7 October 2016
A continuing reprieve in the foreign exchange market
The dollar remains the currency of choice. The yuan is now a reserve currency. The euro’s time
has not come. The BOJ must weaken the yen. New floor for the franc at 1.08.
Key points
- A reprieve in the foreign exchange market
- The US dollar remains the currency of choice for
investors
- The euro’s time has not yet come
- As of October, the Chinese yuan has become a
global reserve currency
- Yuan’s appreciation to depend on demand for
investment and diversification
- The Bank of Japan determined to weaken the yen
- The British pound remains under pressure but
the worst may be over already
- Commodity-linked currencies are taking
advantage of the cycle reversal
- Swiss franc: new floor at 1.08?
A reprieve in the foreign exchange market
The foreign exchange market was not fundamentally
unsettled by Brexit, although some volatility naturally
occurred following the historic vote. Indeed, all
currencies appreciated against the British pound,
starting with the yen (+17%), the dollar (+13%), the
franc (+12%), the yuan, and the euro (+11%).
Surprisingly, it is the yen that benefitted the most from
this flight to safety. Hence, Brexit had no major impact
on cross rates, which remained relatively stable.
Something like a truce prevailed in the last three months
in the currency wars, as we had expected in light of
reduced economic uncertainty and the return of investor
confidence. As such, the key euro/dollar exchange rate
fluctuated only very little around its central value of
1.12. In all likelihood, the British pound was under
strong pressure at first, but that pressure eased off
during
the
summer.
Uncertainty
has
not
Weekly Analysis – A continuing reprieve in the foreign exchange market
disappeared entirely, but the pound seems to have found
a short-term support level. In the absence of a positive
trigger, the currency is likely to enter a more lasting phase
of stabilisation before being able to rise again.
Among recent developments, the inclusion of the Chinese
yuan in the SDR (Special Drawing Rights) currency basket
and the closed circle of global reserve currencies is
certainly a major highlight. According to our analysis, this
should benefit the yuan, which should appreciate based
on developments in investment demand and demand for
diversification.
For many, the second surprising highlight also occurred in
Asia. The yen’s rise, approximately +17% in 2016, is
indeed difficult to reconcile with Japan’s fundamentals.
Some might even say it is paradoxical, as the yen’s
strength contradicts the BOJ’s objectives and inhibits
growth. Except for the Japanese currency, which we
believe will weaken substantially in the next few months,
we anticipate that most major currencies will be
experiencing reduced volatility.
The US dollar remains the currency of choice for
investors
The relative stability of the trade-weighted dollar index in
2016 contrasts with its appreciation in 2014 and 2015.
Since the second quarter of 2015, the US dollar has been
gradually coming to terms with its +25% rise against a
basket of weighted currencies. The appreciation of the
trade-weighted dollar was indeed followed by a
consolidation phase in which the currency fluctuated
between 95 and 100. Thus, the greenback has broadly
stabilised at a high level, pending economic news
confirming expectations of an economic upturn and
normalising interest rates.
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However, 2016 has not yet provided the expected
confirmations on the economic front. Although growth
has picked up again, GDP figures have not been
exceptional, falling short of expectations. In this
context, the evolution of monetary policy, which was
supposed to be the second supporting factor for the
dollar, was rather disappointing for those who had
hoped for rate increases in 2016. Indeed, the
anticipation of four 0.25% rate increases was expected
to increase the relative attractiveness of the dollar.
Instead, and just a few weeks away from the end of the
year, not a single rate increase has been implemented.
These factors explain the on-going global consolidation
of the US currency, which is nevertheless still perceived
as being ahead of the global economic cycle, thereby
justifying the attractiveness of the dollar to investors.
The latest decline in long-term dollar interest rates
following Brexit, coupled with the decision of the
Federal Reserve not to normalise its monetary policy
until a marked resurgence in inflation, will boost
economic growth in the United States and thus
strengthen the dollar. In the short term, stabilisation is
expected to continue, but the dollar may weaken against
the yen and commodity-linked emerging market
currencies. On 8 November, a significant element of
uncertainty may still reverse the predicted trend. Indeed,
the election, however unlikely, of Donald Trump would
certainly not be perceived as a positive factor for the
dollar.
less important. The ECB’s zero interest rate policy, a
negative factor for the euro, is certainly reaching its limits.
It is becoming clear that the banking sector is
struggling to adjust to this policy that is
undermining the financial system to a certain degree.
Deeper commitment to a negative interest rate policy
(NIRP), which could undermine the euro, is no
longer desired.
The recently raised issue of a possible slowdown in the
ECB’s QE programme seems rather implausible in our
mind. We believe that the ECB should not engage in
further key rate cuts. On the contrary, it should pursue its
monetary injection programme, until the expected effects
on the revival of credit and consumption have been
observed. In other words, nothing particularly new to be
expected on that side. The euro should remain weak
against the dollar, unless the pace of economic growth
picks up sooner in Europe than in the United States.
EUR/USD exchange rates
Trade-weighted dollar
Sources: Bloomberg, BBGI Group SA
Since October, the Chinese yuan has become a
global reserve currency
Sources: Bloomberg, BBGI Group SA
The euro’s time has not yet come
In Europe, Brexit initially raised fears of a loss of
international credibility for the euro because of the
potential contagious effect of the British vote on other
EU countries as well as new doubts relating to
economic prospects. These risks are now deemed not to
be as high in light of the resilience observed in
European economic data and the marked resurgence in
consumer confidence in particular. The risks that
weighed on growth in the euro area are now deemed
Weekly Analysis – A continuing reprieve in the foreign exchange market
We discussed it at length a few months ago, when the
IMF announced its decision to add the yuan as a reserve
currency. As of the end of this quarter, it will be a reality.
The IMF has officially included the yuan as the fifth
currency in its SDR basket, which until now only featured
the dollar, the euro, the pound and the yen. Yuandenominated Chinese assets will now be viewed a little
differently by a growing number of investors. Among
them, central bankers in charge of the allocation of
currency reserves for their institutions will certainly be the
first to be interested and affected. However, will they
have any interest in diversifying their assets into yuan and
what will be their motivations to do so?
The inclusion of the yuan into the SDR basket is a small
revolution with huge potential implications. However, it
results essentially from the particularly fast growth in the
use of the yuan in global trade, mainly in the commodities
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sector. The challenge for Chinese authorities now
consists in confirming the status of the yuan as a
credible exchange currency available to a broad range of
investors. For that matter, let us recall a few criteria that
should doubtless be respected.
From the point of view of the IMF, transparency of
market data and the actual convertibility of the yuan are
both key elements. The authorities are aware of the fact
and will certainly work in that direction, as shown by the
yuan’s fluctuations in the last few years, and the last
twelve months especially. Access to the Chinese market
has become slightly freer, and foreign institutional
investors, banks and central banks have been able to
acquire yuan-denominated assets more easily. The
increasing access to yuan-denominated government
bonds and certificates will provide an indication of
demand and how it may develop.
As we had already mentioned, the Chinese
government’s aim was to transform the yuan into a
reserve currency in order to give it a level of credibility
commensurate with the country’s economic and
political weight. Thus, the yuan’s road to
internationalisation is clear. The authorities have
identified a strategy. They are now testing the appetite
of international investors to assess their policies’
chances of success.
In terms of timing, the disappearance of bond yields in
many interest rate markets is a boon to the introduction
of alternative products such as the Chinese
government’s yuan-denominated rate products, which
currently yield close to 2.7%. The growth potential for
investment demand is extremely high and adds to the
strong trend, supported by the government, of
favouring the use of the yuan in China’s international
trade. The Chinese currency should benefit from an
increase in demand and appreciate against the dollar and
the euro.
Ten-year Chinese government bond yield
and CNY/USD exchange rate
The Bank of Japan is determined to weaken the
yen
The BOJ has reinforced its weak yen policy, which is
crucial for a lasting economic recovery. The bank is
committed to pursuing these efforts until its +2%
inflation target has been met and surpassed. This goal will
not be met in 2016, and a drop in the yen’s value will have
to occur in 2017 for it to be plausible. However, the
bank’s scope for action is limited, and price indices will
undoubtedly have to wait until the first quarter of 2017
for the positive base effect on oil prices, at rock-bottom
in January 2016, to push inflationary figures in the right
direction.
We do believe nevertheless that the yen’s rise of +17%
over six months is not justified by the country’s economic
fundamentals and is therefore not sustainable in the
current weak context. We expect a correction that will
replace the yen between 110 and 115 to the dollar. The
triple test of the level of 100 yen to a dollar seems to have
met with success over the summer. The last quarter
should see the yen bounce back.
The British pound remains under pressure but
the worst may be over already
The Brexit shock triggered a brutal readjustment of the
pound, followed by a stabilisation of the exchange rate in
the past three months. We now know that the Prime
Minister will trigger Article 50 in March 2017 or maybe
even a little later, which leaves us with enough time to
ponder the future of economic relations between the
United Kingdom and the European Union.
An amicable divorce would certainly be more comfortable
for everyone, but interests may diverge and public
opinion may be opposed. While we wait for negotiations
to begin, we believe it is likely that the pound will
fluctuate within a 1.27 to 1.35 range against the dollar and
1.13 to 1.20 against the euro.
In Australia, Canada and commodity-producing countries
more generally, the rebound of industrial metal prices,
precious metals and oil prices from USD 26.5 to over
USD 50 has reversed the bearish trends exhibited by their
currencies. The Australian dollar, down -38% since 2011,
has posted a +12% increase.
Sources: Bloomberg, BBGI Group SA
Weekly Analysis – A continuing reprieve in the foreign exchange market
Similar conclusions for the Canadian dollar, up +11%
after a long decline of -55%, and for the Brazilian real,
surging +23% after a -63% crash. Currencies associated
with oil prices have also bounced back, including the
rouble (+22%) and the Colombian peso (+15%). The
improved general context resulting from a rally in
commodities has had a broad positive effect on the
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valuation of emerging currencies (JPM EMCI), which
have posted their sharpest increase (+8%) since the
beginning of the bear market that took hold globally in
2011. These currencies have also stabilised during the
summer, pending confirmation of the upturn in the
commodities cycle.
Currencies against the euro
(CHF, USD, GBP, JPY and CNY)
The Swiss National Bank’s reserves have progressed by
11 billion in August to 626 billion, after smaller
interventions in July (6 billion) and June (7 billion). In
nominal terms, the ten-year yield spread between the
Bund and the Swiss government rates has remained stable
in 2016 at around 0.5%, but the three-month rate spread
has crumbled to stabilise at a level of around 40 basis
points. Nevertheless, this factor has not affected the
evolution of exchange rates in the last few months.
The real yield spread may become a new element that
could weaken the Swiss franc. We still believe that the
franc should lose some of its attractiveness in the coming
months. Our forecasts are for 1.15 against the euro and
1.05 against the dollar.
Evolution of the 7 major currencies against the CHF
(rebased at 100)
Sources: Bloomberg, BBGI Group SA
Swiss franc: new floor at 1.08?
Uncertainty relating to Brexit is still present, but the
worries that led to a flight to quality to the Swiss franc
seem to have abated. The USD/CHF, EUR/CHF and
GBP exchange rates appear to be stabilising. The Swiss
National Bank’s policies remain unchanged. The
negative key rates are intended to create a yield spread
that is unfavourable to the franc, and the bank’s
interventions have enabled our currency to remain
above 1.08 against the euro. Has the Swiss National
Bank fixed a new floor at 1.08?
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Sources: Bloomberg, BBGI Group SA
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Weekly Analysis – A continuing reprieve in the foreign exchange market
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