The US dollar sold off aggressively after the Fed, followed by a stunning recovery. We have adjusted our Fed view and most of our FX forecasts. We expect the Fed to start rising rates in September. We also now expect the federal funds rate will rise to 0.75% at year-end 2015 and to 2.25% at year-end 2016. This is a slower pace than previously expected. Nevertheless given the momentum behind the dollar and ongoing monetary policy divergence we have revised our EUR/USD forecasts for this year lower. In contrast, we now expect a recovery of the euro in 2016. This is because stronger eurozone economic recovery and pick-up inflation will probably result in financial markets starting to price in a tapering from ECB QE next year.
Fed’s caution on rate hikes triggers sharp dollar sell-off
Financial markets cheered the FOMC statement and Yellen’s testimony as the Fed signalled a slower pace of rate hikes. The interest rate implied by the Fed funds future dropped considerably to 0.4% at the end of 2015 (-10bp) and to 1.15% at the end of 2016 (-20bp). US Treasury yields dropped (10y -14bp). Most asset classes loved the idea of slower rate hikes, except of course the US dollar. The US dollar dropped sharply. This was reflected by EUR/USD making a high of 1.1043. This sharp reaction is in the US dollar is not unusual after the substantial rally seen since July 2014. This weakness was not a change in direction, but a temporary move. The US dollar quickly recovered afterwards and EUR/USD dropped below 1.07 again.
Change in fed funds forecast…
Following the FOMC meeting on Wednesday, we have revised our view of the timing and pace of Fed rate hikes. We now think the FOMC will hike rates in September, rather than June. We also now expect the federal funds rate will rise to 0.75% at year-end 2015 and to 2.25% at year-end 2016. We previously expected the fed funds rate to reach 1% at the end of 2015 and 3% at the end of 2016. This revision responds to the more cautious tone of the FOMC statement and their downward revisions to GDP growth and inflation. We recently also lowered our GDP growth for 2015, though we maintained our forecast for 2016. In line with the tone of the statement, the individual interest rate forecasts of FOMC members for the fed funds rate, released together with the statement, showed a lower interest rate path, suggesting that a delay in the rate hike is more likely. Overall, we think that the Fed remains confident enough in the outlook to hike rates this year, but the softer growth forecast and stronger dollar, suggest it will be more cautious.
…but dollar rally to continue this year…
Despite the slower pace of Fed rate hikes than previously expected, we have revised our EUR/USD forecasts for this year lower. The underlying momentum in the US dollar rally is very strong. This is reflected by the substantial recovery after the sell-off following the Fed meeting. In addition, we continue to expect more rate hikes in 2015 and 2016 than financial markets currently anticipate. This is because of our above consensus call on the US economy. We therefore expect financial markets to adjust their US rate expectations up as the prospect of a September hike becomes more concrete. Therefore, we expect most of the US dollar strength versus the euro in 2015. Our new EUR/USD forecast for the end of 2015 is 0.95 (previously 1.05).
…and the euro to recover in 2016
In contrast, we now expect a recovery in EUR/USD next year. This is because stronger eurozone economic recovery and pick-up inflation will probably result in financial markets starting to price in a tapering from ECB QE next year. This should push the euro higher. However, we now expect it to rebound to 1.10 by the end of 2016.
Swedish Riksbank shocked financial markets…
In an intermeeting move the Swedish Riksbank cut its repo rate to -0.25% from -0.1%. It also communicated that it will buy 30bn SEK government bonds, which is still a modest amount relative to the size of the economy. The reason for the action was that the recent appreciation of the krona could push inflation back down. Why was this a major surprise? After the recent better than expected Swedish economic data, including inflation data, financial market had anticipated that the Riksbank would no longer ease monetary policy further. So this announcement came as a complete surprise. What is more is that it is still ready to put in place more expansionary monetary policy, even between the ordinary monetary policy meetings. It also stated that it could take a number of other measures including the possibility of FX interventions. The message of the Riksbank could not have been clearer. As a result, the Swedish krona came under heavy pressure. The Riksbank will continue to ease monetary policy and fight krona strength in our view. We have adjusted our forecasts in EUR/SEK to reflect this.
…so did the Norges bank
After the surprise decision by the Riksbank, financial markets became more dovish on the Norges bank as well. Market consensus, including ours was for a 25bp rate cut. But the Norges bank surprised by leaving interest rates unchanged resulting in a sharp appreciation of the Norwegian krone. The effects of lower oil prices on the economy have been relatively small and house prices are still rising at a fast pace. Therefore, policy rate was left unchanged at 1.25%. But there is a possibility of a reduction in the key policy rate the Norges bank said. Although it remains likely that the Norges bank will reduce interest rates, a large quantitative easing programme or aggressive rate cuts are not on the cards. This is because inflation is close to the central bank target and we expect an expected recovery in oil prices. Therefore, the downside in the Norwegian krone will likely be limited in the short-term and later this year it could strengthen. As a result, we expect the Norwegian krone to outperform the Swedish krona this year and next year. These dynamics are reflected in our new Norwegian krone forecasts.
Sterling weakness to continue in coming months followed by a recovery
Recently, sentiment on the sterling deteriorated. This is because financial markets have scaled back interest rate hiking expectations following the weaker employment report and uncertainty about the elections in May. We expect sterling to weaken further in the run-up to these elections. However, a recovery is likely afterwards bolstered by the prospect that the Bank of England will start its hiking cycle. We have delayed our first rate hike from September to November because of lower inflationary pressures. We continue to expect a total of 100bp rate hikes in 2016 in 25bp steps. With both the US Federal Reserve and the Bank of England hiking interest rates in 2016, we expect no strong direction in GBP/USD next year. We have adjusted our forecasts to reflect this view.
EM forecast adjustments
We have made forecast adjustments for Latin American currencies and central and eastern European currencies. Despite our adjustment in Fed view, emerging market currencies with weak economic fundamentals will remain vulnerable in our view. This is reflected in our new forecasts for the Turkish lira and Hungarian forint. We expect the Polish zloty and the Czech koruna to remain resilient versus the euro in such an environment, because of strong domestic growth. In addition, financial markets will likely anticipate possible rate hikes at the end of 2016 and early 2017.
In case of the Brazilian real, we expect it to remain under pressure in the near-term but to recover in the course of 2015 and 2016 because of the large sell-off already seen. In the case of the Russian ruble we expect the situation to improve. For example Russian GDP will unlikely surprise the already gloomy outlook to the downside, because of rate cuts by the central bank and an expected recovery in oil prices.