The euro recovered after the stronger German Ifo despite dovish comments for the ECB. The US dollar rally has stalled for now. However, we think that higher US rates will restart the US dollar rally in the future. Commodity currencies were dragged down by lower oil and iron ore prices.
Euro recovers despite dovish ECB comments
The EUR/USD recovered partly last week from the sell-off on Friday 21 November. This was mainly the result of stronger than expected German Ifo index on Monday. Surprisingly, dovish comments from the ECB officials failed to hurt the euro. ECB Vice President Vitor Constancio went further than he has gone before in signalling his openness to sovereign bond buys. In a speech in London, he said that “we expect that within the time of the programme, the adopted measures will lead the balance sheet to return to the size it had in early 2012…If not, we will have to consider buying other assets, including sovereign bonds in the secondary market, the bulkier and more liquid market of securities available. It would be a pure monetary policy decision, buying according to our capital key, within our mandate and our legal competence”.
We think there is a strong possibility that the ECB could further ease the conditions of the TLTROs at the December meeting. In addition, we think it is likely that the ECB will extend its asset purchases in the coming months. Our base case is that it will focus on agency debt and corporate bonds, but the chances that sovereign bonds will be included are clearly significant and have risen further. The December TLTRO outcome (11 December) will be key in giving the ECB a steer in terms of how much more it needs to do. We expect the ECB to remain dovish enough to prevent a sharp recovery in the euro. If the ECB is not as dovish as expected, investors could start closing some of their euro short positions with year-end approaching.
US dollar rally stalled for now
US dollar rally has stalled for now. Speculative long positions in the US dollar are substantial and analysts are aligned in their views that the US dollar has further room to appreciate. This loss in momentum has been reflected by the reluctance of the US dollar to move higher after stronger than expected US economic data. A new driver needs to enter the arena to make a restart of the US dollar rally possible. So the loss in momentum in the US dollar rally is only temporary in our view.
We expect the US dollar to strengthen again as soon as financial markets start to adjust upwards their rate hike expectations for the Fed for 2015 and 2016. Therefore, we remain of the view that EUR/USD has much further downside.
Our year-end targets for EUR/USD for 2015 and 2016 are 1.15 and 1.00 respectively.
Commodity currencies were the main losers
Weakness in commodity prices, mainly oil and iron ore, had a negative spill-over effect on the Norwegian krone, the Australian dollar (exporter of iron ore), the Canadian dollar and Russian ruble. In addition, the Reserve Bank of Australia continued its dovish rhetoric. The Australian Prudential Regulation Authority said that they would be announcing macro-prudential measures to cool the housing market by the end of the year. This will give more flexibility to the RBA to keep monetary policy loose to stimulate the economy in our view.
Bank of Canada to tighten monetary policy in 2015 H2
This week we expect the Bank of Canada to keep rates unchanged. The Canadian economy will benefit as the US economy strengthens. There are already signs that this is happening. For example, the labour market has tightened with the unemployment rate in October declining to the lowest level since late 2008. Core inflation has been above the Bank of Canada’s (BoC) target of 2% for three consecutive months since August. The trade balance in the first ten months of this year has also reversed to surplus driven by stronger exports and a weaker currency. Businesses’ outlook on future sales have also risen to above trend rate.
However, we maintain our view that monetary policy will only be tightened in the second half of 2015 as the tight labour market has yet led to higher wage growth. The high household debt is also expected to weigh on future household expenditure. Forward looking indicators also imply that core inflation is expected to trend lower with some moderation in job growth. The recent sharper than expected decline in oil prices is also likely to projected to slow economic growth next year by about 0.25 percentage point. As the economy is projected to reach full capacity only in 2016, we judge that the BoC has the flexibility to wait till the second half of next year before raising the overnight rate from 1.0% to 1.50%. This is about 25bp more optimistic than what is priced in by the market. This is because we expect the Canadian economy to benefit more given our above market consensus US growth next year. Our 2014 and 2015 year-end target for USD/CAD remains unchanged at 1.15 and 1.20.