EUR: EUR/USD heading towards 1.27The announcements of the European Central Bank (ECB) – including a rate cut and an Asset-Backed Securities (ABS) programme – sharpened the correction of the EUR/USD that has been underway since the ECB announced a first series of measures in June. Weaker economic activity and inflation in the eurozone this summer, compared to the US, prompted the ECB to react even before the staging of the first Targeted Long-Term Refinancing Operation (TLTRO) this month. After these latest measures, the EUR/USD broke below our short-term target at 1.30 in reaction to the increasingly diverging monetary policies on either side of the Atlantic.
It is very likely that the EUR/USD’s decline will be far sharper in coming quarters than previously expected, for several significant reasons. Firstly, the 2-year spread can be expected to widen further due to anticipation of a rise in US rates over the coming months. Secondly, the ECB is looking to increase the size of its balance sheet back to 2012 levels, which should be favourable to a weaker EUR/USD over the medium term, as suggested by the ratio comparing monetary bases in the US and the eurozone.
Furthermore, we may see a more significant recycling of the European current account surplus into US assets, as these will be more attractive in coming months. Also, there was another increase last week in short euro positions, even before the ECB meeting, to EUR 20bn. These short positions are nearing levels seen at the height of the European crisis in 2012 before the ECB announced the Outright Monetary Transactions programme. It seems likely short positions will continue to rise in the short- to medium-term, particularly if the market uses the euro as a borrowing currency for carry trades.
The final factor suggesting the euro has downside is the level of 3-month 25-delta Risk Reversals, which remain high, even after a slight decline in recent days. If sentiment remains negative on the euro because of the very weak growth and inflation, one can expect large forex market participants to hedge their exposure to a further and much sharper decline of the EUR/USD in coming months. This should also contribute to the pair’s steady decline.
USD: set to strengthen
Turning to the US, the US dollar should continue to recover as the country’s rate of economic growth picks up. Although the last Employment Situation Report was disappointing, the trend remains positive for employment – as underlined by the latest Institute for Supply Management surveys for the services and manufacturing sectors. All these elements suggest that the Federal Reserve will stick to its monetary scenario of a first hike in the Fed Funds rate mid-2015, which as yet is not fully priced in. Regarding such a hike, an Economic Letter published by the Federal Reserve Bank of San Francisco on 8th September warns that the markets expect a more accommodative policy than do Federal Open Market Committee (FOMC) participants. When expectations of an interest rate hike do heighten in coming months, they can be expected, in our view, to bolster the US dollar, notably against the euro. The widening of the 3-month basis swap in recent months reflects an appreciation of the greenback. This phenomenon has in fact been observed for most currencies against the US dollar, which can also be expected to bolster the US currency.
It follows that we see the EUR/USD weakening to 1.27 (vs. 1.30) at the end of the year, and then to 1.23 (vs. 1.25) at the end of 2015. It is even likely the pair will test 1.21 at some point next year. What happens to the EUR/USD this week will be influenced in particular by the FOMC meeting and the expected change in tone in the accompanying press release. In addition, Thursday will see the first TLTRO, the results of which will be scrutinised to see if it is a real success. Under these conditions, the EUR/USD should correct towards 1.27.
USD/JPY on course towards 108.5
The USD/JPY raced past our first target at 105 to near 107 in the face of a US dollar that was particularly invigorated in the run-up to the FOMC meeting on Tuesday and Wednesday of this week. Meanwhile, the Bank of Japan issued further negative statements about the yen, saying it stands ready to act if its inflation target is undermined. In this environment, the USD/JPY could appreciate to 108.5 and the EUR/JPY towards 139.3.
USD/CHF: buy on any correction
The USD/CHF surged past our 0.93 target last week, chiefly because of the strengthening of the US dollar and concerns that the Swiss National Bank will step in to defend the 1.20 floor rate for the EUR/CHF, which is being tested. There is a risk the USD/CHF will consolidate in the very near term, as technically the pair is overbought, but the underlying trend remains positive. We recommend buying the pair on any correction to play a subsequent recovery towards 0.95. The Swiss National Bank’s monetary policy assessment on Thursday will be watched closely to see if the bank intends to take new measures – such as setting negative rates – to limit the decline of the EUR/CHF, which in the short- to medium-term is likely to hover near 1.20.
GBP: penalised by Brexit concerns
Sterling fell sharply, especially against the US dollar, in reaction to an increase in the probability that the “Yes” campaign will prevail in the Scottish independence referendum on 18th September. This possibility, which was not a serious concern until recently, triggered a sharp rise in volatility caused by the high levels of economic and political uncertainty if the “Yes” campaign wins. Aside from questions regarding the foreign exchange system between the two countries, important as these are, the market will be particularly concerned about the political consequences. If Scotland secures its independence, this is likely to have negative repercussions for the two main British parties – namely the Tory Party and the Labour Party – to the benefit of UKIP. Such a swing in public opinion would, in turn, strengthen the Europhobe camp, raising concerns the UK will exit the European Union – a British Exit (Brexit) being the bugbear of business circles.
If “Yes” comes out on top, this could rapidly precipitate the fall of Cameron’s government, triggering snap general elections, with a probable victory by the Labour Party (possibly in coalition with the Liberal Party). Such a scenario would be positive in that the referendum on EU membership scheduled in 2017 would be called off. For business circles, however, a Labour victory would be cause for consternation – given concerns of a less business-friendly economic policy.
In addition, in the event of a “Yes” result, political uncertainties would not fade greatly since further general elections would have to be held when independence would ultimately be gained in 2016 (at the earliest) – bearing in mind that 59 Scottish MPs (most of whom are Labour) would no longer sit in Westminster, paving the way for a Tory victory, thereby raising anew the spectre of an EU referendum.
On the other hand, if David Cameron were to stay in power after any “Yes” victory, it would be likely that the 2015 general elections would be pushed back in time so as to avoid 59 MPs being returned by Scotland. This would increase the probability of a victory by the Eurosceptic camp (notably UKIP) in the referendum on EU membership; something that, in turn, would have terrible consequences for the British economy, not least because it would trigger massive capital outflows. Shorn of Scotland and out of the European Union, the UK would be weakened and increasingly isolated, even in relation to the US. In short, David Cameron is caught in a vicious spiral from which he will struggle to extricate himself. After a lengthy battle to block the appointment of Jean-Claude Juncker as Commission President, David Cameron needs to reach out to him to find a face-saving agreement that will remove the need for a referendum in 2017.
All these economic and, especially, political uncertainties will continue to weigh on British assets until 18th September. The latest polls cast the “No” campaign as victorious, which suggests the result will be tight. If the “No” campaign does come out on top, sterling should rebound towards 1.64 against the US dollar, especially since Mark Carney’s rhetoric remains hawkish. Given the still significant long sterling positions, a victory by the “Yes” campaign would trigger a further sharp decline of the GBP/USD towards 1.55, and even lower once more is known about Prime Minister David Cameron’s reaction. In this eventuality, the best scenario would be for him to resign, ceding the reins of government to the Labour opposition in coalition with the Liberals, as the 2017 referendum would then be called off, reducing (for a while) fears of a Brexit.
This week, the market will track the latest polls and economic data, bearing in mind that Governor of the Bank of England Mark Carney remains rather hawkish. Watch out too for the minutes of the latest Monetary Policy Committee meeting, out on Wednesday, as well as unemployment and retail sales statistics.
AUD/NZD heading towards 1.099
The AUD/USD fell sharply in the face of the Reserve Bank of Australia’s determination to weaken the country’s currency and, in particular, another downturn in iron ore prices, which are testing USD 80/t; their lowest level since 2009. The very sharp improvement experienced by the labour market in August (121,000 jobs were created compared to an expected 15,000) did limit slightly the currency’s slide. The AUD/USD’s fall was also partly due to the strong rebound of the US currency. In coming days, watch out especially for the minutes of the latest central bank meeting. Under these conditions, the AUD/NZD could extend its correction towards 1.099.
NZD/USD heading towards 0.808
As expected, the Reserve Bank of New Zealand kept its official cash rate on hold at 3.50%, after raising this rate by 100bp in recent months. The Bank wants to see how recent policy tightening will affect economic activity and inflation, and seemed less hawkish than expected in the face of moderate inflation. Indeed, it hinted it would continue to raise its rates, but at a moderate pace, probably after a monetary pause that could last several months.
The central bank’s view is that inflation remains moderate so far, but that it could increase in coming months as spare productive capacity is absorbed.
It estimates that annual inflation will reach 1.4% in Q1 2015 (instead of the 1.8% previously predicted), but remains positive regarding GDP growth, forecast at 3.6% for 2015. Under these conditions, the central bank’s forward guidance has come in for a sharp downward revision, suggesting that there will be a lengthy monetary pause until March 2015.
In the short term, the NZD/USD will remain downbeat due to the downturn in commodity prices, with the publication of Q2 2014 GDP unlikely to modify the current downtrend. Under these conditions, the NZD/USD could rapidly go on to test 0.808.
EUR/SEK on course towards 9.39
The Swedish krona has depreciated by nearly 13% against the US dollar since March in reaction to the deterioration in economic activity (which is very dependent on European growth) and negative inflation (which forced the Riksbank to react and cut its repo rate by 50bp to 0.25%). In recent days, the downturn of the Purchasing Manager’s Index surveys, the decline in industrial output in July, the weaker household consumption and weaker-than-expected annual inflation in August (-0.2%) weighed on the Swedish currency – especially against the US dollar, but also against a euro weakened by the ECB’s latest measures. In coming weeks, the EUR/SEK should continue to appreciate towards 9.39, particularly in the run-up to the publication of the Riksbank minutes and of Q2 GDP, which could be disappointing.
USD/NOK heading towards 6.50
The Norwegian krone has slumped against the USD, with the USD/NOK rising to 6.37. One reason was the strength of the greenback, as well as the likely squaring of long positions on the Norwegian currency. The decline in industrial output and weaker-than-expected annual inflation in August (2.1%) also weighed on the currency. The USD/NOK may well appreciate further in the run-up to this week’s central bank meeting, with expectations that Norges Bank will maintain the status quo but issue a rather dovish statement. Under these conditions, we recommend buying the USD/NOK on any correction to play a subsequent recovery towards 6.50.
Natixis