-US dollar firms post FOMC and risk sentiment improves in FX market
-We maintain bearish on EUR, JPY, GBP, AUD and NZD
-This year commodity prices have been a dominant driver for EM FX…
-… as were prospects of higher US rates and a higher USD
-Going forward we expect a stabilisation and recovery in commodity prices to have a positive impact of currencies of commodity exporters
-PBoC action cools sentiment
US dollar firms post FOMC
The US dollar firmed against its trade weighted basket of currencies after the Federal Reserve, as was widely expected, raised the federal rate target by 25bp on 16 December. Fed Chair Yellen’s confidence on the strength of the US economy supported the US dollar. In addition, the FOMC median projections for 2016 remained steady, with another 100bp increase projected. This is about 50bp more than what is currently priced in by financial markets. We expect in total 75bp rate hikes in 2016. Hence, we remain optimistic on the US dollar in 2016.
Risk sentiment improves in FX market
Risk sentiment in the currency market improved as the Fed reiterated their stance that future rate hikes will be slow and gradual. A stronger US economy is also positive for the global economic outlook. Implied volatility in the currency markets eased lower and the demand for safe haven currencies like the Japanese yen (JPY) declined. A more constructive risk environment could provide some support to high yielding currencies like the Australian dollar (AUD) and New Zealand dollar (NZD) which eased lower after the FOMC decision.
Maintain bearish on EUR, JPY, GBP, AUD and NZD
We expect monetary policy divergence in 2016 to weigh on the Euro, JPY, AUD and NZD. Further monetary stimulus from the ECB, BoJ, RBA and RBNZ is expected in the first half of 2016. Political uncertainties ahead of UK referendum in Q3 2016, some slowdown in the UK economy and later rate hikes by the BoE are expected to weigh on sterling. We maintain our high conviction bearish views on these currencies versus the US dollar.
Commodity price weakness more important than Fed lift-off for EM FX
Weakness in emerging market currencies has mainly been the result of the sell-off in commodity prices and weak domestic fundamentals. In addition, the stronger US dollar has not been helpful either. The graph below shows the high sensitivity of the major emerging market currencies (such as Russia, South Africa, Indonesia, Brazil, Chile, Mexico and Thailand) to developments in commodity prices. Clearly they move in tandem. This does not come as a surprise as these are currencies of commodity exporting countries.
The aggressive sell-off in oil prices since the OPEC meeting two weeks ago has also pressured other commodity prices and emerging market currencies. This year the Brazilian real has been the weakest currency in our coverage (-30% ytd versus the USD) because of the recession in Brazil, political crisis, risk of a downgrade and inflationary pressures. In the near-term these developments could deteriorate further. Overnight, rating agency Fitch cut Brazil’s credit rating to non-investment grade. Brazil has now lost its investment grade status as two out of three rating agencies (Fitch & S&P) have Brazil now as non-investment grade. Despite this news we do not expect new lows for the Brazilian real. This is because most of the negative news appears to be priced in and the central bank continues to intervene. The outlook of the South African rand (-24% ytd vs the US dollar) is deteriorating at a rapid pace and the rand is doing a catch-up with the real. The rand in particular is vulnerable because of weak economic fundamentals (current account deficit, weak growth, impact of low commodity prices), political miscalculation and the risk of a downgrade. In the near-term the rand will unlikely recover.
Stabilisation of commodity prices to be key for commodity FX
Although we think that commodity prices are the most dominant driver for EM commodity currencies, higher US dollar and US interest rates also likely negatively affect these currencies. The next graph shows the sensitivity of commodity currencies to expectations on US interest rates (3M eurodollar futures). The upward adjustment in US interest rate expectations in the US clearly added to the woes of emerging market currencies. A further adjustment in interest rate expectations next year will continue to be a headwind for these currencies. However, if investor sentiment remains relatively constructive and commodity prices stabilise and recover somewhat in line with our view, most of these emerging market currencies will likely be able to recover as well. On the other hand, we expect further weakness in Asian currencies due to weaker Chinese yuan, euro and Japanese yen and firmer short term yields in the US.
PBoC in action
Since the start of December, the CNY index has declined by about 1.5%, sparking market fears that the People’s Bank of China (PBoC) is seeking a weaker yuan to inflate and support the economy. On 11 December the PBoC introduced a new currency index to better capture shifts in its competitiveness. (see our FX Watch – CNY index implies weaker CNY? Published on 15 December). The sentiment in the yuan deteriorated slightly on 17 December after the PBoC raised the USD/CNY daily reference rate higher than the previous day closing rate. We highlight that he higher USD/CNY fixing rate is reflective of stronger US dollar post FOMC and is in line with other currencies. The CNY has remained steady and not weaker against its trade weighted basket of currencies.
Looking ahead, we expect the divergence between the offshore (CNH) and onshore yuan (CNY) to narrow in the coming weeks. Indeed, since the beginning of this week, the CNH discount to the CNY has narrowed from about 1000 pips to about 700 pips at the time of writing. We also expect volatility in the yuan to be higher than in previous years as the central bank allows the currency to be more market determined. Nevertheless, large volatility and depreciation pressure on the yuan will likely not be tolerated. Our 2016 forecast for USD/CNY is 6.55, less pessimistic than what is priced in by financial markets.