Currencies
With US capacity utilisation approaching pre-crisis levels, the
market may start to actively consider Fed rate hikes soon.
This could lead to higher market volatility, causing periphery
currencies to underperform.
USD – In our view, the current low volatility environment is
unlikely to last indefinitely, and there is a risk that the return
of volatility could be abrupt and sharp. After all, raised capital
requirements, curbs on proprietary trading and moves towards
the central clearing of some derivatives have acted to reduce
secondary market liquidity across a range of markets. At the
same time, the current high levels of foreign ownership in
emerging market debt potentially increases the vulnerability
of the asset class should investors start to bring forward their
timing for rate hikes in the US.
Therefore, the transition to tighter US monetary policy could
be less smooth than many seem to expect. On this basis, we
expect the commodity and Asian currencies to underperform
the USD over the medium term.
EUR – The euro has stabilised in the aftermath of its decline in
May in expectation of the ECB’s move to a negative deposit
rate. Notably, the ECB’s statement that interest rates have
reached their lower bound and that policy was on hold until
further assessment helped to soothe investor sentiment
towards the common currency.
We have a constructive view of the euro over the medium
term. Euro strength has been strongly correlated with the
improvement in the balance of payments, meaningful progress
towards greater fiscal sustainability, recapitalisation of the
banking system and implementation of economic reforms.
We expect these drivers to continue to support the currency.
Meanwhile, although the euro area’s composite PMI reading
shows that the recovery may have lost some momentum in late
2Q, the modest uptrend remains intact, in our view. See chart.
JPY – Japan’s core inflation (ex consumption tax effect) has
been hovering around 1.3%yoy for some time. In our view,
inflation has peaked and may begin to soften in the third
quarter. Indeed, the impact on inflation from a weaker JPY
seems to be easing. At the same time, although wage growth
has improved, it is likely to be too modest to sustain inflation
at 2%yoy, which is the BoJ’s inflation target. As such, we expect
the central bank to come under pressure to ease policy again
around October. This, coupled with our expectation for higher
US bond yields, suggests that further weakness could be in
store for the JPY.
GBP – The recovery in the UK economy remains impressive and
growth is likely to be above trend for some time. Notably, the
improvement in the labour market has been encouraging and
the unemployment rate is currently 6.6%, significantly below
the BoE’s earlier unemployment target of 7%.
That said, the recovery in the labour market has yet to
be accompanied by a rise in real wages. Nevertheless, if
unemployment continues to fall by 0.1% per month, then
the spare capacity in the labour market could potentially be
absorbed within 9-12 months. Since monetary policy tends to
work with a lag, this suggests that interest rates could rise in
the UK sometime later this year. As such, the backdrop remains
supportive for the sterling.
AUD – The current environment of suppressed volatility is
encouraging yield seeking behaviour and driving the AUD
further from fundamentals.
Domestically, challenges posed by the decline in mining
investment are likely to keep the RBA on hold but the risks are
tilted to the reintroduction of an easing bias, especially if the
AUD continues to rally independently of commodity prices.
Although a relief rally in iron ore prices cannot be ruled out
in the short term, the