FX Weekly – ECB sends euro lower

by: Georgette Boele , Roy Teo

FX-Weekly-23-January1.pdf ()

The ECB surprised financial markets with a more substantial asset purchase buying programme. As a result, EUR/USD dropped to a low of 1.1115 before recovering somewhat. We expect the Fed to confirm that it will start raising interest rates this year.  As the financial markets have priced out most rate hikes for 2015, such communication should push rate hike expectations and the US dollar higher. It is very likely that our year-end forecast of 1.10 in EUR/USD will already be reached before long. Our forecasts are therefore under review. The Bank of Canada also surprised with a 25bp rate cut. This resulted in a sell-off of the Canadian dollar.

ECB surprised with a bigger asset purchase programme

Central banks have continued to surprise financial markets. Despite all the reports before the ECB meeting, the ECB surprised with a much bigger asset purchase programme than expected. It added government bonds and agency debt to its existing programmes and in total will now buy EUR 60bn a month ‘at least’ through to September 2016 (see our Global Daily Insight of 23 January 2015). This points to a programme totaling EUR 1.14 trillion. As a result, EUR/USD dropped from 1.1650 to a low of 1.1115 before recovering somewhat. Nervousness about the Greek elections also added to the negative euro sentiment.

As the period of US Fed quantitative easing showed, quantitative easing will remain a negative force for the currency as long as the program remains in place. Therefore, the euro will continue to feel the impact of ECB QE. Moreover, growth and monetary policy divergence across the Atlantic will also remain a negative force for EUR/USD going forward.

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FOMC meeting to confirm the current path

Next week the FOMC meeting will get full attention. Financial markets have been quick to price out most of the rate hikes for 2015 following lower than expected US inflation data and aggressive action by central banks elsewhere. Financial markets currently price in not even one rate hike for 2015. We have penciled in a 25bp rate hike every other meeting from June onward bringing the Fed funds rate to 1.0% at the end of 2015. If the Fed confirms that it will start raising interest rates this year, then a sharp upward adjustment in interest rate expectations could be the result. This should be supportive for the US dollar across the board. It is very likely that our year-end forecast of 1.10 in EUR/USD will already be reached before long. Our forecasts are therefore under review.

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New Canadian dollar forecasts…

The Canadian dollar by more than 3.5% in past week after the Bank of Canada unexpectedly cut interest rates by 25bp to 0.75%. We think that this was triggered by the need to insure against the highly uncertain negative spill-over effects from the sharper than expected decline in crude oil prices. We think that there is more room for the Canadian dollar to weaken to 1.27 against the US dollar due to the divergence in monetary policy and economic growth outlook between the US and Canadian economy. Therefore, we have adjusted our forecasts in USD/CAD to reflect a weaker Canadian dollar. Our new year-end forecasts for 2015 and 2016 are 1.27 and 1.35 respectively.

However, we do not expect further rate cuts. First, core inflation is not projected to decline substantially and to remain close to 2% target this year. Second, the decline in exchange rate is expected to benefit the non-energy export sectors. Third, the US economy,  Canada’s largest export partner is expected to benefit from weaker oil prices. Fourth, there are still concerns about the state of the housing market and high levels of household debt. Last but not least, we expect crude oil prices to recover in the coming months. We expect monetary policy to remain unchanged until second half of 2016.

… and also new CEEMA FX forecasts

Earlier this month our CEEMA economist  released two reports: “Russia Watch – A near perfect storm”  on 9 January 2015 and “Emerging Europe Watch – Enduring Russia’s collapse” on 15 January 2015. We have revised Russian growth for 2015 and 2016 substantially lower, while the impact on Central and Eastern Europe seems to be limited.

What does this mean for CEEMA FX? The downward adjustment in growth, low oil prices and political developments will continue to act as headwinds for the Russian ruble. Therefore, we now pencil in a smaller recovery of the ruble in 2015 and 2016. For the other Central and Eastern European currencies, the impact will be more muted. Stronger growth from the eurozone and lower oil prices are positives and they will counterbalance the negative impact of lower Russian growth and Swiss franc loans on the economy.

However, more accommodative policy by central banks because of low inflation (on the back of lower oil prices) and to support growth will weigh on some currencies. We now expect more monetary policy easing in Poland, Hungary and Turkey because of lower inflationary pressure. It is likely that the central banks of Poland and Hungary will cut by another 50bp, while the central bank of Turkey will probably only cut until the moment the Fed starts hiking. As a result, we now expect more modest recoveries versus the euro in 2015 and 2016.

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