Uneven global economic conditions within the developed world, intensifying intervention by the European Central Bank (ECB), a more cautious rhetoric by the Federal Reserve, escalating uncertainties regarding UK’s future relationship with the European Union, and increasing global risk appetite on the back of a gradual recovery in energy and metal prices have all emerged as key factors shaping global foreign exchange markets.
The US dollar (USD) is ending the first quarter on a weak note despite underlying economic strength, reflected in positive labour market developments, benign inflationary pressures and resilient domestic consumption. Overall, 2016 so far has been unkind to USD bulls, with the Fed choosing to stand pat on interest rate policy in March, and Fed Chair Yellen emphasizing downside risks to the US economy originating from external factors. We remain constructive on the USD over the balance of the year. However, we have opted to recalibrate our expectations in view of our changed assessment of Fed’s monetary policy normalization course (two 25bps rate hikes this year, from four). We now expect EURUSD to bottom out at 1.02 late this year and expect USDJPY to end 2016 at 118.
The strength in the EUR is unsustainable. Support for the USD from the asymmetric growth and diverging monetary policy dynamics between the US and Europe has yet to materialize but we find it hard to get too negative on the dollar – or constructive on the EUR. We cannot exclude the potential for EURUSD to gain towards 1.15 in the short run, but sluggish euro zone growth and extremely low inflation (and inflation expectations) will weigh on the EUR later on in the year.
Additionally, a more aggressive European Central Bank QE programme (increasing asset purchases to EUR80bn/month from EUR60bn) with enhanced liquidity support for non-financial corporate debt issuers should encourage EURUSD bears. Relative central bank balance sheet considerations and the risk of euro zone portfolio outflows due to negative interest rates and Brexitlinked uncertainties, remain important EUR-negative factors also.
We are more constructive on the Canadian dollar (CAD) outlook. We think USDCAD’s late January run up to 1.47 marked the high water mark of the bearish CAD tide. Oil prices have bottomed out and the fiscal stimulus in the federal budget should discourage the Bank of Canada from lowering rates further. We now look for USDCAD to end 2015 at 1.30 but technical signals suggest the risk of a serious downside overshoot materializing in the next few weeks.
We are more reticent about prospects for the AUD and NZD because of a preference for a weaker exchange rate expressed by their central banks. We continue to feel that the Reserve Bank of Australia could lower monetary policy rates this year. Slower Chinese economic growth may also undercut demand for regionally-sourced commodities.
Heightened volatility in the pound (GBP) remains a concern ahead of the UK referendum on EU membership scheduled for June 23rd. Our base case assumes that the UK electorate will choose to remain in the EU and a “stay” vote should generate a broad GBP relief rally.The GBP is the only G-10 currency to have lost ground against the USD year-to-date as investors price in the risk of a “Brexit”; uncertainty is liable to keep the GBP under pressure leading up to the vote. A vote to leave the EU will be significant negative development for the UK economy and the GBP – but it may also have negative implications for the EUR. A UK withdrawal may weaken EU structures and fuel concerns about a euro zone breakup.
The yen (JPY) gained in a typical safe-haven response to weaker global equity markets at the start of the year. The JPY is the best-performing G-10 currency year-to-date but there is little to suggest that the JPY’s strength is fundamentally justified. A rebound in energy prices is negative for the country’s terms of trade and growth momentum remains feeble. We expect solid support for USDJPY around 110/111 going forward.
Developing market currencies have performed quite strongly overall in the first quarter despite a sharp sell-off in mid-January. Gains have been influenced by stable Fed policy and a steady rebound in crude oil prices. Attractive bond yields and firmer commodity prices have been especially supportive for the likes of the Brazilian real and the Malaysian ringgit, which have outpaced gains in the majors versus the USD.
The Mexican peso (MXN) is little changed in the quarter overall but continues to strengthen in line with external market conditions following February’s unprecedented round of fiscal and monetary support for the peso. The Chinese yuan (CNY) has edged slightly higher versus the USD from the early January low. Contained movement in the exchange rate reflects the Chinese authorities’ desire to keep the CNY “basically stable”. We expect slower growth to exert a modestly negative influence on the CNY over the balance of the year. Despite recessionary conditions in Russia, the ruble (RUB) has also gained from the reversal of global risk aversion in the past month.