The Fed’s Bold Move – What Does It mean For FX?

Coutts Wealth Watch: The Fed’s Bold Move – What Does It mean For FX Forecasts? 

By Brian Jackson, Global FX Strategist, Coutts.

US Federal Reserve (Fed) Chairman Ben Bernanke has surprised markets with a bold plan to scale back policy stimulus over the next 12 months. This warrants some adjustment to our FX forecasts.

Main points:

 We continue to expect moderate US dollar (USD) gains versus the euro (EUR) and sterling (GBP), and more substantial gains versus the yen (JPY) and Swiss franc (CHF).

 We have revised our AUD/USD forecasts significantly lower (Australian dollar, AUD, to weaken), reflecting domestic policymakers’ clear preference for a weaker currency and the outlook for higher US yields.

 We continue to expect moderate Canadian dollar (CAD) gains. We also continue to expect moderate Chinese yuan (CNY) and Singapore dollar (SGD) gains, but have adjusted our forecasts slightly.

 We have shifted our USD/INR forecast profile higher in response to its recent sharp increase, although we continue to expect some recovery in the Indian rupee (INR).

Policy risks warrant some changes to forecasts

Chairman Bernanke’s current views on the policy outlook, as revealed on Wednesday, are more aggressive than we had anticipated, reflecting an assessment of the US growth outlook that appears markedly more optimistic than that held by the market. This suggests there is a high risk of further volatility until the views of the Fed and the market are aligned – either incoming data needs to convince the market to accept the Fed’s assessment of the growth outlook, or the Fed needs to step back from its plans to withdraw policy support and to communicate this message effectively to markets.

This also suggests that some adjustments to our exchange rate forecasts are warranted, particularly in light of the immediate reaction to this news. Other recent developments have also impacted the outlook for some currencies.

Euro and sterling – moderate weakness expected

For some currency pairs, however, Chairman Bernanke’s comments do not change our views materially. Both EUR/USD and GBP/USD moved away from our medium-term forecasts in recent weeks but have moved back towards them in response to this week’s Fed news.

Although some recent improvement in UK data suggests a modest upward revision to our forecast profile for GBP/USD is warranted, we continue to expect some further downside in this currency pair given the more hawkish Fed and the potential for additional policy stimulus from the Bank of England. The relative growth and policy outlook for the Fed and the European Central Bank also reinforces our view that EUR/USD is likely to move moderately lower from current levels.

Yen and Swiss franc – still forecasting solid falls

We have been more positive on the dollar’s medium-term prospects versus the yen and the Swiss franc. Recent gains in those currencies, however, have represented a major challenge to our views, with investors clearly favouring these traditional safe-haven currencies in part on concerns about the potential impact on risk appetite of a significant scaling back of policy support by the Fed.

As discussed above, the outlook for overall risk sentiment will depend heavily on whether the Fed is right about the US economic outlook, suggesting there may now be greater downside risks to our forecasts for USD/JPY and USD/CHF. As a result, we have scaled back our forecasts for these currency pairs slightly, reflecting the potential for market volatility to offer some support to JPY and CHF sentiment, at least in the near term.

Nevertheless, other factors still support our view that these currency pairs are likely to trend higher (yen and Swiss franc to weaken against the US dollar) over the medium term. In the case of USD/CHF, reduced systemic concerns about the euro area should drive a moderation of safe-haven flows into Swiss assets, with Swiss policymakers also still determined to see the franc weaken.

Meanwhile, in the case of USD/JPY we expect this pair to rise in line with renewed gains in Japanese equities as the Abe government provides additional policy support in the months ahead. Reflecting these factors, we continue to expect solid gains for these two currency pairs.

Australian dollar – a large downward revision

In the case of AUD/USD we had been forecasting the currency pair to stabilise after its sharp sell-off in May and to post a moderate recovery over the next 12 months, reflecting our generally positive view on the outlook for the Australian economy. However, sentiment for the Australian dollar has continued to deteriorate in the last few weeks. This partly reflects growing concerns about the Chinese growth outlook but also clearer signs from Australian policymakers that they favour additional currency weakness.

The minutes of the latest Reserve Bank of Australia policy meeting, released earlier this week, noted that the Australian dollar had already depreciated “noticeably” since early May. But, despite this move policymakers explicitly argued that it remains high given recent weakness in export prices, and that a further fall would help rebalance growth.

The more hawkish Fed outlook has also weighed heavily on Australian dollar sentiment and its future prospects, with AUD/USD collapsing from above 0.95 to below 0.92 following Chairman Bernanke’s comments. Even if a confirmed improvement in the US economic outlook were to drive a pick-up in global risk appetite, it appears that there has been a step-change lower in the market’s assessment of this currency pair as investors anticipate an eventual return to more normal global policy settings and higher US yields. The scale of the Australian dollar’s recent depreciation will also likely undermine demand from reserve managers and other investors previously attracted to the yield and security offered by Australian assets.

Reflecting these factors, we are making a significant downward revision to our AUD/USD forecast and also adjusting the trajectory to project some additional weakness instead of recovery over the next 12 months. We now forecast AUD/USD to fall to around 0.89 by the end of 2013 and to 0.87 by mid-2014. Although some near-term support is possible given the high volume of short positions and the speed of its recent decline, medium-term risks seem skewed to further downside.

Canadian dollar – back towards parity

Prior to this week’s Fed news USD/CAD was trading close to our near-term forecasts but has since spiked higher. Nevertheless, we remain comfortable with our forecast for the currency pair to move back towards parity over the next 12 months. Speaking earlier this week, newly-appointed Bank of Canada Governor Poloz expressed cautious confidence in Canada’s growth outlook and stressed that he sees little justification for further domestic stimulus. This continued bias in favour of an eventual move higher in policy rates should support moderate gains for the Canadian dollar over the medium term, with any improvement in the US economic outlook providing further support.

Chinese yuan – slower and smaller gains forecast

USD/CNY has generally moved in line with our forecasts since the start of the year but has in recent weeks stalled to around 6.13. This appears to reflect efforts by Chinese authorities to keep bank lending in line with official targets and to curb “hot money” inflows attracted by steady yuan gains earlier in the year. More broadly, the new political leadership has shown signs that it is prepared to tolerate somewhat slower growth in pursuit of other policy objectives. Recent economic data has generally disappointed, while heightened volatility in global markets over the last month has also likely weighed on yuan performance.

Although we continue to expect USD/CNY to trend lower over the next 12 months, these factors suggest yuan gains may slow relative to the pace seen in recent months. There is also now a greater risk of two-way volatility in this currency pair, particularly in the near term given recent weakness in other Asian currencies. Officials seem increasingly keen to dispel the view that yuan appreciation is a one-way bet. As a result, we are shifting our USD/CNY forecast profile higher, with slower and smaller yuan gains now anticipated.

Singapore dollar – modest gains still expected

The weaker Chinese growth outlook also suggests some adjustment to our USD/SGD forecast is warranted. The outlook for the US economy and the impact of any move in Fed policy also represents a risk to Singapore dollar sentiment, particularly in the near term. Although we continue to expect external demand to strengthen over the next 12 months, this improvement may be weaker than previously anticipated. Recent falls in headline inflation also provide Singapore policymakers with scope to target a somewhat weaker exchange rate. Reflecting this assessment, we are also shifting our USD/SGD forecast profile slightly higher.

Indian rupee – recovery once uncertainty eases

Emerging economies with persistently high current account deficits have seen particularly sharp sell-offs in their currencies over the last month as investors fret about the potential impact of Fed tapering. The rupee has been no exception, with USD/INR up almost 5.0% over the last month, with trading at record levels. Following this sharp sell-off we have been expecting the rupee to stabilise and recover over the medium term, reflecting recent policy measures taken by Indian officials and our assessment that global liquidity conditions are set to remain very supportive by historical standards, even if the Fed were to scale back its asset purchases in the months ahead.

The reaction to Chairman Bernanke’s comments this week, however, clearly shows that investors remain very concerned about India’s ability to manage a potential withdrawal of policy stimulus given the vulnerability created by its weak external position. As noted earlier, if the Fed and market assessments of the outlook move back into alignment, we would expect these concerns to ease, paving the way for some recovery in the rupee and other emerging-market currencies. At the moment, however, it is very uncertain how long this will take, making it difficult to judge where USD/INR will peak.

Nevertheless, we expect this re-alignment to take place one way or another over the medium term. The outlook for the rupee is also supported by the prospect of stronger Indian growth in response to previous cuts in domestic policy rates and further government measures aimed at boosting structural reforms and easing restrictions on foreign investment. As a result, we continue to project a downward-trending USD/INR profile, albeit from a significantly higher starting point after the sharp price action seen over the last month. We now forecast a move to around 56.50 at the end of 2013 and 55.50 by mid-2014.