US dollar still on the defensive as raw materials drop in price
The Fed might sound optimistic on the remainder of the year, but the US dollar has taken a hit regardless, says Nordine Naam, Senior Forex Analyst at Natixis…
Despite the optimistic tone of the Federal Open Market Committee (FOMC) statement, the US dollar weakened slightly last week. This was due, in large part, to the downturn in price of raw materials. As a result, the Dollar Index (DXY) pulled back below 99.
Meanwhile, the Federal Reserve (the Fed) intends to press ahead with its monetary normalisation even though there has been a sharp slowdown in GDP growth to +0.7% in Q1 2017 (from +2.1% in Q4 2016). According to the Fed, slower growth in Q1 is temporary and it remains positive with regards to growth over the rest of the year. Indeed, business surveys still point to a recovery in growth, while the labour market remains dynamic.
On this occasion, we have revised our monetary policy scenario for the US as the Fed remains intent on shrinking its balance sheet before the end of the year.
It is also worth noting that $415bn of bonds will reach maturity next year. As such, we now expect only two further hikes in the Fed Funds rate in 2017 (one in June, another in September). However, we still expect three hikes in 2018 and, although inflation is expected to fluctuate around 2.8% in coming quarters, the Fed’s monetary normalisation will be conducted carefully. Furthermore, we remain cautious on Donald Trump’s fiscal reform – given the risks over his programme being passed by Congress by the end of the year.
In this context, the Fed Funds futures curve steepened anew with the probability of a hike in the Fed Funds rate at the 14 June meeting now put at 94%. In this respect, there will be a raft of speeches by FOMC members in the week ahead. These should be used to prepare the market for the June hike – in turn bolstering the US dollar, particularly if the April Employment Situation is positive.
EUR: EUR/USD could appreciate temporarily
The EUR/USD held stable around 1.09 ahead of the second round in the French presidential election and the US Employment Situation Report. Certainly, Emmanuel Macron’s victory should be positive for the euro in the very near term.
However, the EUR/USD’s rebound potential will be limited for several reasons. Firstly, for the rebound of the EUR/USD to continue, the OAT-Bund spread would need to narrow to significantly less than 45bp. Secondly, short euro positions remain very slight, as well as insufficient if there is some profit-taking to fuel a sharp technical rebound. Finally, it is unlikely the market will turn buyer of the euro over the short-to-medium term.
The EUR/USD could rapidly go on to test 1.1035. Above this level, however, the pair will start to run out of steam in the face of a European Central Bank (ECB) that is still reluctant to overhaul its monetary policy.
Even a change in the central bank’s forward guidance in June and the announcement of the tapering (or at least a recalibration of QE) will not fuel a sharp rebound by the euro.
These possible developments are starting to be priced in the Eonia forwards, their curve having steepened anew. The ECB will not raise key monetary rates before the end of 2018, which means that in the interval key monetary rates on each side of the Atlantic will move further apart.
Finally, the EUR/USD being closely correlated to the TNote-Bund spread suggests that the pair should head towards 1.07-1.08 over the short to medium term as the TNote-Bund spread is expected to hold between 200bp and 210bp in coming quarters. To take into account the change in our monetary scenario for the US and delays in the US fiscal reform, we have revised our target for the EUR/USD to 1.10 at the year-end.
GBP: stable in the short term
Despite frictions between British and European authorities over the Brexit Bill – now revised from €60bn to €100bn – sterling did not budge much last week. For the moment, the European Union (EU) has ruled out opening negotiations over the future trade agreement (which were supposed to start in June) before the cost of the divorce has been settled.
Sterling seems to be bolstered by the absence of signals pointing to a sharp slowdown in British growth and hopes that the trade negotiations will be less difficult once Theresa May has consolidated her political base following the June snap elections. All this has spurred a squaring of short sterling positions in recent weeks which explains the currency’s technical rebound. Given that there are still sizeable short positions, an extension of this technical rebound can no longer be ruled out as investors will not be able to remain short for very much longer. Under these conditions, the GBP/USD could temporarily test 1.31 before correcting.
This week, watch out for industrial production and the Bank of England (BoE)’s Inflation Report. Bearing in mind crude oil prices have fallen back and that the central bank is concerned growth will slow over the medium term, we do not expect a change in the BoE’s monetary policy triggered by the stronger inflation. This week, we see the EUR/GBP being relatively stable around 0.845.
However, over the medium term we remain cautious. Indeed, with the prospect that the UK will lose access to the single market and the City surrender its passporting rights, growth is expected to falter. As such, company and household investment should weaken. Under these conditions, we see the EUR/GBP pulling back towards 0.90 at the end of the year.
JPY: USD/JPY heading towards 115
With a greater appetite for risk – owing to the decreased French political risk and the stand-off with North Korea – the Japanese yen weakened against the US dollar. Also, the Bank of Japan (BoJ) has stressed that it intends to maintain an accommodating monetary policy.
Certainly, the divergence in the monetary policies of the Fed and the BoJ is evidenced by the USD/JPY and US long interest rates to which the pair is closely correlated. The USD/JPY tracked the rebound in US long interest rates from a low of 2.20% mid-April to 2.35%. In the run-up to the June FOMC meeting, when we expect a 25bp hike in the Fed Funds rate, US long interest rates should continue to rise – in turn favouring the appreciation of the USD/JPY towards 115 and of the EUR/JPY towards 127.
Commodity currencies under pressure
Commodity currencies corrected in reaction to the continuing downturn in prices for raw materials
Last week, commodity currencies corrected in reaction to the continuing downturn in prices for raw materials, as well as the weak business surveys recently published by China. For instance, iron ore corrected as low as $65/t, while copper weakened by 3% last week. At the same time, Brent slumped, pulling back below $50/bbl to $48/bbl.
In this context, the AUD/USD pulled back below 0.74 – this was in part due to theReserve Bank of Australia (RBoA) seemingly disinclined to raise key policy rates and the property risk, which stems from the significant indebtedness of Australian households. This week, the AUD/USD could correct to 0.729 in the face of a stronger US dollar, notwithstanding what should be some upbeat macroeconomic data out of Australia (NAB business survey, retail sales, etc.).
The New Zealand dollar proved somewhat resilient given its lesser dependence on metal prices
The New Zealand dollar proved somewhat resilient given its lesser dependence on metal prices yet its significant exposure to dairy product prices (which have been on the rise since mid-April). The currency also benefited from the rise in 2-year inflation expectations to 2.17% in Q2. The Reserve Bank of New Zealand (RBNZ) meets this week and it is expected to maintain its neutral bias – the New Zealand dollar remaining overvalued, though it is likely the currency will be dragged lower by other commodity currencies.
Meanwhile, the Canadian dollar and Norwegian krone will continue to be penalised by the sharp fall in crude oil prices. The Canadian currency was also affected by concerns over the Canadian property market after the difficulties experienced by Home Capital. As of yet, the risk of Home Capital’s travails spreading to the rest of the property sector appears limited, but concerns will linger and durably penalise the Canadian dollar.
Under these conditions, the USD/CAD could go on to test 1.40. The Norwegian krone has reeled from the slump in crude oil prices, with the EUR/NOK testing a high at 9.582 before pulling back towards 9.49. There is a risk the krone will extend its correction in the short term towards 9.74 against the euro.