EUR/USD has traded with high volatility over the past month driven by shocks to relative rates, risk sentiment and European sovereign debt markets. We expect volatility to remain elevated, but also for underlying support to remain – and for the pair to reach 1.48 in three months. The euro is also expected to gain against sterling, while correcting lower against the Scandies and not least the Swedish krona.
Note that this is the last FX Forecast Update before the summer period; the next forecast update will be published on 15 August 2011. ‘FX Forecast Update’ is also published as a slide-show – presentation.
ECB hikes should secure renewed EUR/USD upsideRelative rates remain the dominating driver on the currency market and the dominating theme underlying our forecasts – not least for EUR/USD. The euro has gained strongly on the Euroland-US monetary divergence during H1 and we expect support to remain from European monetary tightening over the coming months and probably also quarters.
From very aggressing pricing a few months ago the money market is now pricing in very little tightening from the ECB beyond the expected July rate hike. And while weaker global macro data and declining European leading indicators do bring into question the degree of tightening on the 12-month horizon we still see a strong case for both a July and October hike and likely also a final hike in early 2012. This in turn suggests potential for a significant re-pricing on the money market once global economic data, as expected, begins to improve. This combined with a high probability that the EU will agree on additional financial aid should secure further euro upside. We maintain our forecast of EUR/USD to reach 1.48 in three months and 1.46 in six months.
However, higher US yields are a risk to our forecast of a higher EUR/USD. Euroland bond yields have fallen since early April, but US yields have fallen more. This has led to a further widening of the EUR-USD rate spread and supported EUR/USD in an environment of weaker risk sentiment. Economic data is expected to improve over the coming months, however, which could lead to a sharp rebound in US yields. US economic surprise indicators are already showing tentative signs of a rebound – usually a good indicator for the bond market. Our main scenario is that EUR rates will rise in tandem with US rates, but the potential for a sharp spread narrowing is a key downside risk to our EUR/USD forecast.
Sell-off in SEK exaggeratedOver the last couple of days we have seen EUR/SEK moving significantly higher testing 9.17. Even though risk appetite has been under pressure lately and global growth concerns have intensified the move looks exaggerated, in our opinion. One way to evaluate SEK is to take a closer look at our short-term financial models that give a “fairvalue” estimate of G10 currency crosses, taking into account daily changes in variables like relative rates, the yield curves, risk appetite represented by Vix volatility and oil prices.
In respect of EUR/SEK, our fair-value estimate is currently 9.01 - well below the current level. Hence, we believe that the move higher in EUR/SEK is overdone. The Riksbank is still widely expected to outhike the ECB and Swedish fundamentals are still outstanding. The Riksbank is expected to hike rates next time on 7 July. Today’s inflation survey from Prospera shows rising inflation expectations, which support our view that the fixed income market is wrong, when less than three more rate hikes from the Riksbank are expected this year. We therefore believe that our short-term financial model is correct this time and we continue to maintain a positive stance towards the SEK and expect EUR/SEK to fall to 8.80 in three month’s time.
EUR/NOK has also risen somewhat lately, but less than EUR/SEK, which has pushed NOK/SEK higher. In our view, it reflects that the NOK has received extraordinary support from the oil price, which has traded at an elevated level since OPEC last week failed to reach an agreement on stepping up oil production. Going forward, the NOK will continue to receive support from relative rates and the oil price. However, compared with the SEK the value in the NOK is much more limited. On a three-month horizon we expect EUR/NOK to fall to 7.75. Hence, we see downside risk for NOK/SEK going forward. See in this respect: FX Trade Recommendation: SEK sell-off exaggerated – sell NOK/SEK spot.
Support remains for the Deutsche Mark proxyEUR/CHF is expected to trade at low levels as long as European funding concerns remain – but volatility should remain high. That is, the Swiss franc has the potential to move significantly in either direction on developments in (not least) the Greek funding situation. Hence, while the Swiss franc is overvalued and long positions likely stretched, we do not expect a large correction lower over the coming quarters.
In fact, the Swiss National Bank (SNB) may end up capping the EUR/CHF upside. The cyclical situation of the Swiss economy is very strong and does not justify the current very accommodative setting of monetary policy, with near-zero rates. But the strong appreciation of the Swiss franc has dampened inflationary pressures, which has allowed the Swiss National Bank (SNB) to postpone monetary tightening. However, should the Swiss franc weaken significantly, this would open up for earlier rate hikes, which could potentially cap Swiss franc downside. We have opted to lower our EUR/CHF forecast profile and now expect the pair to trade around 1.24 on the 6-12 month horizon.
USD/JPY most sensitive to a summer rebound in US yieldsOne of the currency pairs most disposed to a correction in US yields is USD/JPY, as the correlation with relative rates is high and prospects for higher Japanese rates slim. We look for USD/JPY to correct higher over the coming months as US yields bottom out.
Decent carry and further potential in the commodity currenciesThe central banks of commodity currencies are becoming increasingly hawkish. The BoC struck a harsher tone in May, notably saying that if the good times continue "some of the considerable monetary policy stimulus currently in place will be eventually withdrawn". CAD should also receive support from our commodity team’s expectations for oil prices to stay strong in coming months on uncertainty over OPEC supplies. The RBA June statement was little changed, reiterating that "the current mildly restrictive stance of monetary policy remains appropriate". Nevertheless, governor Stevens said in a recent speech that inflation risks are on the upside and that rate rises will be needed at some stage. We agree.
Finally, the growth outlook for New Zealand has been improving of late as indeed recognised by the RBNZ in its quarterly statement in June and the bank has noted regarding the cash rate target that "a gradual rise over the next two years will be needed". However, the recent afterquakes in Canterbury have again raised uncertainty regarding the country’s near-term growth outlook. On the whole, risks are increasingly that further tightening from the RBA and RBNZ may end up coinciding largely with the Fed’s exit during H2 while the BoC could deliver a hike in Q3. We still see some upside in the three but beyond the 3-6M horizon, dollar strength is set to kick in and end the party. We have revised higher our three-month AUD/USD as well as our six- and 12-month NZD/USD forecasts.