FX Weekly – Central banks’ cue dominates FX

by: Roy Teo , Maritza Cabezas

FX-Weekly-27-February.pdf ()

Currency markets were dominated by central banks over the last week. The US dollar edged down after Fed Chair Yellen struck an optimistic outlook on the US economy but cautious tone on the timing of rate hikes. Losses were erased after US core inflation firmed. The Sterling and Canadian dollar were supported after the Bank of England was more hawkish while the Bank of Canada was less dovish than market expectations. On the other hand, the Swiss franc lost more than 1% as sentiment surrounding Greece improved. The Euro declined by about 2 cents to 1.12 as the market refocus on the ECB bond purchase programme due to commence next week. Next week, key central banks are expected to keep monetary policy unchanged, though the Reserve Bank of Australia is expected to strike a dovish tone.

Firmer US dollar expected

Earlier in the week, the US dollar edged lower after financial markets somewhat scaled back their expectations of the timing and pace of rate hikes in the US this year. This was triggered by an optimistic but cautious speech by Fed Chair Yellen. The US dollar rallied later in the week after core inflation in the US firmed.

FX 1

Fed Chair Yellen stated that the US economic recovery is on solid ground and this should result in a further gradual decline in the unemployment rate. However the weak labour participation rate and moderate wage growth suggest some cyclical weakness still persists. Fed Chair Yellen also spent some time in clarifying the forward guidance for interest rate normalisation. She mentioned that patience remains necessary as long as inflation continues to run below the Committee’s 2% objective, while room for sustainable improvement in the labour market remains.  She stressed that dropping the term “patience” should not be read as indicating that the FOMC  will necessarily increase the target range in a couple of meetings.

Fed Chair Yellen used her testimony to prepare the public and financial market for a rate hike later this year. She maintains her view that a rate hike is unlikely in the next couple of meetings. But she emphasized that if economic conditions continue to improve, the FOMC will at some point begin considering an increase in the target range for the federal funds rate on a meeting-by-meeting basis. Although we expect a strong labour market to continue driving the economy, we think both headline and core inflation will remain subdued for a while. Our base scenario is for a rate hike in June. Downside risks to core inflation in coming months, suggest there is a chance of a slightly later move (Global Daily Insight 25 February 2015).

We remain optimistic on the US dollar given that financial markets are significantly underestimating the pace of rate hikes in the US. We expect the labour market to continue to improve with gains in non-farm payrolls in the coming months well above 200k, unemployment rate declining to 5% by the end of 2015 and average hourly earnings to move to 3.0% (yoy) at the end of 2015.

FX 2

Weakness in the Euro to continue

The Swiss franc lost more than 1% as market concerns surrounding Greece declined. Indeed, since the beginning of this month, the 10y Greek yields premium over German bunds have declined by 200bp to around 9% as the Eurogroup approved the list of planned reforms proposed by the Greek government. The Euro declined by about 2 cents to 1.12 in the past week ahead of the European Central Bank’s EUR 60bn per month asset purchase programme. The latter is expected to result in a wider interest rate differentials between the Eurozone and the US. As a result we expect the Euro to extend its decline towards 1.05 later this year.

 Less dovish central bank supports CAD

The Canadian dollar (CAD) was supported after the Bank of Canada (BoC) doused market speculation that further rate cuts are imminent. We remain cautiously optimistic that the overnight lending rate will remain at 0.75% this year as we are more optimistic on US economic growth (ABN: 3.8%) than the BoC forecast of 3.2%. A recovery in crude oil prices and weak exchange rate will also benefit the export sector. On the exchange rate, we expect the CAD to ease towards 1.27 later this year. This is supported by our view that financial markets are more dovish on monetary policy in the US than in Canada.

 More hawkish BoE supports Sterling

Sterling firmed to 1.55 after the Bank of England (BoE) signalled that low inflation is temporary and that tighter monetary policy may come earlier than what is priced in by financial markets. Indeed, we do expect the BoE to hike rates by 50bp this year compared to market expectations of 25bp. However, we think political uncertainty will dominate macro fundamentals over the next few months, leading to a weaker sterling.

 Most EM currencies cheer as risk sentiment improves

Most emerging market currencies rose as risk sentiment in financial markets improved. Despite Russia’s sovereign rating being downgraded by Moody’s, the Russian ruble managed to recover due to tax payment demand and firmer oil prices. The South African rand was also supported after economic growth in the last quarter of 2014 was stronger than expected. In Asia, both the South Korean won and Taiwan dollar were the main beneficiaries after economic data in China recovered in February. On the other hand, the Turkish lira underperformed as the central bank’s measured rate cut disappointed market expectations.


Central banks to keep monetary policy unchanged…

The upcoming week, several central banks will announce monetary policy. We expect the Reserve Bank of Australia (RBA), Bank of Canada, Bank of England and European Central Bank to keep monetary policy unchanged. The start of the ECB bond buying programme will come into focus (2 March).

 …RBA to strike dovish tone, paving way for rate cut in Q2

We expect the RBA to increase their dovish tone on 3 March for the following reasons. Since the last monetary policy meeting on 3 February when the RBA surprised financial markets (but not us) by lowering the official cash rate from 2.5% to 2.25%, the Australian dollar (AUD) is trading more than 2% stronger against its trade weighted basket of currencies. Economic data releases in the past month have been mixed. On the bright side, consumer confidence has recovered and the pace of contraction in the service and construction sectors have slowed. On the other hand, the job market has deteriorated and wages are growing (qoq) at the slowest pace since the third quarter of 2009. Furthermore the weaker than expected capital expenditure in 2014 Q4 has increased downside risk to economic growth in the coming quarters. We now expect the RBA to lower the cash rate to 2% in April. Looking ahead, further rate cuts in the second half of this year cannot be ruled out if the AUD remains stronger than expected and/or the Fed is more dovish. Our year end AUD/USD target remains unchanged at 0.72.