices likely to end the year lower at 0.82.

More hands off policy to currency intervention in Brazil and Russia…

US dollar strength was also being felt versus emerging market currencies. The interesting development last week was that two major emerging market central banks appear to have changed their stance towards currency intervention. For starters, the central bank of Brazil decided last week to surprisingly hike interest rates by 25bp to 11.25% and decided this week to reduce the rollover of FX swaps meaning less support for the Brazilian real. This is a signal that policy may be moving into the direction of more rate hikes to contain inflationary pressures instead of direct intervention to prop up the currency.

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Moreover, the behaviour of the central bank of Russia also changed. Last week it aggressively intervened in FX markets – with daily interventions up to $3bn a day – to stop the fall in the Russian ruble that already lost more than 40% so far this year versus the US dollar. It also hiked the policy rate on 31 October by 150bp to 9.5%, which was above market consensus. Both decisions were not sufficient to halt the sell-off in the ruble. On Wednesday, the central bank communicated that it will allow more exchange rate flexibility going forward. One of the reasons why the ruble faced so much downward pressure was speculation that it would weaken more significantly once the CBR would move to a flexible exchange rate regime, a move that was generally expected to take place at the beginning of next year. Last week, the CBR pre-empted this threat by capping the amount of FX interventions to just $350m a day, though the central bank could still carry out one-off interventions in case of financial threats. As a result of the decision, the ruble has continued to weaken. As such, we think that the central bank of Russia will soon be forced to continue hiking rates aggressively in order to support its currency. Both the Brazilian real and the Russian ruble were among the weakest performing currencies.

…while weak euro and yen hurt Asian currencies

In Asia, weakness in the euro and yen continue to weigh on Asian currencies. The South Korean won was the worst performer, sliding by more than 2% due to market speculation that the central bank may cut interest rates in the coming months to curb gains in the won-yen exchange rate. Indeed, one of the central bank board member stated that there is room for monetary conditions to be more accommodative due to weak demand and downside risks to the economy from weak yen. On the other hand, the Chinese yuan was resilient due to market speculation that authorities in China will lower borrowing costs to support the economy. We remain sceptical that Chinese authorities will tolerate further gains in the currency given declining inflationary pressures. Indeed, given the weakness in other currencies, the People’s Bank of China has raised the USD/CNY fixing rate from 6.14 to 6.16 since the end of October as they attempt to signal a stronger yuan does not reflect economic fundamentals. We think that the yuan (CNH) has based around 6.11 with prices likely to head higher towards our year-end target of 6.17.

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