Monetary policy divergence should drive EUR/USD lower
Recent developments have not changed our view on the US dollar and the euro. It is likely that the Fed will start its rate hiking cycle this year driven by a strong domestic economy. This should also give a clear signal of confidence in the state of the US economy. Therefore, we expect an improvement in overall investor sentiment. Financial markets are widely underestimating the probability of a Fed rate hike this year. The probability derived from the options market show a 36% chance of a rate hike in December. In the futures market, Fed fund futures price in a rate of 0.20% for the end of this year and 0.66% for the end of next year, respectively. We foresee one rate hike this year and four 25bp rate hikes next year. If financial markets start to move in this direction, the US dollar could rally strongly. Meanwhile, we stick to our base case scenario that the ECB will step up its monthly QE purchases by EUR 20bn before year end. As a result of this divergence in monetary policy, compared to market expectations, it is likely that EUR/USD will fall to parity this year.
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BoJ to signal downside risks to economic growth and inflation in October
Our bearish view on the Japanese yen has also not changed. We expect the Bank of Japan (BoJ) to signal in October that downside risks to its economic growth and inflation forecasts have increased. Hence the BoJ is likely to increase monetary stimulus by early 2016 as inflationary pressures are likely to fall well below the 2% target by the first half of Fiscal year 2016. Widening interest rate differentials between the US and Japan will continue to weigh on the yen versus the US dollar.
More downside in AUD and NZD
Despite the recent sharp falls, we continue to see value in short AUD and NZD positions and keep them on our conviction list. Recently, we have downgraded our Australian and New Zealand dollar year end forecasts to 0.68 (from 0.70) and 0.60 (from 0.63). Both central banks are expected to lower monetary policy in the last quarter of this year.
MAS easing bias in October to weigh on SGD
We also maintain our short SGD. The Monetary Authority of Singapore (MAS) is likely to shift its current modest appreciation of S$NEER policy to neutral in October. A wider trading band to accommodate recent higher volatility cannot be ruled out. We expect the SGD to decline towards 1.46 against the US dollar later this year.