Calm returns for emerging currencies
Some calm returned to emerging markets last week, as several central banks (including those of Turkey, South Africa and India) announced interest rate hikes. This was in a bid to curb inflationary pressures and reduce their current account deficits.
As a result, investors have moved back into a number of emerging assets, taking advantage of the now-attractive valuations. This is a tactical move that has benefited local debts, with five-year rates pulling back by around 30 basis points since the start of February.
In the short-term, however, the rally staged by emerging assets will be rapidly capped if the frailest countries’ current account deficits and inflation continue to deteriorate – not least due to the Federal Reserve’s ongoing tapering, and monetary tightening in China.
USD: no tone
In an environment characterised by declining risk aversion, the DXY dollar index corrected last week, pulling back below 81. The improvement in several economic indicators (such as the non-manufacturing ISM and the ADP Employment Report) reassured the market’s perception of US growth. Several Federal Reserve members – chiefly hawks like Charles Plosser – have called for an acceleration of “tapering” before the summer.
Even so, economic data will have the greatest bearing on the US dollar’s performance. Despite relatively disappointing employment figures and retail sales released just this morning (which is likely to weigh on the greenback – or at least limit its recovery in the short-term), it should be remembered that employment in the manufacturing and construction sectors rebounded sharply.
EUR: set to hold steady against the USD in the short term
The EUR/USD tested 1.3490 last week, in reaction to heightened expectations of an interest rate cut by the European Central Bank (ECB), following a weakening of annual inflation to 0.7% in January.
However, the pair rebounded back above 1.36 after the central bank maintained its monetary position, due to the complexity of the economic situation and the need for more data. Next month, the central bank will have more relevant growth and inflation forecasts at its disposal. As for actions, an eventual end to the sterilisation of the ECB’s Securities Market Programme (SMP) seems less likely than recourse to the Asset-Backed-Securities (ABS) market.
Yet, the euro will remain under pressure, particularly if inflation does indeed remain weak come the March meeting. This is all the more likely because a strong euro will continue to drive down energy prices and stoke concerns of deflation taking hold in the eurozone.
At the same time, the EUR/USD will depend largely on the situation in the US and, in the short-term, on the potential for negative economic data following January’s adverse weather conditions.. These combined factors suggest that the EUR/USD should continue to hover between 1.35 and 1.37 in the short-term. Over the medium-term, however, we remain bearish on the EUR/USD towards 1.30 come June, bearing in mind the ECB will be forced to take action. Indeed, given mounting deflationary pressures, the market could quickly lose patience if the ECB does not react rapidly.
JPY: still under upward pressure
As expected, the Japanese yen strengthened in reaction to renewed risk aversion over emerging markets. The USD/JPY pulled back temporarily below 101 before recovering above 102 at the end of the week, after the stabilisation of the emerging markets.
The US dollar will continue to influence the pair’s performance, so we recommend selling the USD/JPY on any significant rebound to 103 (to play a pullback towards 100). This is especially as there is much market concern for capital repatriations in the run-up to the Japanese fiscal year end. In fact, Japanese investors were net sellers of foreign bonds for the fifth consecutive week.
The market will also focus on salary negotiations in Japan. If companies still baulk at pay increases in order to bolster consumption – and hence growth – then the Japanese yen could rebound, particularly ahead of the VAT hike at the start of April.
GBP: under pressure ahead of Inflation Report
After last week’s correction, the GBP/USD is set to remain under pressure pending the publication of the Bank of England’s Inflation Report. This should provide an opportunity for the central bank to modify its “forward guidance”, given the rapid decline in the unemployment rate towards the 7.0% threshold.
The Bank of England could lower this to 6.5%, at which point it will consider raising its bank rate. Alternatively, like the Fed, it may minimise the criticality of the unemployment rate in favour of a larger number of indicators – notably salaries and productivity, which remain weak. This would likely weigh on sterling, as it reduces market expectations of an interest rate hike, which have risen over the last fortnight after the publication of some positive economic indicators.
However, we expect this correction to be short-lived. Sterling’s strength in recent months has not been linked to expectations of an interest rate hike, but to the significant inflow of capital coming from emerging countries. In this environment, we prefer to play a strengthening of sterling against the euro to 0.817.
CHF: still very firm
In demand during the recent emerging market volatility, the Swiss franc appreciated against both the euro and the US dollar over the course of last week. There was no respite for the currency, even with the stabilisation of emerging markets at the end of the week.
Against this backdrop, the Chairman of Swiss National Bank, Thomas Jordan, indicated that the central bank would continue to defend the floor rate for as long as necessary.
In the short-term, the USD/CHF is likely to hover within a narrow range from 0.8950 to 0.91, whereas the EUR/CHF could pull back temporarily below 1.22, especially if expectations of an ECB rate cut intensify.
Commodity currencies: resilient AUD, NZD and CAD
During the correction undergone by emerging currencies, the Australian and New Zealand dollars proved rather resilient – even in the face of a US dollar bolstered by the renewed risk aversion.
The Australian dollar drew strength from the Reserve Bank of Australia’s neutral bias for its monetary policy, thanks to economic improvement. In particular, there was no allusion to the Australian dollar being overvalued, likely due to the recent spike in inflation (to 2.7% in Q4 2013, above the 2.4% consensus). It seems the central bank is ensuring inflation is first stable before implementing any new measures, even though the unemployment rate has been rising sharply for more than one year now.
In this respect, watch out for the January unemployment figures due out this week, as well as the NAB monthly business surveys. Another rise in the unemployment rate will likely push down the Australian dollar. Conversely, the AUD/USD could extend its rebound past 0.90 if the Australian unemployment rate improves.
The New Zealand dollar, meanwhile, was bolstered by the decline in the unemployment rate to 6.0% in Q4 2013. This figure has heightened expectations of an interest rate hike as early as March, as suggested by the Reserve Bank of New Zealand. This week, the NZD/USD still has some upside to 0.8346, possibly 0.843.
As for the Canadian dollar, it appreciated slightly to 1.0987 on the back of a better Ivey manufacturing index in January and Canadian employment report (29,400 jobs vs an expected 24,000). But, given that growth is not reaching its potential and inflation remains low, trends remain negative looking forward. Consequently, we recommend buying on dips below 1.10, towards an objective of 1.13.
SEK: under pressure
The Swedish krona rebounded last week, even though Swedish macroeconomic data was mixed (there was an increase in manufacturing PMI figures, whereas the services PMI weakened). In addition, industrial production fell by 1.0% month-on-month in December.
This week, the krona will be under pressure ahead of the meeting of the Riksbank, though the central bank is not expected to modify its monetary policy. Keep a close eye out for the latest inflation forecasts, however, which could confirm the deflation risk. If this holds true, monetary policy is likely to remain unchanged for some time, heaping more pressure on the krona. We therefore recommend selling the Swedish krona on any recovery, and the USD/SEK is likely to recover towards 6.70 this week.
Natixis