FX Weekly – US dollar hegemony

by: Georgette Boele , Roy Teo

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The US dollar has resumed and we expect another 10-15% appreciation on trade weighted terms until the end of 2016. The ECB started its bond buying programme and this added to pressure on the euro. The direction of the move in EUR/USD is in line with our view, but it went even faster than we had expected. EUR/USD temporarily breached our year-end target of 1.05. Our current forecasts are 1.05 by the end of this year, 1.00 by end 2016Q1 and 0.95 by the end of next year. Given the powerful forces at play, there is a rising chance that parity and below is achieved even sooner. Next week the FOMC meeting will be eyed. We expect a signal in the statement that it remains on track to hike interest rates in June.

US dollar take off …

Since July 2014, the US dollar index has risen by around 20%. This is substantial. Will the rally come to an end now? We don’t think so. We expect that US dollar will rise another 10-15% on trade weighted terms until the end of 2016. The strong ascent in the US dollar is for a considerable part the result of the divergence of monetary policies across the globe, divergence in macroeconomic and currency fundamentals and weakness in other currencies. These trends have a way to run.

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Next week the FOMC decision is of crucial importance for the continuation of the US dollar rally in the coming months. We expect the US Federal Reserve to signal in its statement that it remains on track to raise interest rates at a gradual pace from June onwards. Financial markets have not fully priced in this trajectory. As a result, financial markets will substantially adjust their expectations for  interest rate hikes in 2015 and 2016 and this will trigger a general rally of the US dollar. If the FOMC were instead to sound very dovish, the US dollar may come under some pressure in the near-term.

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… and EUR/USD downtrend accelerates

This week the ECB started to buy government bonds. ECB board member Coeure and German central bank President Weidmann revealed on this week that eurozone central banks bought EUR 9.8bn of securities in the first three days of QE. The average duration was around 9 years. Of the total EUR 9.8bn, EUR 2.1bn of German sovereign bonds were bought, which equates to 21% of the total purchases. The amount bought suggests that the QE programme has started on a good note. We estimate that national central banks will have to buy on average of around EUR 2bn of sovereign and national agency debt per working day. The ECB bond buying added to the  downward pressure on the euro. EUR/USD dropped below 1.06 and even temporary spiked below our year-end target of 1.05.

Further falls ahead

There are good reasons to think that despite the recent sharp falls, that further declines lie ahead. For a start, the US experience of QE shows that portfolio adjustments and currency weakness continue during most of the period of asset purchases. We are one week in the programme and the programme will likely last until September 2016. In addition, the Fed will likely start raising its policy rates in coming months.

Parity calling and maybe earlier than expected

Given the chasm opening up between the monetary policy on either side of the Atlantic, EUR/USD will likely head to parity and below. Our current forecasts are 1.05 by the end of this year, 1.00 by end 2016Q1 and 0.95 by the end of next year. However, given the powerful forces at play, there is a rising chance that parity and below is achieved even sooner.

Norges bank to cut by 25bp

The recovery of the Brent oil price in February gave support to the Norwegian krone. In addition, weakness in the euro also gave indirect support. Next week the Norges Bank will decide on monetary policy. Market consensus is for a 25bp reduction to 1%, in line with our view. Lower inflationary pressure and the impact of the low oil price on the economy are the main reasons behind such a cut.

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RBNZ upgrades GDP but lowers inflation outlook

The New Zealand dollar (NZD) was supported after the Reserve Bank of New Zealand (RBNZ) upgraded its economic growth projections over the next two years. Nevertheless given that inflation is now expected to reach 2% target only in the third quarter of 2017, we now expect monetary policy to remain unchanged over the next two years. We also expect the NZD/USD to decline to 0.68 by the end of this year for the following reasons. First, our monetary policy expectations are not materially different from what is priced in by financial markets. Second, the NZD is the most overvalued currency among G10 currencies. Third, interest rate differentials between New Zealand and the US are expected to narrow as the Fed tightens monetary policy while the RBNZ remains on hold. This will reduce the carry attractiveness of the NZD. Last but not least, financial markets are significantly under-estimating the magnitude of rate hikes in the US in our view.

EM currencies lower

The US dollar hegemony was also apparent versus emerging market currencies. They all underperformed the US dollar. Currencies with weak fundamentals were among the heavy losers such as the Brazilian real and the South African rand.

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LatAm American currencies under pressure

The Brazilian real was the most out of favour and the political crisis and weak economic fundamentals continue to hurt the real despite tighter monetary policy. In addition, FX authorities have decided to reduce interventions in the FX market. On Sunday, there will be large demonstrations to express discontent with Dilma Rousseff. Mexican authorities have taken an opposite stance to Brazil concerning FX interventions. The Mexican FX Commission announced measures to support the Mexican peso. First, the Banxico will auction USD 52 million daily with no minimum price through 8 June. At the end of the period, it will be evaluated if it will continue. In addition it also maintains the current daily dollar auction mechanism for up to USD 200 million

…while Russian ruble was relatively resilient…

In Russia, the CBR cut its policy rate by 100bp to 14%. This was the second time this year that the Russian Central Bank loosened its policy, after it was forced at the end of last year to bring its policy rate to 17% in order to defend a plunging ruble. The latter has broadly stabilised since the beginning of the year, helped by a slight rebound in oil prices. The move  was therefore expected by financial markets, and had a negligible impact on the ruble, even though in the past days oil prices were facing some renewed downward pressure. A relatively resilient ruble opens the door for more rate cuts going forward. Indeed, Russia’s central bank (CBR) sees the surge in inflation on the back of past ruble weakness as transitory and therefore its policy has clearly shifted towards combating the weakening economy, which is now sinking into a deep recession. We therefore think that the CBR will continue to cut its benchmark rate in coming months (see “Russia Watch: Sliding into recession”).

Asian central banks orchestrate weaker currencies

In Asia, the South Korean won was the worst performer declining by around 2.5% to the weakest level since the third quarter of last year. This is due to increased concerns that a weaker Japanese yen and euro would adversely affect South Korea’s export price competitiveness. The Bank of Korea also cut interest rates by 25bp (in line with our monetary policy view), as the negative output gap is envisaged to last longer than previously anticipated. The Thai baht also declined to the weakest level in three months after the Bank of Thailand (BoT) unexpectedly cut interest rates to stimulate the domestic economy. The BoT also stated that a weaker currency is favoured to support exports. The Indonesian rupiah extended its slide after the central bank reiterated that the current weak exchange rate is necessary to support exporters and narrow the current account deficit. On the other hand, sentiment towards the Chinese yuan improved due to increased market speculation that Chinese authorities will increase monetary stimulus to support the economy.

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