Central Banks dictate FX moves

The debate over the outlook for rates and central bank stimulus (alongside uncertainty over the Chinese economic growth path) continues to be the dominant driver of G10 currency pairs

As a result, volatility remains a key fear for investors across asset markets and currencies have not been overlooked.
Nonetheless, currency volatility has moderated and we anticipate more subdued volatility levels in Q4. We expect underlying growth and policy fundamentals to sway market sentiment as investors focus on the underlying economic outlook for the global recovery in the coming months.
Low oil prices are keeping inflation measures subdued globally and this will encourage many central banks to continue their aggressive easing stance toward year end and into 2016.
Indeed, it is only the US Federal Reserve that we expect to tighten policy this year.
A result of the benign inflationary environment, central bank accommodation will continue to be a feature of the currency landscape for the foreseeable future. Policy rates will remain low or negative to support economies and this will predictably exert continued downward pressure on exchange rates.
Currency wars will therefore remain a consequence of such stimulatory central bank policy, whether or not it is a stated direct policy objective or not.
Currency adjustments will help improve international competiveness for countries significantly exposed to global trade and encourage import competition. We remain structurally bullish on the US Dollar in the medium term, expecting tighter policy by year-end.
The Euro, Yen and Norwegian Krone are likely to be the underperformers as growth outlook remains subdued and central banks firmly in stimulus mode. Low rates and the flood of liquidity is likely to keep these currencies under pressure and 2016 could see further easing of policy to support growth and lift inflationary expectations. Any tightening of policy is not expected ahead of 2017 at the earliest.

USD: Rates to (finally) move higher
FOMC members seem torn as to when to hike rates, with several members appearing comfortable with 2015 as the appropriate time to tighten policy, while others feel that this year would be too early.
See-sawing market expectations of when the US central bank will raise benchmark rates has kept the US dollar largely rangebound against major currencies. But it has been a wide range and while currency volatility has declined, USD trading has been choppy.
After some expected consolidation, the US Dollar looks primed for further gains in the Q4 of 2015 as the US Federal Reserve embarks on its long anticipated tightening cycle.
We expect the next leg of the USD’s rally will be driven by the continuation of the US economic recovery and investor expectations for tighter policy from the Fed, in stark contrast with those for other major central banks. Currently the market is almost pricing in a rate hike for early 2016. Economist estimates are slightly more hawkish.
The Fed has been balanced in its communication with investors, noting that the economic recovery remains solid enough to justify the beginning of policy tightening this year.
There is stronger evidence of wage growth alongside rising household spending. In turn, the strengthening economic environment has seen inflation indicators begin to improve. A gradual and well communicated tightening cycle combined with the Fed maintaining a healthy balance sheet is unlikely to derail the US recovery, but it should keep the USD well supported.
The USD Index has consolidated and has moved broadly back in line with interest rate differentials in recent months.
Accordingly, we feel that any weakness is an opportunity to again establish long positions.

Euro: Election risks
Although the Euro has traded a broad 1.10-1.15 range against the US Dollar in recent months, we remain bearish for the currency. Continued instability on the political front for Europe remains a considerable risk for the Euro. Coupled with the rising chance of an extension to the central bank stimulus program the future direction for the Euro remains firmly skewed to the downside against major currencies.
Elections in Spain will come into focus going into year-end, with anti-establishment parties likely to gain ground and dent already fragile sentiment. After the Greek example gave an example of what can occur, issues like unemployment and migrants could surface and increase currency volatility in late December, when liquidity is already low.
While volatility has moderated to more normal levels for Euro crosses in recent months, the Euro could still trade lower as fundamentals suggest a weaker currency in coming months.
We expect the ECB is likely to expand and/or extend its current QE policy and coupled with wider rate differentials put downward pressure on the Euro.
While economic activity is likely to benefit from ECB stimulus measures and low/negative rates, the recovery is going to be gradual. The employment environment remains subdued and as a result consumption remains sluggish. We expect the Euro to grind lower in coming months and retain our year-end target of 1.05 against the USD as the threat that rate hikes in the US becomes a reality.

CHF: Still overvalued
The Swiss Franc (CHF) performance has assisted the local economy in recent months, with a moderate decline. However, this is not expected to last, according to market pricing, with a modest appreciation against currencies of its major trading partners, particularly the Euro.
The modest improvement in the Swiss economy has largely been driven by externally improving demand, despite the exchange rate environment providing headwinds. Nonetheless, the Swiss Franc has depreciated over the quarter and is close to our initial Q3 target of 1.10 against the Euro. We continue to foresee further weakness, but the Swiss National Bank may need to engage in further intervention to offset any policy driven weakness of other European currencies, with currency wars being firmly in play.
Risks for the Swiss economic growth have moderated but the Swiss Franc remains ‘significantly overvalued’ from the Swiss National Bank’s (SNB) perspective. As a result, and with the SNB remaining active in currency markets, we feel that he recent decline in the Franc should continue.
The SNB has kept policy settings unchanged but remains willing to continue its intervention in fx markets to counteract what it sees as an overvalued currency. With inflation staying in negative territory, monetary policy settings are likely to be made looser if anything, especially with other central banks in the region firmly in stimulus mode. Indeed we perceive the aggressiveness of the SNB’s policy to eclipse that of the ECB and should thus be a key focus for investors in Q4, with inflation well below zero.
The SNB expects short-end interbank rates to be significantly negative until inflation becomes positive in 2017. Capital outflows are likely to assist the decline of the CHF, as investors look to other higher yielding markets for returns. We anticipate EUR/CHF will likely to breach 1.10 level to the upside over Q4 2015, moving toward 1.12 by year end.

CAD: Commodity currency outperformer
The Canadian Dollar (CAD) continues to be one of the strongest performing ‘commodity currency’ thus far in 2015, aided by the rebound in crude oil prices in recent months.
The Bank of Canada (BOC) appears comfortable, not only with its policy stance, but also with how the response of the economy to policy is progressing and the depreciation of the Canadian Dollar. The positive feedback from the central banks rate cuts in 2015 are beginning to be experienced and the inflation profile has stabilised.
Lower oil prices are restraining the business sector but this negative impact should begin to fade going into 2016. The
weakness in the Canadian dollar is also providing a buffer for economic activity. Trade is gaining momentum, assisted by both the CAD weakness and the strengthening US economy, a market which accounts for over 75% of Canadian exports. In addition, the household sector is also experiencing positive momentum, with spending. To the extent that the oil price delays any strength in CAD, Canadian exports will remain competitive, and domestic substitution for imports will also help lift activity.
We expect that CAD will begin to rebound against the USD, as oil prices stabilise and begin to rise into year end. Against the EUR, we expect a return to strength as the Canadian recovery outpaces that of Europe and the ECB retains a more aggressive and accommodative policy stance. The recent stronger EUR/CAD has moved out of line with fundamentals and as the oil shock impact on the CAD fades, we expect the currency pair to move back toward 1.35.

GBP: 2016 rate lift-off
We expect there is upside potential for the pound as currency (and other asset market) volatility eases. Volatility has historically had an adverse influence on the value of the British Pound.
We expect GBP to find strong support, on the back of rising rate expectations and declining volatility. Bank of England Governor Carney has indicated that even the recent volatility, stemming from China concerns, would not derail its plans to raise rates. Voting on the MPC Board has turned more hawkish in recent months with one policy member voting for a rate hike at both the August and September MPC meetings.
The domestic environment in the UK has improved. Business investment has surprised to the upside and retail sales remain strong. We expect the uptick in UK economic momentum to continue with consumer confidence remaining at decade highs.
We expect the GBP will slowly grind lower against the USD as rate hike expectations in the US again take hold going into year-end. Against the Euro the outlook is more favourable and we expect further appreciation in the medium term. However, after the beginning of tighter US policy, GBP could pare losses as the policy focus switches to the UK toward the end of the year. EUR/GBP is trading near the top of the 0.70-0.74 range for 2015 and we expect that upward momentum to fade. We feel the pair could move toward 0.72 in coming months, as the market increasingly sees rate hikes likely in the first half of 2016.

JPY: Downside potential
The economic landscape in Japan continues to pickup and this has supported the Yen against major currencies. The recovery is being assisted by the Bank of Japan’s accommodating stance and the central bank continues to add to the monetary base via its Quantitative and Qualitative Easing (QQE) policy. The BOJ is likely to continue this policy for some time as inflation remains depressed, balancing the fine line between inflation and deflation. We expect that against the USD, JPY could weaken substantially and potentially break our 125 year-end target to the upside if the BOJ are forced to widen its accommodative policy stance, if the recovery falters.
Wage growth has been positive for two years, supported by improving corporate balance sheets and helping buttress solid private domestic demand. The improving wage environment is being assisted by a stronger jobs environment, and the unemployment rate is at the lowest level in nearly 20 years.
Positive signs are emerging on the corporate side as well. Corporate profits are at record levels – sustained rise in corporate profits are a critical element of a sustainable recovery in Japan, which will foster business investment. Currently business investment expectations for large manufacturers are at the highest level since 2004, and capital expenditure plans are rising.
Strengthening job environment is helping support a robust retail environment. But while household balance sheets are becoming more healthy, there are ongoing signs that the BOJ’s QQE strategy is helping the long anticipated recovery, we feel most of the good news has been priced in.
We expect that USD/JPY will grind higher toward 125 by year end, with upside risks if the BOJ loosens policy further and rate differentials widen.

SEK: Stimulus bearing fruit
The Swedish central bank, the Riksbank, continues to push the boundaries of monetary policy and remains one of the most aggressive central banks in the G10 currency space. The Risksbank’s commitment appears to be beginning to pay off.
The inflation trajectory is showing signs of a modest upward trend, thanks to negative interest rates and a committed quantitative easing plan. However, the Riksbank doesn’t want to rest on its laurels: after cutting rates three times in 2015, it has also extended its QE program till end 2015 in order to ensure the economic and price momentum can gain traction.
The improving economic backdrop has been cause for optimism, with economic growth surprising to the upside and expected to remain above average in coming years. Consumer confidence is near longer-term average levels, while optimism from businesses over the economic outlook is approaching multi-year highs, rebounding strongly this year. Growth and jobs are expected to continue their gradual improvement in 2016.
Rates are not expected to get back into positive territory until Q3 2017, a significant change from the end-2016 expectations earlier in the year. Such a depressed rate environment is likely to remain a significant drag on currency performance. The Riksbank has continued to indicate its willingness to add to the current stimulus measures, in case the recovery begins to stumble. We expect that the Swedish Krona will remain soft against major crosses until there is clear evidence of a sustainable rise in price pressures, and a material improvement in external demand that will allow the central bank to begin to scale back its support toward the end of 2016. We expect that SEK could make gains against the Euro in the medium term as a more sustainable recovery is witnessed, however, the near-term outlook remains more muted. We feel that EURSEK will trade a range between 9.30 and 9.40 in Q4.

NOK: Norges Bank ready to do more
The Norges bank has begun to take its cue from its Scandinavian counterpart – cutting rates unexpectedly in June, and likely to follow up with more policy easing if Norwegian economic growth remains sluggish. With the highest official rates outside of Australia and New Zealand, there is room to do more, and Krone weakness should be seen in this light.
In contrast to the Swedish economy, the Norwegian economy is struggling. Additional cuts in business investment, tied to depressed oil prices and the petroleum industry, are likely to remain a weight on growth dynamics.
Despite a worsening jobs environment, household consumption remains a bright spot, supported by low (and likely lower) interest rates. Wage growth has been supportive, and the housing sector is being buoyed by rising household debt levels. However, this could unravel if business investment remains soft in 2016/17, in turn further depressing the jobs market.
While we expect that the stronger commodity market fundamentals to give greater buoyancy for energy linked currencies going into year-end and early 2016, NOK could be the laggard if the economic backdrop fails to be quickly revived and Norges Bank further loosens policy settings.

AUD: Soft domestic activity and China fears
The Australian dollar breached our downside targets over the past quarter and we expect this downside risk to remain elevated as pessimistic sentiment surrounding the outlook for the Chinese economy is pronounced. Indeed, the AUD was the worst performing G10 currency over the past three months. Meagre economic growth, narrowing interest rate differentials and the softening terms of trade remain the key drivers for the Aussie Dollar and are unlikely to provide a catalyst for an AUD rebound in Q4 2015.
The Reserve Bank of Australia (RBA) remains determined to provide economic support with accommodative policy. While we expect that the RBA’s policy stance will remain broadly neutral are after May’s rate cut (the second for 2015), central bank rhetoric will likely remain a weight for the currency.
Despite a stronger employment environment, wage growth remains modest. Lower oil prices and lower interest rates have been providing a tailwind for consumer spending. Lower rates are expected to continue to feed through to the real economy and assist business investment in the medium term, but evidence is lacking at this point and better signs from nonmining investment earlier in the year are beginning to fade.
The AUD susceptibility to the external environment remains high and market volatility surrounding China and the potential for tighter US policy remain key risk factors. AUD remains exposed to fragile sentiment surrounding the uncertainty Chinese growth path.
The Australian Dollar’s strong link to the external environment via its terms of trade, could add an additional layer of downward pressure as long as concern over Chinese growth lingers. Australia’s terms of trade forecasts have declined in recent months as the economic outlook for its major trading partners has become less certain. In an environment of uncertainty over the Chinese growth path, commodity price growth could remain depressed. If commodity fundamentals improve, it will provide AUD support. However, this is likely to be tempered by expectations of further rate cuts in the year ahead. Accordingly, we expect that AUD will hover in a tight band around 0.70USD over the next quarter, but with downside bias. Market expectations indicate that AUD should be the worst performing G10 currency going into year-end.

Kiwi: RBNZ talks NZD down
The Reserve Bank of New Zealand (RBNZ) is being equally active in cutting rates in 2015 as it was in hiking rates in 2014.
The central bank has now cut rates three times in four months, with the propensity to do more. Nonetheless, the NZ Dollar was the best performing commodity currency over the past three months, something that hasn’t bypassed the RBNZ’s attention.
Falling dairy and oil prices have been a persistent weight on inflationary pressures, with inflation expectations in a downtrend, but hovering in the middle of the target range. CPI remains well below the central bank’s target 1-3% range. NZD remains closely linked with dairy prices, as New Zealand is the world’s largest exporter of dairy products and a recovery to more historical levels is not expected to occur in the foreseeable future.
Dairy prices have bounced in recent months but remain depressed, near six-year lows. Abundant supply, similar to other commodities, remains the problem, and inventory levels are elevated. While household spending is being supported by lower oil prices and low interest rates, there are continued fears surrounding farm incomes as a result of falling dairy prices.
Employment has begun to tail off and both business and consumer sentiment has declined in recent months.
We expect further weakness in the NZD, as the potential for further rate cuts weigh on the currency. At the end of August, two rate cuts were fully priced in over the coming year.
Although this has since been pared back and we expect further downside risk of the NZD, in line with RBNZ rhetoric.

Martin Arnold, Edith Southammakosane – Directors, ETF Securities Research – ETF Securities