FX Weekly – How low will the yen go?

by: Roy Teo

FX-Weekly-21-November.pdf ()

US dollar gains despite slightly dovish FOMC minutes

Despite relatively dovish FOMC minutes, the US dollar was resilient as the Fed is still on track to be the first central bank among advanced economies to tighten monetary policy next year. Financial markets are still lagging behind in terms of their views on the timing and pace of rate hikes in the US. At the time of writing, the Fed funds futures is implying that fed funds rate will rise to around 0.50% compared to our view of 1.0% by the end of next year. As markets adjust their view higher, this will provide further support to the dollar.


The euro dropped by more than one cent to below 1.2450 early this week after ECB President Draghi said that government bonds were one of several options to expand asset purchases in the future. However losses were reversed after expectations of sovereign QE abated, fuelled by a rebound in Germany’s ZEW economic sentiment indicator. The euro came under pressure later today after Draghi stated that ECB must raise inflation as fast as possible given that some inflation expectations are excessively low. He also said that the ECB would broaden purchases if policy is not effective. We continue to expect the ECB to step up its asset purchases, but we expect it to focus on other securities than government bonds. The monetary divergence in the euro area and the US is expected to widen significantly over the next two years. We expect the Fed to increase interest rates to 3% by 2016 while the ECB will continue to roll out stimulus measures over that period. As such we expect the euro to decline to 1.15 and 1.00 in 2015 and 2016.

 Yen weakness fast and furious

The Japanese yen has declined for the 5th consecutive week as an unexpected contraction in GDP in Q3 triggered Prime Minister Abe to delay the planned sales tax hike by 18 months to April 2017. The combination of weak economic growth, political uncertainty and aggressive monetary stimulus are hurting the Japanese currency. All this suggests that yields in Japan are likely to remain low, providing larger incentive for domestic investors to search higher yielding assets overseas. Indeed since the BoJ increased monetary stimulus on 31 October, domestic investors continue to purchase overseas bonds albeit at a slower pace in the week ending 14 November. This is expected to weigh on  the yen. Furthermore, a delay in fiscal consolidation has also resulted in uncertainty about Japan’s sovereign credit outlook which is also negative for the yen. The decline in the yen has been sharp and quick and a number of indicators we look at suggest that investors are heavily positioned for yen weakness. The yen strengthened on Friday (21 November) after Japan Finance Minister Aso said that the yen has weakened too fast, though he ruled out intervention to stem weakness in the currency. We think that the yen could strengthen temporarily after political uncertainty clears after the elections on 14 December. However, the trend beyond that is likely to remain one of ongoing yen weakness. As monetary divergence between Japan and the US widens in the next two years, the yen is expected to decline to 125 and 135 in 2015 and 2016 respectively.

 RBA to delay rate hikes until 2016; further AUD weakness on the cards

The recovery in the Australian dollar (AUD) ran out of steam this week, with the currency failing to break above 0.88. It subsequently weakened. Lower iron ore prices, weak economic data out of China and dovish comments from the Reserve Bank of Australia (RBA) weighed on the AUD. The RBA hinted that measures are likely to be implemented to curb speculative investment in the housing market. This will give more flexibility for the central bank to keep monetary policy low for a longer period to stimulate the rebalancing of the economy away from mining. So far this process has been slow. Indeed, in our view the RBA is likely to keep rates unchanged through 2015. We expect more AUD weakness in the coming weeks and months. We see AUD/USD at 0.78 and 0.75 by the end of 2015 and 2016, respectively.

 RBNZ to downgrade rate hikes trajectory in December

The New Zealand dollar was also not spared in the sell-off of commodity currencies. Lower dairy auction prices weighed on the NZD. We expect the Reserve Bank of New Zealand (RBNZ) to lower its guidance for the path of its policy rate in the next monetary policy outlook on 11 December. This is due to lower than expected inflation in the third quarter and weaker commodity export prices. Furthermore, house price and household credit growth have both slowed on the back of the central bank’s tougher macro prudential measures aimed at cooling the housing market. In addition, the official cash rate was raised by 100bp this year, which has also helped to curb credit and house price growth. We think that the RBNZ has the flexibility to delay tightening monetary policy until the third quarter of 2015, bringing the cash rate from 3.50% to 4.0% next year (compared to previous assessment of 4.25%). This means monetary policy will be less supportive of the currency compared to the US. The NZD/USD is expected to  decline further towards 0.73 and 0.68 in 2015 and 2016. Our 2014 year-end target of 0.77 remains unchanged.

 Emerging market currencies: mixed drivers

Sentiment towards the Russian ruble improved after the EU did not impose more economic sanctions against Russia. The Brazilian real was also supported as economic growth in September was stronger than expected. However a continued slow recovery in the Chilean economy and wider than expected current account deficit in the third quarter weighed on the peso. Weakness in the yen also weighed on both the South Korean won and Taiwan dollar, reflecting concerns the countries’ exports would become uncompetitive compared to Japan’s.


The end of yuan appreciation path?

Expectations that the Shanghai-HK connect will result in a stronger yuan  faded in the second half of last week as weaker than expected economic data out of China undermined the currency. Indeed we have argued that the daily quota for Shanghai bound investments pales in comparison (less than 1%) to the daily average turnover for the yuan. In our view, the relative macro and monetary policy view between China and the US will dominate the direction of the yuan. Our view is that authorities in China will continue to implement targeted stimulus, if needed to ensure a gradual slowdown in the economy. Indeed, the State Council recently announced that they will take measures to cut financing costs for businesses and may adjust the second home sales tax by the end of this year. We expect economic growth to slow from just below 7.5% this year to 7% in 2015016. Our view that the yuan will ease lower towards 6.25 in 2015 remains unchanged.