We remain US dollar bullish
We have kept in place our long US dollar views versus the euro, the yen, the Australian dollar and the New Zealand dollar. We expect that the US economy will strengthen in the months ahead. This will also trigger a Fed rate hike in September in our view. Currently, money market futures have not even fully priced in one rate hike. We expect two rate hikes this year. This, and the upward adjustment interest rate expectations for 2016 should give a strong boost to the US dollar this year. However, this scenario should play out against the background of positive investor sentiment. If investor sentiment were to deteriorate, it is unlikely that the US dollar will profit unless there is market panic. We expect constructive investor sentiment and certainly not market panic.
EUR/USD to move to parity
The resilience of EUR/USD during the escalation of the Greek saga has surprised many. This was mainly because modest risk aversion weighed on the US dollar. Since investor sentiment has improved, the US dollar has gained across the board including versus the euro. Going forward, we expect EUR/USD to test parity in the coming months mainly because of the monetary policy divergence between the US and eurozone. The US dollar is currently driven by cyclical forces, such as the relative economic performance and the outlook for the Fed.
We remain bearish on the yen as headwinds to inflation remain
We maintain our bearish view on the yen as headwinds to rising inflationary pressures have surfaced. The Bank of Japan (BoJ) has also downgraded its inflation forecast. Widening interest rate differentials between the US and Japan will continue to weigh on the yen versus the US dollar.
Downgrade of AUD and NZD forecasts
We have downgraded our Australian and New Zealand dollar forecasts as weak key commodity export prices will cap any recovery in these currencies. We expect both central banks to ease monetary policy in September to cushion the economy. Both central banks also reiterated that further declines in the exchange rate are likely and necessary. More importantly, financial markets are still under-estimating the magnitude of rate hikes in the US, in our view.
Initially safe haven currencies had the upper hand…
During the escalation of the Greek saga, safe haven currencies such as the Japanese yen and the Swiss franc rose. The US dollar did not behave as a safe haven currency, because monetary policy and growth divergence are more important for the US dollar at the moment. In addition, the market was not in real panic.
…but after the Greek deal the US dollar gained…
The first reaction after news hit the market that there was a deal between Greece and its creditors, EUR/USD moved to 1.12. Since then it has been under pressure again. Why? For a start, financial markets already anticipated a possible deal in the making. In addition, comments from Fed’s Yellen that the Fed will start hiking rates this year weighed on EUR/USD. Moreover, the improvement of investor sentiment following the deal has resulted in a refocus on monetary policy and growth divergences across the Atlantic and between the US and other countries. The weakness in safe-haven currencies such as the Japanese yen and Swiss franc reflect the same dynamics. Recently, the US dollar lost some shine following weaker-than-expected US corporate earnings’ reports.
…and commodity price weakness hurt commodity FX…
The slide in oil prices weighed on the Canadian dollar (CAD), Norwegian Krona, Russia ruble and Mexican peso. The CAD was the worst performing major currency after the Bank of Canada (BoC) surprised financial markets (but not us) by cutting the overnight lending rate by 25bp earlier this month. We highlighted this risk and downgraded our USD/CAD forecast in our FX Watch – More bearish on CAD, published on 13 July. Weaker iron ore, dairy and copper prices were the dominant drivers for the Australian (AUD), New Zealand dollar (NZD) and Chilean peso (CLP). The Reserve Bank of New Zealand (RBNZ), as widely expected, also lowered the Official Cash Rate by 25bp to 3% on 23 July and maintained its easing bias. On the other hand, the Reserve Bank of Australia (RBA) kept monetary policy unchanged but reiterated that the AUD had provided less assistance in rebalancing the economy and further depreciation seemed both likely and necessary.
…and the Riksbank eased to push the krona lower
On 2 July, the Riksbank surprised financial markets by cutting interest rates to -0.35% from -0.25% and extending government bond purchases by SEK 45 bn. It stated that since the repo rate decision in April, the krona had also become stronger than the Riksbank had forecast and the development of the exchange rate remains a risk to the upturn in inflation.
“Monetary policy needs to be even more expansionary in this uncertain environment to ensure that inflation continues to rise towards the target of 2%”. The Riksbank signalled it is ready to do more if necessary, even between the ordinary monetary policy meetings. It is also prepared to intervene on FX markets if the upturn in inflation is threatened as a result of, for example, very problematic developments in the markets.
EUR/USD to move to parity
The resilience of EUR/USD during the escalation of the Greek saga has surprised many. This was mainly because modest risk aversion weighed on the USD dollar (see above). The unwinding of overcrowded short futures positions in the EUR is also another important contributing factor. Since investor sentiment has improved, the US dollar has gained across the board including versus the euro. Going forward, we expect EUR/USD to test parity in the coming months mainly because of the monetary policy divergence between the US and eurozone. The US dollar is currently driven by cyclical forces, such as the relative economic performance and the outlook for the Fed.
BoJ downgrades inflation forecast; remain bearish on JPY
We stick to our bearish view on the Japanese yen (JPY) as recent developments in Japan have not surprised us on the upside. The Bank of Japan has recently downgraded its core inflation forecast, expecting inflation to rise to 1.9% in FY 2016 (from 2%). We maintain our view that further monetary stimulus is needed in early 2016 as the central bank’s inflation forecast is too optimistic. Headwinds to higher inflation have increased as oil prices declined recently and the slack in the economy was more than expected (negative output gap widened in May). In addition wholesale inflation has contracted at a faster pace in June, implying that core inflation will remain subdued in the short term. Furthermore the increase in household spending might be more gradual than expected as recent wage gains were driven by special cash payouts. Last but not least, as financial markets adjust to our view that the Fed will begin tightening monetary policy in September, firmer short term yields in the US will push USD/JPY towards 128 later this year.
More bearish on NZD/USD
We expect the RBNZ to cut the Official Cash Rate (OCR) by 25bp to 2.75% as soon as in September to cushion the slide in commodity export prices. Another rate cut bringing the OCR back to 2.50%, cannot be ruled out if dairy prices continues to fall sharply. Our commodity strategist expects dairy prices to fall further in the coming months before stabilizing towards the end of this year. Hence, any relief recovery in the NZD is likely to be capped. Furthermore, though the RBNZ was less dovish on the exchange rate in its last monetary policy meeting, the central bank maintains the view that further depreciation in the NZD is necessary. Hence, a stronger NZD is likely to result in a more dovish RBNZ. In addition, consumer and business confidence have also deteriorated. Household spending and investment plans could be delayed as a result. Last but not least, non-resident holdings in government bonds remain elevated at around 70%. As interest rates in the US rise later this year, a reversal of capital flows will put further pressure on the NZD. We have lowered our 2015 year end NZD/USD forecast from 0.65 to 0.63.
Downgrade AUD/USD forecast
We now expect the Reserve Bank of Australia to lower the Official Cash Rate by 25bp in September (previously August). The trigger to delay the timing of rate cut was due to several recent events. Core inflation in the second quarter, though declining, remains above the lower bound of the RBA 2-3% target. In addition, Reserve Bank of Australia (RBA) governor Stevens recently warned that monetary policy should not be used to respond to short term market events. As a result, the cash rate futures have reduced the probability of further rate cuts in the coming months. We disagree as Stevens did not rule out further rate cuts. In our view, the RBA remains concerned about the slow rebalancing in the economy, the recent decline in iron ore prices and the still relatively strong exchange rate. However, the RBA prefers to take a more cautious approach given financial leverage risks. We expect economic growth to slow in the second quarter and recent measures announced by the Australian Prudential Regulatory Authority to cool house price inflation and address leverage risks. We also expect business investment data to be released on 27 August to remain weak which should warrant further monetary stimulus sooner than later. As financial markets have not fully priced in a 25bp rate cut in Australia and are underestimating the magnitude of rate hikes in the US, we have lowered our Q3 and Q4 AUD/USD forecast to 0.72 (from 0.73) and 0.70 (from 0.72). We have also lowered our 2016 year end forecast to 0.64 (from 0.66).