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Outlook 2015: A Welcome Return for Volatility?

As usual, in the run-up to the New Year institutional economists and analysts have been working furiously to produce outlooks for the year ahead, trying to predict how various global events will affect different currencies.

One broad consensus is that the US dollar, which performed strongly in 2014, will continue to do so in 2015.

"2014 was only the beginning. The appreciation of the dollar is expected to continue," says Ulrich Stephan, chief investment officer at Deutsche Bank. One reason for this appreciation given by Stephan is the increasing capital flows into US bonds and equities from the low interest rate regions Europe and Japan.

Desutsche Bank predicts that by the end of 2015, the greenback might be at 1.15 to the euro. In the medium term, it even considers parity between the euro and the dollar as possible.

The main driver of dollar strength identified by many analysts is the expectation that the US Federal Reserve will raise interest rates at some point in 2015.

“As the Federal Reserve begins to exit quantitative easing, we believe the burden of keeping the world economy afloat will shift to other major central banks. This means two things. First, rates outside the US are likely to stay low or even decline further. Second the US dollar will probably have another good year,” says Bank of America Merrill Lynch (BAML) in its 2015 outlook.

BAML says that as a result of this trend five-year German government bond yields could fall to zero and the EUR/USD and USD/JPY could sit at 1.20 and 123.00 respectively by the end of next year.

But although there appears to be a tentative consensus in the market that the Fed will raise interest rates around September 2015, Steven Englander, head of G10 FX strategy at Citi, warns that while the market has interpreted the Fed’s forward guidance as a semi-commitment, the US central bank is data dependent and therefore could surprise a number of people.

“What the market hasn’t really priced in well is the possibility that the Fed is going to end up tightening sooner and possibly tightening quicker than has been advertised,” he says.

Shahab Jalinoos, head of FX strategy at Credit Suisse, subscribes to this view and is therefore bullish on the dollar, predicting it will be at 1.20 against the euro at the end of Q1 2015 and at 1.15 by the end of the year.

Political Problems Loom Large in Europe

In contrast the forecasts are unanimously bearish on the euro’s prospects in 2015.

“We expect the ECB to strengthen its active balance sheet management language, aiming for a 1 trillion expansion in assets. The ensuing crowding out of private investment might drive reversal of the portfolio inflow surge of the past two years,” says Jalinoos.

The possibility of countries exiting the euro is once again looming into view despite ECB President Mario Draghi’s commitment to “do whatever it takes” to keep the single currency together.

“2013 and 2014 were the most benign political years that the Eurozone is going to have for a long time. There’s a risk of Greek and Italian elections and, even without potential crisis precipitating elections, there’s the still the normal election cycle,” says Englander.

Strategists at HSBC, who warn that extreme dollar strength could have negative implications for the global currency market, claim that this political risk is exacerbated by the belief that the downside of leaving the Eurozone will not be as great in 2015 as it was in 2012.

They point out that in 2012 peripheral countries in the Eurozone ran sizeable primary fiscal deficits, meaning that even if they reneged on their debts and left the Eurozone they wouldn’t have enough revenue to run their governments. But since then Italy and Portugal ran a primary surplus in 2013, Ireland is expected to run a primary surplus in 2014 and Greece expects to run a primary budget surplus of 3% of GDP in 2015.

The HSBC strategists further observe that a Eurozone breakup is a tail risk that cannot be ruled out and that, because of the ECB’s bond back-stop programme, any heightened risk of such a breakup is unlikely to be reflected in the peripheral bond yields like it was in 2012.

“Instead, the currency is likely to be the first point of least resistance when factoring in any breakup risk. The EUR needs to reflect the exit risk in 2015, and additional USD strength is again the likely echo of the EUR weakness,” say the strategists. Their prediction is that EUR/USD will finish next year at 1.15.

Abenomics to Continue, but Not Without Risks

With Abenomics set to continue in 2015, the yen is expected to depreciate further after already weakening by one-third on a trade-weighted basis since the programme began at the end of 2012.

Michael Feser, global investment director and portfolio manager, GIM solutions at JP Morgan Asset Management, notes that despite being into the second year of Abenomics the monetary policy “arrow” is still shouldering most of the weight of the economic adjustment.

Although this monetary policy has been successful in weakening the yen to USD/JPY 120, Feser says, “Given the limited market share gains realised by Japanese companies despite this significant decline in the yen, we are concerned that the fair value estimate for the yen might be too high.”

The HSBC strategists say that the decline of the yen has generally been orderly and that policy makers appear comfortable with the direction, pace and volatility of the shift and predict that USD/JPY will finish at 128 by the end of 2015.

“Yet it is entirely plausible that the yen decline becomes disorderly and swift,” they continue. Two of the factors that they believe could lead to an uncontrolled decline would be if the market started to anticipate aggressive future quantitative easing (QE) from the central bank and expectations for fiscal largesse and monetisation.

But even if Abenomics is successful, it could still weaken the yen excessively, they say.

“Wages growth could finally pick up, supporting consumer spending in a lasting way, and pushing underlying inflation higher, which supports even swifter wages growth in Japan’s tight labour market. This wage-inflation spiral would likely be viewed as reflective of Abenomics’s success, but it could still lead to a view that the yen should be weaker alongside rising inflation expectations,” the HSBC strategists claim.

According to Jalinoos, a combination of an election, additional Bank of Japan easing and anticipated Government Pension Investment Fund flows should keep the yen under pressure. “We believe owning USDJPY vol is a good expression of this view,” he adds, predicting that USD/JPY will be at 125 at the end of the year.

Sterling to Weaken Against the Dollar

GBP had a mixed year in 2014, performing well for the first half of the year but then losing this value in the second half, so that it now stands below GBP/USD 1.56 with EUR/GBP just above 0.7800.

“With the spectre of a sudden end to the 307-year union between England and Scotland lifted from FX markets, the pound sterling appears again quite fairly valued,” says Feser.

“At the beginning of 2014 pound sterling looked like a pretty simple story, EU growth was poor but UK growth was good and so the sterling started to appreciate. In 2015 the story’s much more ambiguous – UK growth has slowed a bit and in the election coming up in May the choice is between possibly the most leftist leader since the early seventies and a party committed to a referendum on the Eurozone if they win,” says Englander.

Camilla Sutton, chief FX strategist and managing director at Scotiabank, argues that sentiment in sterling has deteriorated over the past year and that technicals warn of ongoing weakness in the currency. Broadly speaking, sterling is expected to weaken against the dollar, with Sutton expecting GBP/USD to close 2015 at 1.54 and HSBC predicting it will finish at 1.48.

SNB to Defend EUR/CHF Floor

Elsewhere in Europe, the Swiss franc tested its Swiss National Bank-imposed 1.20 ceiling to the euro during November, marking a low of 1.2009 mid-month. The 30 November referendum saw voters reject the proposal that the SNB hold 20% of reserves in gold, leaving the current reserve management structure intact.

“The SNB is likely to defend the EUR/CHF floor and accordingly we expect EUR/CHF to close 2015 at an uneventful 1.23,” says Sutton.

Feser sees the Swiss franc at close to fair value, stating that it should benefit from a relatively more benign inflation outlook than the US and is likely to end this year at USD/CFH 0.93.

Scandinavia

In Scandinavia researchers at Danske Bank see EUR/SEK appreciating from around EUR/SEK 9.40 at the end of 2014 (currently at 9.41) to 9.00 in 12 months' time.

“Fundamental macro arguments unambiguously suggest the SEK is undervalued, which in turn serves as an anchor for our medium to long-term forecasts on EUR/SEK,” they say.

This prediction is in line with HSBC analysts who also predicted 9.00 and Sutton who put EUR/SEK at 8.97 by the end of the year.

Danske Bank researchers lifted their forecast for EUR/NOK (currently trading at 9.03) in mid-December as oil prices collapsed and Norges Bank cut its interest rates.

“There is a significant risk of the oil price undershooting, which would weigh on the NOK. In addition, the market is likely to price in two additional cuts from Norges Bank in coming months, while ECB sovereign QE in Q1 will mitigate NOK losses,” they say.

As a result, they lifted their EUR/NOK forecasts to 9.25 (from 8.80) in one month, to 8.50 (from 8.20) in 12 months. Again, HSBC analysts reached the same figure.

Commodity-Driven Currencies to Weaken

With the slowdown of the commodities “supercycle” many market commentators are expecting the currencies tied to commodity performance to struggle in 2015.

Feser considers Australian and Canadian dollars to be overvalued despite the correction seen over the past year.

“While the same forces are impacting both currencies, we consider the Australian dollar to be considerably more exposed. Having benefitted strongly from China’s rise over the last 15 years, the Australian dollar has to adjust from a much higher degree of overvaluation than the Canadian dollar,” he says.

Feser expects the loonie to fall to USD/CAD 1.14 (currently 1.16) and the Aussie dollar to decline to AUD/USD 0.71 (currently 0.82) by the end of the year.

With regards to the Canadian dollar, Englander says that Canada is struggling with increased competition from Mexico in the exportation of manufacturing and processed goods, and issue that had previously been masked by strong oil prices.

Jalinoos is bearish on the New Zealand and Australian dollars, arguing that commodity prices will continue to weaken and that “the upcoming overhaul of Australian financial regulation could add downside risks to AUD that markets are not fully pricing in”. As a result he expects AUD/USD and NZD/USD (currently at 0.78) to finish the year at 0.78 and 0.71 respectively.

However, Jalinoos is more bullish on the Canadian dollar, arguing that strong gearing growth in the US will allow CAD to outperform other G10 currencies other than the dollar and finish 2015 at USD/CAD 1.17.

This prediction is echoed by Sutton, who expects CAD to underperform the USD, outperform EUR and JPY and accumulate modest gains against AUD, GBP, SEK and NZD by year-end.

Brazil is another country that will be impacted by the slowdown in the commodities supercycle. Feser argues that the slowdown has created a cyclical downturn in the country that has been aggravated by the political uncertainty following the recent elections and scandals at energy giant, Petrobras, and a lack of progress on economic reform and a worsening inflationary trajectory.

“We therefore expect the Brazilian real to decline at a rate of 2.25% per annum to USD/BRL 3.26,” he says. USD/BRL is currently trading at 2.66.

Time for a Nuanced Approach to EM

The now infamous “taper tantrum” of 2013 showed how susceptible EM currencies could be to any potential interest rate hike by the US Federal Reserve. With such a hike now due in 2015, analysts are predicting that there will be a range of reactions provoked in different EM currencies.

Researchers at Standard Chartered say, “There is little doubt that emerging markets face challenges resulting from a strengthening US currency and the prospect of interest rates hikes by the Federal Reserve in 2015.”

Despite this, they do not predict broad dollar strength against EM currencies. “In EM, we expect a more mixed and nuanced performance, with bottom-up local factors taking on greater importance,” they say.

In particular, Eimear Daly and Nick Verdi in Standard Chartered’s fixed income, currencies and commodities (FICC) research team claim that Asia ex-Japan currencies could appreciate on the back of continued JPY weakness, which affects these countries mainly via the trade and price channels.

“Beyond the trade disinflation channel, easier BoJ and ECB monetary policy is increasing the ‘hunt for yield’ in EM; the INR and IDR have been the main beneficiaries (on a REER basis) in 2014,” say Daly and Verdi.

Standard Chartered’s prediction is that USD/IDR will go from 12,200 at the end of 2014 to 11,900 at the end of 2015 and that USD/INR will go from 61.50 to 58.50 during the same period.

Mixed Fortunes in Latin America

In Latin America, the outlooks remain mixed for a number of currencies. The Colombian peso remains one of the currencies most adversely affected by declining oil prices, yet its economy is one of the best performing in the region, estimated to expand by 5% in 2014.

The Chilean peso has been subject to a steady phase of currency weakness as a result of declining metal prices and a contraction in domestic economic activity, but Pablo Bréard, an analyst at Scotiabank, thinks that the it may enter a period of consolidation in the coming months as markets adjust to a less benign global economic environment.

“The Mexican peso remains supported by the dual positive effect of a thriving US economic outlook and the broad-based expectation of sizable foreign capital inflows associated with the process of structural reforms adopted by the administration of Enrique Peña Nieto,” says Bréard. However, he also notes that the MXN has been battered by the end-of-year attack against oil-linked currencies, as a result of a sharp collapse in crude oil prices in the second half of the year.

Analysts Divided on China

The growth of China’s economy is expected to slow next year, which will have a number of knock-on effects in the global FX market.

“The consensus is that global growth will accelerate in 2015, but that Chinese growth will moderate further to 7%. If either Chinese growth were to fall below 7% or Beijing had to resort to rate cuts to achieve 7% growth, it would have a depressing impact on global rates, including the US. Meanwhile, the US dollar should continue to be the prime beneficiary of slowing Chinese growth,” says BAML in its outlook.

The slowdown in China will also have a significant impact on commodity driven currencies and its trade partners in the region such as Japan and Australia, for whom exports to China represent 6% of their GDP.

Analysts at Standard Chartered and Scotiabank see USD/CNY appreciating to 5.98 at the end of 2015, while Jalinoos places it at 6.12 (currently at 6.20).

HSBC strategists argue that 2015 will be a year of RMB volatility as the People's Bank of China (PBoC) steers away from accumulating sizable FX reserves, internationalises the RMB and attempts to remain on the sidelines of currency tensions elsewhere.

“USD/RMB volatility will likely rise in both the spot and FX forwards markets. This will be a function of further reforms to make the RMB more market driven. But higher volatility will also emerge due to monetary policy divergence between the US and other major banks, including the PBoC,” they say.

HSBC is forecasting that USD/CNY and USD/CNH will end 2015 at 6.22, although they add that it will continue to outperform some other Asian currencies.

All Eyes on the Fed

At a macro level the main themes that will drive the FX markets in 2015 will largely be the same ones that were driving the markets at the end of 2014, and foremost amongst these is the divergence of central bank policies.

Having largely operated in tandem since the financial crisis, central banks are now implementing different – and sometimes contrasting – solutions to the problems that they’re facing.

With Japan already well into its new economic policy and Europe limited in its options by anaemic growth and political dissidence, it is the Federal Reserve in the US that will be the major driver of change in the FX market in the next 12 months.

Market participants will be keeping a watchful eye on the rhetoric coming out of the Fed and the data being published in the US. Although the timing and speed of the US interest rate increase remains uncertain, it is clear that it will be a driver of volatility in the FX market.

Which many of these market participants, after the extended periods of low volatility that marked much of 2014, are likely to be eagerly anticipating.

galen@profit-loss.com

Profit & Loss

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