FX Weekly – USD/JPY clears 121

by: Georgette Boele , Roy Teo

FX-Weekly-5-December.pdf ()
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The US dollar was back in favour this week. This was the result of more hawkish comments from Fed officials and strong US data. In addition, weakness in other currencies also helped. The euro remained under pressure despite market’s disappointment about the ECB. USD/JPY rallied above 121, a level not seen since 2007, driven by a combination of dollar strength and negative yen drivers. Emerging market currencies were not able to withstand dollar strength either.

Dollar remains in favour

The US dollar extended its gains in the past week supported by firm economic data and an adjustment in market expectations towards the view that the Fed may tighten monetary policy sooner than later. Fed Vice Chairman Fischer signalled that the Fed is getting closer to dropping the “considerable time” phrase in the FOMC statement, the forward guidance used to signal that rate increases are some way off. We think that the pace at which the slack in the labour market is diminishing and the stronger economy, suggest that the Fed is on track to raise interest rates in mid-2015. The US employment report was very strong. Not only did US job growth take off, but there are also signs that earnings are firming. This will be ammunition for the FOMC hawks. It is now more likely that the Fed will drop the ‘considerable time’ phrase from its statement went it meets on 17 December. Against a trade weighted basket of currencies, the US dollar has reached its highest level since the first quarter of 2009. We see further strength in the US dollar in 2015-16 as in our view the market is still underestimating both the timing and pace of rate hikes in the next two years.

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Draghi caused volatility but no change in euro downtrend

Despite the fact that monetary stimulus by the ECB is very likely in Q1, financial markets were clearly disappointed following Mr. Draghi’s press conference. Ahead of the meeting EUR/USD was under heavy pressure. At the start of the press conference, EUR/USD dropped to a low of 1.2280. But when it became clear that there would be no monetary policy action at this meeting, EUR/USD rallied to a high of 1.2450. Afterwards, the pair fell under pressure again. For starters, the ECB is considering several options for QE, with and without government bonds. If the December TLTRO disappoints, then the ECB would have no option but to also include government bonds in a broad programme, as it would otherwise not be able to achieve the balance sheet expansion it wants.  The chances of sovereign QE are therefore significant. Economic data and the direction of oil prices will be the other two crucial considerations. Therefore, the outlook for further monetary stimulus continues to weigh on the euro. In addition, currency markets were rightly upbeat about the upcoming US employment report. Therefore, the US dollar had been supported ahead of the release. Going forward we remain negative on EUR/USD because of monetary policy divergence and growth divergence. Our year-end forecasts for 2015 and 2016 are 1.15 and 1.00, respectively.

Yen weakens beyond 121 versus the dollar…

USD/JPY broke above 121, which marked the first time since July 2007. The Japanese yen extended its underperformance against the US dollar for the 7th consecutive week. First, domestic yields continue to underperform US treasuries. Second, ratings agency Moody’s Investor Service cut Japan’s credit rating by one level to A1. It cited uncertainty over whether Japan will achieve its deficit-reduction goals and succeed in boosting growth. Third, there are market doubts on Japan’s ability on fiscal consolidation given the decision to delay the sales tax increase. Last but not least, it is likely that lower oil prices will push core inflation (excludes food but not energy prices) even lower. As result, the Bank of Japan will probably need to step up monetary policy easing in order to reach its 2% inflation target in the second half of fiscal year 2015.  We expect the yen to extend its slide to 125 against the USD in 2015 as interest rate differentials between the US and Japan widens.

…while the CAD was very resilient

The Canadian dollar was very resilient. The stabilisation of oil prices was an important factor. In addition, the Bank of Canada’s (BoC) monetary policy statement was slightly more hawkish. It stated that  – ‘output gap appears to be smaller than what had been projected in October.’ Nevertheless, the central bank acknowledged that weaker oil prices pose an important downside risk to the inflation profile. Looking ahead, we maintain our view that the BoC will tighten monetary policy by 50bp in the second half of 2015, which is more than what is priced in by the market.

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Australian dollar was out of favour

The Australian dollar (AUD) declined for the third consecutive week as economic growth in the third quarter slowed more than expected. This triggered market expectations that the Reserve Bank of Australia (RBA) will resume cutting interest rates next year due to slowing economic growth and inflationary pressures and sharp falls in key commodity export prices. Indeed, the interest rate futures market is pricing in about 35bp of rate cuts in the second half of 2015.

Though we acknowledge that the risk of monetary policy rate cuts have increased, we think that the hurdle remains high for the RBA to cut rates next year for several reasons. For starters,  economic growth in the first 3 quarters of this year was 2.8% yoy, a sharp improvement from the 2% growth during the same period last year. We remain cautiously optimistic that the economy will recover in the second half of 2015 after some slowdown in the coming months. Furthermore, the decline in oil prices is positive for the economy as Australia is a net importer of oil. This is likely to support household expenditure. In addition, the RBA’s preferred measure of inflation excludes volatile items including automotive fuel. Moreover, we expect both iron ore and crude oil prices to recover from current spot levels. What is more, the RBA is reluctant to cut interest rates because this could add fuel to speculative activities in the housing market Last but not least, we expect the decline in the exchange rate to support economic growth and boost tradable inflation next year. Our forecast for the end of 2015 in AUD/USD is 0.78, because monetary policy divergence between Australia and the US widens next year.

EM FX not able to withstand dollar strength

EM FX also weakened against the US dollar. The Indian rupee was the major exception outperforming the dollar. Stronger economic data in  November supported the Indian rupee. Furthermore, the Reserve Bank of India signalled that monetary policy could be more accommodative to support economic growth given the sharp decline in inflation. Indeed, we do think that the RBI has room to support economic growth via rate cuts next year as the current account and inflation outlook have improved.

On the other hand, currencies from oil exporting countries were beaten up the most. The Russian ruble extended its slide; USD/RUB reached a high of 54.84. The Russian central bank has aggressively intervened in currency markets to halt the slide of the ruble. They also lowered the rate it charges banks to access its dollar reserves. The ruble remains very volatile. Political news adds to the current negative sentiment. However, the most important driver remains the oil price. As our energy analyst thinks that oil prices will firm, this should take away a major negative and help the currency to stabilise. That said, political risks remain large.

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