Given monetary policy and growth divergence across the Atlantic and the momentum behind the euro’s fall we have adjusted our EUR/USD forecasts downwards. This results in our new forecasts of 1.10 by year-end and parity by end-2016. We are now also even more bearish on commodity currencies given the sharper than expected decline in commodity prices in recent months. The Japanese yen was supported due to safe haven flows as uncertainty surrounding political situation in Greece continues. Emerging market currencies were driven by lower oil prices and a deterioration in sentiment.
The euro has continued to head south…
The euro has started this year how it ended the last one. In 2014, the EUR/USD declined by 12%, starting at 1.3789 and closing at 1.21. The EUR/USD has fallen further over recent days, and was trading at 1.1810 at time of writing. We expect the euro to fall significantly further, and have revised our forecasts even lower (see also “How low can the euro go?” Global Daily Insight 6 January).
…driven by monetary policy, growth and now politics
This euro’s weakness versus the US dollar mainly reflects a sharp divergence in growth and monetary policy on either side of the Atlantic. Growth in the eurozone has been sluggish, while headline inflation has turned negative. We expect headline inflation to remain negative over the next few months. The exact path depends crucially on oil prices. If they were to remain at current levels, inflation would likely remain negative until June of this year. The case for further ECB action is strong and the negative rates of inflation will provide great mood music for Mr Draghi to push QE through the Governing Council. We expect the ECB to announce that it will embark on a large scale asset purchase programme, including sovereign bonds, at its January meeting.
Further euro weakness to come…
Monetary policy divergence will likely continue to drive the EUR/USD lower. We expect the Fed to start raising rates in June and to raise interest rates somewhat faster than currently expected by markets. The US economy is set to remain strong. The ECB could well eventually expand its balance sheet by more than a trillion. Given these fundamental drivers and the momentum behind the euro’s fall, we have adjusted our EUR/USD forecasts for this year and Q1 2016 downwards.
…resulting in our new forecasts: EUR/USD: 1.10 by year-end, 1.00 by end-2016
Our new end-of-period forecasts for the coming quarters are as follows: 1.17 (Q1 2015), 1.15 (Q2 2015), 1.12 (Q3 2015), 1.10 (Q4 2015) and 1.08 (Q1 2016). We previously expected EUR/USD to fall more slowly to 1.15 by the end of this year. We continue to expect the EUR/USD to reach parity by the end of next year.
We are also even more bearish on commodity currencies
Given the sharper than expected decline in key commodity export prices, we are now even more bearish on commodity related currencies. We expect the Reserve Bank of Australia to cut interest rates by 50bp in the first half of this year given weaker than expected terms of trade and slower rebalancing in the economy. Our 2015 and 2016 year end AUD/USD forecasts have been lowered to 0.74 (from 0.78) and 0.70 (from 0.75). Similarly we have lowered our 2015 and 2016 NZD/USD year end forecasts to 0.71 (from 0.73) and 0.66 (from 0.68) as we expect the Reserve Bank of New Zealand to leave monetary policy unchanged this year (from previous view of 50bp hike).
The sharp decline in oil prices has made us less optimistic on the pace of economic recovery in Canada. We expect the Bank of Canada to shift towards a slightly dovish stance in the next monetary policy meeting on 21 January. Indeed we think that it is increasingly likely that monetary policy in Canada will remain unchanged for the rest of this year (from previous assessment of 50bp hike). Our 2015 and 2016 USD/CAD forecasts have been raised to 1.22 (from 1.20) and 1.27 (from 1.25).
Safe haven flows supports the yen temporarily
In the past week, the yen was in favour. This was the result of a general deterioration in investor sentiment. The yen remains one of the major safe haven currencies. Lower interest rate differentials between the US and Japan also supported yen gains against the US dollar. We think that this short term trend favouring the yen may continue until there is further clarity on the Greek political situation following elections on 25 January. Upside in the yen is likely to be limited towards 115.60 in our view.
Looking ahead, we continue to expect a weaker yen as lower crude oil prices are expected to increase the risk that the Bank of Japan (BoJ) undershoots its inflation target. As the BoJ is expected to further increase monetary stimulus this year, at the same when the US Federal Reserve tightens monetary policy, the yen is projected to decline towards 130 against the USD.
Emerging market currencies under pressure in risk off mode
Oil price weakness and an overall deterioration in investor sentiment remained the dominant themes for emerging market currencies last week. As a result, the Russian ruble was out of favour again while currencies of oil importing countries such as Turkish lira and Indian rupee did relatively well. The Brazilian real also firmed, because the market is becoming more confident that fiscal measures may finally be taken this time.
In Asia, the Indonesian rupiah was the worst performer as energy prices extended their slide and the terms of trade are expected to deteriorate. Indonesia also relies heavily on foreign direct investments to develop its oil and gas industries. Given weaker commodity prices, such investment flows might decline and this is negative for the currency given its current account deficit. Given the recent weakness in the rupiah, the central bank announced that they intervened in the currency market earlier this week to smooth volatility in the currency. We think it is likely that they will hike interest rates by 25bp on 15 January to defend weakness in the currency.
In contrast, the Indian rupee managed to outperform as India’s inflation outlook is expected to improve due to lower oil and food prices (food prices constitute almost 50% of CPI basket in India). Lower oil prices are also expected to improve the current account balance.