FX Convictions – Still upside US dollar

by: Georgette Boele , Roy Teo

151208-FX-Convictions.pdf (264 KB)

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On 12 November 2015 we put euro short versus US dollar back on our high conviction list…
…and on 25 November we also added sterling short versus US dollar
Meanwhile we keep our US dollar longs versus Japanese yen, and the Australian and New Zealand dollars in place



Recent developments

Up to the ECB meeting the euro was the weakest performing major currency losing around 4% versus the US dollar. The euro recovered strongly after the ECB decision and the press conference/Q&A session. EUR/USD rallied to levels above 1.09 during the press conference. Financial markets had anticipated on average a 15bp rate cut in the deposit rate and a 10bn increase in monthly purchases. Mr. Draghi did not meet these expectations as the deposit rate was cut by 10% to -0.30% and there was no increase in monthly purchases.

This ECB decision has also resulted in a lower probability of further monetary policy easing in Sweden and Switzerland. As a result, the Swiss franc and the Swedish krona also rallied versus the US dollar.

Australian dollar rebounds sharply….

The Australian dollar (AUD) was the strongest performing major currency last month as economic data surprised on the upside. Employment gains were stronger than expected. In addition, net exports contributed to a strong economic recovery in the third quarter. Furthermore, the Reserve Bank of Australia (RBA) seems cautious to ease monetary policy anytime soon.

…and the US dollar supported by rate hike expectations

The US dollar also performed strongly in currency and commodity markets, but gave up most of its gain on an index level after the ECB meeting (euro has a heavy weight in the index). Fed rate hike expectations a weaker commodity prices weighed on emerging market currencies.


Our convictions views

Since our latest report on 29 October, we have added euro short (12 November 2015) and a sterling short (26 November 2015) versus US dollar. Meanwhile we have kept in place our long US dollar views versus the Japanese yen the Australian and New Zealand dollar.

We added euro short US dollar long to our list again on 12 November…

We put EUR/USD short back on our conviction list on 12 November. The downward pressure on EUR/USD will likely increase when financial markets fully price in a December rate hike by the Fed (now 76% priced in). The risks are also skewed towards further ECB easing. This divergence of monetary policy across the Atlantic should push EUR/USD lower in the coming months. We have more Fed rate hikes next year than financial markets currently anticipate. We expect financial markets to catch up with our view in the course of next year. We expect parity in EUR/USD to be reached in March 2016 and 0.95 in June 2016.

…and also a sterling short versus US dollar on 26 November

Sterling will weaken significantly in 2016 in our view. Fiscal consolidation, past sterling strength and the fear of a Brexit will weigh on UK growth and result in a later start of the BoE lift-off than currently is anticipated in financial markets. Therefore, we added sterling short versus US dollar to our high conviction list on 26 November. We expect that the UK government will hold a referendum on Brexit in the third quarter of 2016. It is likely that GBP will build a risk premium in the months leading up to the referendum. We expect our first rate hike in November 2016. Financial markets still expect a one rate hike of 25bp and a 50% probability of another rate hike (in 2016). Our main scenario is that Brexit will be avoided. As a result, we expect sterling to recovery strongly following this referendum outcome also because the focus will turn to the start of the BoE rate hike cycle. Compared to market expectations, we see less rate hikes for 2016 but more tightening in 2017. Therefore, we expect a rally of sterling in 2017.


Monetary divergence and net investment flows to weigh on the yen

We maintain our view that the Bank of Japan (BoJ) is likely to further increase their qualitative and quantitative easing program in 2016 as they seek to achieve their 2% inflation target by the second half of fiscal year 2016. Recent economic data have weak. The first estimate of GDP growth in the third quarter was -0.8%, but this has been revised up to 1.0%. However, the components suggest that GDP growth could remain subdued in the coming quarters. In addition, inflation ex-fresh food and energy declined from 0.9% to 0.7% in October. (For more details please refer to our recent publication Global Outlook – Japan – So far, a poor score card for Abenomics published in 25 November 2015).

Wider interest rate differentials between the US and Japan are likely to exert downward pressure on the Japanese yen versus the US dollar. Furthermore, net outward investment flows from Japan will cap any sustained strength in the yen. The Government Pension Investment Fund (GPIF) has recently stated that they do not intend to hedge their US dollar investments exposure due to higher hedging costs and firmer USD trend outlook. Indeed, this is consistent with other life insurers investment plans announced a few months ago. We expect the yen to decline to 135 against the dollar by the end of 2016.

Strong NZD and weak dairy prices outlook to trigger RBNZ rate cut

In our view the current resilience in the New Zealand dollar (NZD) is not sustainable. House price inflation remains elevated, providing less flexibility for the Reserve Bank of New Zealand (RBNZ) to lower monetary policy further. However, new macro prudential tools which came into effect on 1 November are likely to cool house price inflation. Both the manufacturing and service sectors’ expansion trend remains intact. Consumer and business confidence have also recovered.

However, the weak dairy prices outlook will continue to weigh on domestic farm incomes and may lead to deterioration in both consumer and business sentiment. Weak food prices and the strong NZD are also likely to exert further downside pressure on inflationary pressures. The labour market outlook has also become softer in the third quarter. Last but not least, data from the RBNZ showed that the central bank were net sellers of NZD in October as it seeks to weaken the currency given that the NZD is much stronger than its forecast.

We expect the NZD to decline because of a cut in Official Cash Rate by 25bp to 2.50% on 10 December. We also expect the RBNZ to step up its interventions to weaken the NZD. This will result in an unwinding of speculative long positions in the NZD. Our 2015 and 2016 year end NZD/USD target is 0.64 and 0.58, respectively.

Recovery in AUD not sustainable – stay bearish

We maintain our bearish view on the AUD. We remain sceptical that the strong employment gains in October will be sustainable. Weak business investment is also expected to weigh on economic growth in the coming quarters. In addition, the recent recovery in the AUD is likely to weigh on net exports contribution to economic growth. It is worth noting that economic growth in the first three quarters of 2015 is weaker than in 2014. We also expect the RBA to increase its dovish tone on the exchange rate given the wider divergence between the AUD and key commodity export prices.

Furthermore, we expect non-tradable inflation to trend lower as housing auction clearing rates continue to decline and wage growth remains subdued. Looking ahead we maintain our view that it is likely that the RBA will lower the Official Cash Rate by 25bp to 1.75% in early 2016 as inflationary pressures continue to decline and the strong AUD will be a headwind to the rebalancing in the economy. As financial markets have not fully priced in the monetary divergence between Australia and the US, we maintain our 2015 and 2016 year end AUD/USD target of 0.70 and 0.62 respectively.