The US dollar continued its correction against most currencies last week, with the DXY dollar index testing 79.2.
Clearly, negative sentiment still overhangs the US economy, hindered by last month’s shutdown and the fact the government only managed to temporarily extend the debt ceiling to 7 February 2014. Furthermore, September’s weak job creations (148,000 vs. an expected 185,000) have heightened expectations that the Fed’s tapering of QE3 will be delayed until March 2014.
The Fed could indeed err on the side of caution in the months ahead, especially as data from October and November will be unreliable due to the negative effects of the government shutdown. In the short-term, the US dollar will continue to react to September’s economic indicators – with great importance resting on the manufacturing ISM report and figures for retail sales.
Hence, the market will be particularly attentive to the next Federal Open Market Committee meeting looking for light to be shed on precisely when the tapering will begin in the first quarter of 2014.
In this environment, the greenback will remain under pressure, and the DXY dollar index could decline as low as 78.6. The sole factor that could bolster the US dollar in the short-term would be a correction by the equity markets if earnings reports are mixed – bearing in mind the negative beta for the DXY dollar index vs. the S&P 500.
EUR: still a little upside potential
The euro profited from both the weakness of the US dollar last week and economic news out of the Eurozone, notably concerning the peripheral countries. In particular, the Spanish economy is reported to have emerged from recession in Q3, with growth reaching 0.1%. Furthermore, foreign investors are continuing to flock back into Spanish debt.
On the other hand, the market is paying no heed to negative reports, which suggests to us that the EUR/USD’s recovery back above 1.38 is an overreaction linked to the weakness of the US dollar. Indeed, October’s Purchasing Manager’s Index wasn’t impressive, with the composite index declining to 51.5 from 52.2 in September, confirming our scenario of a weak economic recovery in Europe.
Similarly, the market shrugged off the details of the Asset Quality Review for the European banking sector, which will take into account sovereign exposures. Following this will be stress tests and the likely recapitalisation of a number of banks at the end of 2014. The main concern of this comprehensive assessment is the fiscal capacity of some European countries to recapitalise their banks if they are found inadequate. To avert this risk, it’s important that European countries reach an agreement on the Single Resolution Mechanism in coming months.
Our view is that the EUR/USD is overvalued and it fails to reflect the gap in economic fundamentals between the Eurozone and the US. This is shown by the disparity of 2-year interest rates, which suggests the pair should be lower. Although the EUR/USD could overshoot as high as 1.40, we remain sellers above 1.38. If we look at the rebound of the 3-month Risk Reversals 25D to -0.4 from a low of -1.6 at the end of August, the market is already positioned very long. The Relative Strength Index (RSI) also suggests that the EUR/USD is overbought.
This week, the European Commission will be releasing its business surveys and, like the October PMI, they should reflect a deterioration of activity. Sooner or later, these factors will end up weighing on the EUR/USD.
Finally, an increasing number of European companies and institutions could voice their concerns that the strength of the EUR/USD will hold back the economic recovery and stoke deflation. In this respect, the publication of the October flash estimate, expected to put inflation at 1%, could fuel these concerns and affect the euro’s performance.
GBP: stronger
The minutes of the latest Monetary Policy Committee meeting underlined the fact the economic recovery had been swifter than the Bank of England had anticipated. As a result, the central bank has implicitly acknowledged that the 7% unemployment rate target could be reached before 2016.
The market has since been wondering whether the bank’s forward guidance will be revised, perhaps by a lowering of the unemployment rate target. As yet, a revision does not appear necessary – given that the economic surprise index has deteriorated steadily since September.
In the short-term, sterling should extend its rebound against the US dollar as well as against the euro, particularly after GDP firmed to 0.8% in Q3 (from 0.7% in Q2) and property prices continue to inflate. Under these conditions, we estimate that the GBP/USD still has upside potential to 1.6310, while we would be sellers of EUR/GBP above 0.858.
JPY: still very stable
Like other currencies, the Japanese yen continued to appreciate against the US dollar last week, though it also benefited from a resurgence of risk aversion prompted by the correction of the Nikkei index and Asian equity markets. The International Monetary Fund (IMF), however, is expressing increasing concern about the sluggish Japanese economic recovery, which could lead to an upturn in long rates.
This would be negative for the Japanese banking sector, which – along with the life insurance sector – is the main holder of Japanese government bonds. The Japanese 10-year rate, however, remains low at 0.6% thanks to the Bank of Japan’s aggressive monetary policy direction.
In the short-term, the performance of the USD/JPY will be dictated by the US dollar. This week, the pair could go on to test 96.8. Nonetheless, it is preferable to play a further decline in 3-month implied volatility, which has continued to decline to 8.85% and could go on to test 8.0%.
CHF: will remain under upward pressured against USD in short-term
Due to the weakness of the US dollar, the USD/CHF corrected to 0.891 last week. In addition, the Swiss franc benefited from the trade surplus improvement of CHF 2.49 billion in September, much higher than the expected CHF 2 billion. The EUR/CHF did not move much, still holding around 1.23. This week, the USD/CHF could go on to test 0.885 – a level at which we would be buyers to play a sharp rebound six months out, once US risks have subsided. As for the EUR/CHF, it should hold above 1.23.
AUD: toppish
After a strong rebound to 0.975 on the back of a weaker US dollar, the AUD/USD corrected sharply at the end of last week, reaching as low as 0.9575. This correction came after the Chairman of the Reserve Bank of Australia suggested that a weaker currency would facilitate the economic transition that aims to reduce dependence on the mining sector. The central bank’s view is that the strength of the currency is the biggest brake on the recovery of certain sectors of the economy, while its major fear lies over Chinese growth (which as yet is proving rather resilient, as shown by October’s PMI).
Even so, risks overhanging the Chinese economy have not vanished, with the Chinese yuan at an all-time high of 6.08 against the US dollar and further monetary strains.
Under these conditions, we remain cautious on the AUD/USD above 0.9750, a level at which we would be tempted to turn sellers even though a sharp correction is unlikely in the short-term given the weakness of the US dollar.
NZD: unsettled, but could have some upside potential
The New Zealand dollar managed to move higher last week, but it ended up correcting in reaction to the monetary strains in the Chinese banking system. The kiwi was also penalised by a local press report that the government was planning to introduce a capital gains tax to curb rising property prices.
No doubt, the currency will remain under pressure following the view of the Reserve Bank of New Zealand that the currency remains overvalued and it stands ready to intervene in the markets. This is despite the fact it still intends to raise its interest rates in Q2 2014 on account of the property bubble. Hence, the NZD will remain on the defensive ahead of this week’s central bank meeting.
We would not hesitate to turn buyers of the New Zealand dollar once the current consolidation is over. But we would be sellers of the AUD/NZD above 1.1585.
CAD: weaker
The Bank of Canada removed the upward bias on its key monetary rates when it met last week. There was no mention of the need to tighten or normalise these rates, because risks for inflation are tilted on the downside and this is taking on an added importance. The bank’s growth and inflation forecasts were both lowered and there is now an expectation for a return to full economic capacity six months later than planned (at the end of 2015) and for inflation to reach 2%.
Accordingly, the bank has trimmed its growth forecasts to 1.6% for 2013 (from 1.8% previously) and to 2.3% for 2014 (from 2.7%). The global environment is less conducive for a recovery in the country’s export levels and company investments. Hence, it is unlikely the Bank of Canada will start raising its interest rates before March 2015 (instead of the expected fourth quarter of 2014). For these reasons, we see the USD/CAD extending its rise to 1.057.
SEK: set to remain volatile…
As expected, Riksbank kept its repo rate on hold at 1.0%. Although it trimmed its 2013 growth forecast to 0.7% from 1.7% previously, it remains optimistic about the 2014 outlook given the improvement in European growth, though it still expects inflation to move back towards its target level over the medium-term. Under the circumstances, Riksbank has stressed that monetary prospects priced in by the market were appropriate, and that an interest rate hike is likely over the next 12 to 18 months. This announcement bolstered the Swedish krona against the US dollar and the euro, especially after the publication of statistics showing industrial and consumer confidence improved sharply in October. In reaction, the EUR/SEK corrected as low as 8.75. Given the short-term uncertainty, we would be buyers of the EUR/SEK around 8.70 to play a recovery to 8.90.
… as should the NOK
The meeting of Norges Bank this month did not shed any new light on their policy direction, as the intention remains to raise the key policy rate in Q3 2014. In the short-term, the performance of the Norwegian krone will depend on the next set of economic indicators, notably those due to be published this week (including figures for industrial confidence, retail sales, employment, and lending). Given the likelihood that these statistics will disappoint, the EUR/NOK could test 8.25.
Natixis