The US dollar gained after the FOMC maintained their view that inflation will gradually rise towards the 2% target as the labour market improves and the effects of lower energy prices dissipate. We maintain our view that the Fed is on track to tighten monetary policy in the middle of 2015. Gains in the euro and the yen reversed as short term yields in the US firmed. Sentiment towards the Swedish Krona and Australian dollar were negative as both central banks remained dovish. The Swiss franc was also sold off aggressively after the Swiss National Bank unexpectedly introduced negative interest rates. The selloff in emerging market currencies extended, led by falls in the Russian ruble. The Chinese yuan declined to the lowest level in the past six months as economic data disappointed and the central bank signalled that they are more tolerant towards weakness in the currency.
Fed remains on track to hike rates in mid 2015
The US dollar (USD) extended its gains in the past week after the FOMC stated that the underutilization of labour resources has continued to diminish and that it expects inflation to gradually rise towards 2% target as the labour market improves and transitory effects of lower energy prices dissipate. Given a slower upward trajectory in inflation due to lower oil prices, the median rate projections by the FOMC was slightly lower with the Fed funds rates expected to rise to 1.125% (from 1.375%) and 2.5% (from 2.875%) by the end of 2015 and 2016 respectively. This is not materially different from our view that the Fed funds rate will rise to 1% and 3% in 2015 and 2016. We continue to favour the dollar as the divergence in monetary policies between the US and other economies will widen next year. Crucially, the market is underestimating both the timing and pace of rate hikes in the US.
Gains in the euro and yen halted by firmer US yields
The Japanese yen’s (JPY) outperformance against the dollar reversed as yields in the US firmed and the deterioration in risk sentiment stabilised. We maintain our view that the yen will continue to underperform the dollar towards 130 in 2015. This is because the Bank of Japan will increase monetary stimulus to achieve its inflation target. Meanwhile, the US Federal Reserve will tighten monetary policy.
A similar price action was seen in the euro. At the start of the week the euro (EUR) was supported by better economic data in the eurozone and profit taking on euro short positions. Afterwards the euro also gave up earlier gains, because interest rate differentials between the eurozone and the US widened. This was the result of investors adjusting their expectations that the Fed remains on track to tighten monetary policy in the middle of 2015
Dovish central banks weigh on the SEK and AUD
The Swedish krona was the worst performer. On 16 December the Riksbank left monetary policy unchanged, but it continued to sound dovish. In the statement it said that the repo rate needs to remain at zero percent for a slightly longer period than was forecasted earlier. It will not be until the second half of 2016, when CPIF inflation is close to 2%, that it will be appropriate to begin raising the repo rate. It is open to further postpone the rate hikes when necessary. In addition, it is preparing further measures that can be used to make monetary policy more expansionary if necessary. These measures could be announced at the next meeting.
The Australian dollar (AUD) declined for the 5th consecutive week as carry trades were unwound. Weaker than expected economic data in China also sparked market concerns that the slide in Australia’s key export commodity, iron ore may persist longer than expected. Indeed, lower iron ore prices have eroded tax revenue and may result in sharper than expected fiscal spending cuts. On the exchange rate, the Reserve Bank of Australia (RBA) reiterated that the AUD remained overvalued and a lower rate closer to 0.75 is desired. We think that risk of a rate cut by the RBA in the first half of 2015 is rising as uncertainty surrounding the economy is increasing.
SNB: negative rates and commitment to maintain CHF cap at 1.20 against the EUR
The Swiss franc (CHF) was sold off aggressively after the Swiss National Bank (SNB) surprised the market by introducing negative interest rates. It also reaffirmed its commitment to buy unlimited amounts of foreign currency to defend the Swiss franc cap of 1.20 against the euro. The SNB will impose a rate of -0.25% on sight deposit account balances at the SNB. It is expanding the target range for three-month Libor to -0.75% to 0.25%. This action highlights how committed the SNB is in preventing the franc from strengthening in an environment that the ECB has loose monetary policy and negative rates. In addition, low/negative inflation is also an important reason for the SNB action. As a result of the decision EUR/CHF spiked to a high of 1.2093 before stabilising around 1.2040.
Emerging market currencies sell off continues
At the start of this week, sentiment in emerging market currencies deteriorated. Investors moved from being negative on currencies of oil exporting countries to countries with weak fundamentals such as the Turkish lira, Indonesia rupiah, Indian rupee, Brazilian real and the Hungarian forint. Later during the week most of them showed some recovery. The Hungarian forint also weakened because of a dovish central bank. Hungary’s central bank revised lower its inflation and economic growth forecast. The sentiment towards the HUF also deteriorated given the large exposure Hungarian companies and banks have in Russian markets.
Panic week for the Ruble
The Russian ruble had a panic week. Lower oil prices, continued sanctions from the US and European Union, fears of deep economic recession in Russia and fears that the Russian central bank (CBR) lost control of the situation resulted in a sharp slide in the ruble. At the start of the week the CBR tried to stop the slide by an aggressive 650bp rate hike to 17%. However, market sentiment went from bad to worse and at some point in time the USD/RUB moved to above 79. This triggered aggressive reaction by the central bank. The Russian Central Bank unveiled a set of measures to underpin the banking sector, that together with FX interventions, helped the ruble to stabilise. The CBR signalled that it stands ready to recapitalise the banking sector, if needed. Also, it will provide more dollar liquidity to banks. Meanwhile, banks no longer need to mark their securities to market, can calculate the value of their currency loans using the exchange rate of the previous quarter, and do not need to write down loans to companies affected by EU/US sanctions. These measures basically allow banks to ignore the recent market turmoil, when calculating their capital ratios.
…but Russian financial system not out of the woods yet
Still, strains in the banking sector continue to mount. After reports of long queues before banks, and ATM machines being depleted, Russian banks are increasingly becoming nervous of lending to each other. The three month MosPrime Rate surged to 28.3% this week, a level last seen during the financial crisis. While President Putin’s promise during his annual press conference that capital controls are out of the question should avoid complete panic, it is clear that the CBR and the government are still in the eye of a financial storm and will continue to struggle to restore calmness in coming days. In our base case, we think that Russia’s economy is heading for a deep recession, but the risk of the country sliding into a full blown financial crisis remains significant.
The Chinese yuan also moved lower. According to reports, Chinese officials indicated that they are more tolerant towards a modest depreciation in the yuan. Profit taking in the yuan in a perhaps a relatively illiquid market (year end effect) exacerbated the decline in the yuan. We maintain our view that the yuan will depreciate to around 6.25 against the dollar in 2015.