Euro caught between rates and optimism

Bank of Japan on expansion course

Swiss franc: danger not averted


Euro caught between rates and optimism

Since the last Forex News, the dollar has weakened slightly. On one hand, this might be related to weaker US economic data, which led to a postponement of expectations for the timing of a slowdown of the Fed’s asset purchases (longer purchases, weaker dollar). However, the last labor market report provided relief regarding a sharper economic slowdown. Hence, this factor should decrease in importance. On the other hand, the ECB has cut rates and left the door open for further rate cuts - including a deposit facility. In the medium term, we had expected the ECB to become more expansive, speaking against the euro. Indeed, the interest rate differential would speak in favor of a slightly stronger dollar. US yields are higher in all maturities than German ones, which makes the dollar more attractive as an investment (e.g. for FX reserve purposes). The Fed is expansive and should remain so, but the ECB has become increasingly expansive and could take further steps, likely leaving rates low for even longer than the Fed.

In contrast, ECB measures - in particular those targeting an improvement in the periphery, such as the planned ABS measures - could also improve sentiment with respect to Italy and Spain, thus lending support to the euro. If optimism were to outweigh rate considerations, this would imply a stronger euro. Currently, the exchange rate seems to be ‘in between’ these two forces. In the medium to longer term, though, higher growth prospects in the US than in the Eurozone speak in favor of a slow strengthening of the dollar throughout the year, in consonance with a fair value of between EURUSD 1.30 and 1.20.


Bank of Japan on expansion course

At his first monetary policy meeting, the Bank of Japan’s new governor, Haruhiko Kuroda, announced a massive expansion of the monetary base in Japan. Total assets of the BoJ are intended to almost double to 290trn yen by the end of 2014. The monetary base will increase by 60-70trn yen per year. In order to reach this target, predominately Japanese government bonds will be purchased. While market participants already priced a looser monetary policy into the exchange rate (a higher money supply tends to weaken a currency), the extent of the measure seems to have surprised markets. After the announcement, the JPY depreciated significantly to 131, from 119 EURJPY.

The new measure aims to increase inflation in Japan to 2% by 2014 (it is currently at -0.5%). The new inflation forecasts from the BoJ signal its confidence in the target - it predicts an inflation rate of 2.6% for 2015 (1.9% without a planned tax increase). Analysts expect that the BoJ could increase the money supply further in case inflation does not increase as expected. In the medium run, a slight depreciation of the yen against the dollar is still expected, which translates into a sideways movement against the euro.


Swiss franc: danger not averted

The franc continues to move at levels close to the minimum exchange rate of 1.20 EURCHF. Positive political developments in Italy contributed to an easing of the situation in the Euro Area. As a consequence, the ‘safe haven’ Swiss franc depreciated slightly. The fall in value was limited, though. It seems as though for quite some time not much market intervention by the Swiss National Bank has been necessary to keep up the lower bound. This is indicated by the foreign exchange reserves and the sight deposits of commercial banks at the SNB, which are almost unchanged since last autumn. Still, a suspension of the lower bound does not seem to be in sight at the moment. At the general meeting of shareholders of the SNB, President Jordan recently reaffirmed that the National Bank was willing to defend the minimum exchange rate with the utmost determination. ‘It is clearly too early to relax our guard,’ he said. Since the franc could suddenly come under upward pressure again, the minimum exchange rate remained an important instrument.

President Jordan’s statements are in accordance with our expectations. Switzerland is still in a phase of negative inflation rates.
The Eurozone debt crisis has still not been solved and the appreciation pressure on the Swiss franc could start again at any time. Without any lower bound, Switzerland would suffer severe consequences. We thus expect a sideways movement of the EURCHF exchange rate close to the lower bound of 1.20, while short-term fluctuations remain possible, depending on the developments in the sovereign debt crisis.