FX Weekly – Wall of worry

by: Georgette Boele

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Risk sentiment turned sour this week supporting safe haven assets. The Japanese yen was the top performer in currency markets. Meanwhile, currencies of oil exporting countries were badly hurt again. The take-up of the TLTRO was very disappointing and we now expect sovereign QE by the ECB in January 2015. This should lead to ongoing downward pressure on the euro. Meanwhile, we have revised down our yen forecasts to reflect more BoJ easing.

Oil price weakness hurts sentiment…

Recently financial markets have experienced a bout of risk aversion. The sharp decline in oil prices has triggered deeper concerns about the strength of the economy of oil exporting countries. Some currencies, such as the Russia ruble, Mexican peso, Norwegian krone and Canadian dollar, have dropped significantly and authorities have signalled their aim to prevent sharp volatility. For example the Central bank of Russia hiked by 1% to 10,5% on 11 December. Even this move was not able to stem the slide in the Russian ruble. The Mexican peso has also weakened dramatically. The announcement by the Foreign Exchange Commission in Mexico to intervene in currency markets, because of market volatility has yet to stabilise the Mexican peso. It will offer as much as USD 200 million per day in auctions starting 9 December. There will be three auctions per day. The auctions will be activated if the peso weakens by 1.5% or more. Furthermore, these auctions are done at a minimum exchange rate based on the previous day’s level. It is crucial for the outlook for these currencies that oil prices manage to regain some traction.

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We cut our high conviction MXN view

The long Mexican peso – our top pick in the EM universe against the euro – has proved to be a major disappointment and we have lost our patience. After the peso’s slide continued this week, hand in hand with lower oil prices, we decided to cut our Mexican peso high conviction long versus the euro with a considerable negative total return of 8.3%. The situation is very fluid with oil prices being under heavy pressure and disappointing performance of the economy. This is despite the willingness by Mexican authorities to intervene. We have also substantially adjusted our Mexican peso forecast. Our new forecasts for the end of 2015 and 2016 are 14.0 (13.0) and 13.5 (12.5), respectively.

Concerns about Chinese growth also weigh…

Moreover, the side in oil prices has triggered fear that demand will be weak, hinting to weaker than expected global growth. Such growth concerns were also fueled by recent weaker than expected Chinese economic data. For commodity markets the health of the Chinese economy is crucial for the demand outlook. A weaker Chinese growth outlook has a negative spillover effect to commodity prices. This in turn hurts currencies of commodity exporting countries.

…as well as political uncertainty in Greece…

Investor sentiment has also been undermined by the political uncertainty in Greece. One of the risks for 2015 – the election of a new Greek President –  has been brought forward.  The process, which could potentially trigger elections early next year if unsuccessful, was scheduled for the first quarter, but will now take place later this month. A majority of 180 votes in the 300 seat parliament will be needed to elect the new President, while the coalition has 155. Greek markets tumbled and investor sentiment softened. This reflects the fear that early elections will result in the Syriza party coming into government. It is against the economic adjustment programme. Still, it may not come to that. We think it is most likely that independents and deputies from other parties will help to elect the new President, which would mean elections would be unnecessary before 2016. In addition, even if there is an early election, a Syriza government might be more constructive than it appears. Over recent months, it has toned down its rhetoric, and softened its general stance, against the programme.

…and the impact of US rate hikes in 2015

A less important factor is the strong US economy and the prospect of the start of the hiking cycle in June 2015 have unnerved investors, because of worries about the fall-out for EM assets. They have drawn parallels between the current situation and the EM currency crises in the 1990s. We do not agree with this view, because fundamentals of most emerging markets are much stronger and currency regimes are more flexible.

Fed to drop ‘considerable period’ guidance

Although Greece and Russia will undoubtedly remain ‘front of mind’, next week’s FOMC meeting could well steal the limelight. With the economy going from strength to strength, the Committee well may decide to drop its promise to keep its policy rates on hold for a ‘considerable period’. However, with inflation subdued, it could replace it with a phrase that signals that rate increases are not imminent. We expect the Fed to start hiking its target for the fed funds rate at around the middle of next year.

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Yen lived up to its safe-haven status, but the dollar didn’t

This deterioration in investor sentiment was reflected by a rally in US Treasuries (yield dropped to levels not seen since June 2013) and lower equity markets, while equity volatility (VIX), gold and the Japanese yen rose. Surprisingly, the US dollar did not behave like a safe-haven currency. Why is this? Currently the dollar’s behaviour is a rather cyclical one. This means that the strongly outperforming US economy has given strong support to US assets such as the dollar. The prospect of Fed rate increases in 2015 will even reinforce this view. Because of its cyclical nature at the moment, risk aversion is not a positive factor for the US dollar unless a real systemic risk emerges.

LTRO a peashooter rather than bazooka

The second TLTRO disappointed market expectations, with total borrowing of just EUR 129.8bn (consensus: EUR 148bn). It means that banks took up only around 50% of the maximum take-up of EUR 400bn over September and December. Given that there is EUR 270 bn of the 3-year LTROs maturing early next year, it means that the TLTROs will not lead to a major ECB balance sheet expansion.

Sovereign bond purchases on the cards

It now looks close to impossible for the ECB to achieve anywhere near a trillion euro balance sheet expansion with its existing measures. It will need to broaden asset purchases and sovereign bonds will need to be part of the mix.  Overall, we expect the ECB to announce a broader and bigger programme of asset purchases at its January meeting.

…Sovereign QE by the ECB will undermine the euro

In previous episodes of Fed QE programmes, the dollar remained under pressure during QE. However, their impact diminished. QE results in an increase of a currency in circulation and therefore hurts the currency. Moreover, QE programmes imply that interest rates will not go up in the coming years. Therefore, currencies of these countries will be used as the funding currency in carry trades. These two forces together will weigh considerably on the euro going forward. As the Fed is moving in the opposite direction, monetary policy divergence will be the main driver of a lower EUR/USD in the coming two years.

But no change in our EUR/USD forecasts

Financial markets have increasingly anticipated sovereign QE by the ECB. Therefore, we believe that this news will not add extra pressure on the euro than we have now already factored in. In addition, it is likely that a more substantial rally in the US dollar will result in a change of behaviour of the Fed. Some weeks ago we scaled back aggressive rate hikes for 2015, because the Fed will likely hike at a lower pace when the dollar rallies sharply. If the ECB QE results in a sharper drop in the euro in the first half of 2015 and other currencies remain weak as well, the Fed may even further slowdown rate hikes in 2015. Therefore, we have not adjusted our forecasts for EUR/USD. We see EUR/USD moving towards 1.15 at the end of 2015 and to parity at the end of 2016. But the risk has increased that the euro weakens more versus the dollar in 2015 than we have now pencilled in.

New yen forecasts to reflect more BoJ easing

After a weak GDP report which revised the initial estimate of third quarter GDP growth to -1.9% qoq annualized down from -1.6% qoq, other data released continue to disappoint. The real private consumption index of the Cabinet Office, the best monthly indicator to track quarterly GDP-based consumption, fell by 0.2% mom in October, while the September report was revised up by 0.8% (previously 0.5%). Even after the huge slot of stimulus from the BoJ at the end of October, the economy is far away from the growth and inflation targets recently announced. Looking forward, the ruling Liberal Democratic Party should come out with a stronger mandate to support the economy. On top of this we expect that the fall in energy prices to support consumption and the decline in the yen to boost exporters. However, the low inflation outlook and the risks of a return of deflation suggest that there will be a further stepping up of monetary stimulus in 2015. Because this is not priced in financial markets, this should weigh on the yen. Our new USD/JPY forecasts for the end of 2015 are now 130 (125) and 140 (135), respectively.

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