JPM – FX Weekly Update – EUR: No change now, no sign of a change tomorrow

USD: Q1 Tapering still seems likely
Last week brought a run of strong US data, which was topped off by another robust employment report…..

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            Non Farm payrolls came in significantly above the consensus estimate at +203k (consensus +185k) with private and manufacturing payrolls also surprising to the upside at +196k and +27k respectively. Good news also came from the household survey which showed unemployment falling to 7%. Despite this positive news, the USD was largely unmoved. We think this is for one key reason – the Bernanke/Yellen transition. We think that without spectacularly good data, the Fed will wait until Yellen is at the helm and has the opportunity of a press conference to express her views before tapering. This institutional change has led the market to believe that March is the most likely date for tapering for sometime. As last week’s data releases were merely consistent with market expectations, they had limited impact on the USD. In addition, we believe that Yellen will push down the unemployment rate threshold for rate hikes. So while the fall in the unemployment rate was welcome, if the bar is also likely to be moved lower, it suggests a change in policy is still a long way away again muting the impact of this good news on the USD for now.

            EUR: No change now, no sign of a change tomorrow
            After cutting the refi rate in November, the market largely expected the ECB to stand pat last week. It did. The deposit rate remained at 0%, the refi rate at 0.25% and its forward rate guidance was unchanged. So why did the EUR rally? We believe the answer is because the market was looking for the ECB to signal it would do more in future, and it didn’t. For example, while the December staff macroeconomic projections showed low euro area inflation for sometime (1.1% in 2014 and 1.3% in 2015), they also suggested that deflation will be avoided. Similarly, although they are forecasting a recovery with growth of just 1.1% in 2014 and 1.5% in 2015, it is a recovery nonetheless. As this is an environment that the ECB has arguably already responded to through the last month’s refi rate cut, the implication is that the ECB will continue to stand pat unless conditions deteriorate. We feel this view was corroborated by Draghi’s determination to highlight the possibility of future action remains an “if”, not “when” question throughout the ECB press conference.
            In the short term, this news is positive for the EUR. Without action from the ECB, the EUR is likely to continue to find support from the on-going decline in the liquidity surplus (which is pushing up the short end of the euro area curve and the currency). Consequently, the near term downside for EURUSD is likely to depend upon just how good US data is and how soon the market expects tapering to begin.
            Longer term, however, we still believe the EUR will fall modestly against the USD. As yesterday’s projections show, the euro area recovery is fragile. This suggests that too much passive tightening (through a declining liquidity surplus and/or rising EUR) could start to derail the recovery and prompt an ECB response. In our opinion, another LTRO seems a more likely response than the use of negative deposit rates. But as both would push down euro area rates, either response would be negative for the EUR. We also believe that the more the EUR rallies the less attractive European assets appear and the less support the EUR will receive from inflows. Finally, it is important to remember the USD side of this equation. We continue to believe that tapering has been moved, not removed and look for UST 10y yields to rise faster than European yields next years. This move in interest rate differentials will favour the USD and help keep EURUSD within its range.

            AUD: More downside to come
            As universally expected the RBA kept rates on hold at the historic low of 2.5% last week. Also as expected, the accompanying statement continued to talk down the currency by remarking that the AUD is still “uncomfortably high” and that a “lower exchange rate is likely to be needed to achieve balanced growth”.
            However, without accompanying rate cuts and with better than expected retail sales numbers, the RBA’s jawboning had no sustainable impact on the AUD.
            Despite the RBA’s rhetoric, we believe the RBA will not use rate cuts to push the AUD lower unless the AUD rallies aggressively first (we think above 0.95 is a likely intervention zone) or the economy deteriorates substantially. This is because rate cuts would potentially inflate an already robust housing sector and further unbalance Australia’s growth.
            Rather, our bearish view on AUDUSD stems from our beliefs that 1) the USD will outperform and 2) the support from China for the Australian economy will continue to dwindle. We believe data last week has corroborated both of these views. In the US a very strong ISM manufacturing print of 57.3, a further improvement in the Markit PMI which was crucially led by new orders, and a stellar payrolls report, all fit with our view that tapering will commence in Q1. And with 10y UST yields still below 3%, there is plenty of room for US yields to rise and support the USD.
            Over in China, the PMIs seemed to bring good news with both the official manufacturing PMI and HSBC’s manufacturing PMI printing above the market’s expectations. However, neither print advanced on the prior month. Moreover, the underlying data provide further evidence of slowing growth momentum, with inventories showing the biggest pick up, while the forward looking orders components remained on a downward trend. Apart from a modestly slowing Chinese economy (which will drag on the AUD), we also believe the changing nature of Chinese growth means that Australia’s China fuelled heyday is well and truly over.
            Our 1 year forecast for AUDUSD is 0.88.

            INR: A sweet spot
            The INR remains our favourite carry currency and quarter to date it hasn’t disappointed. In fact, of the currencies we cover, it has delivered the strongest performance (spot and total return) since the start of September. The change in the INR’s fortunes began with the arrival of the new RBI governor in September who proceeded to deliver a number of sweeping reforms to help attract FX inflows and reform the financial sector. At the same time, the authorities’ actions to squash gold imports alongside a weaker INR helped India to achieve a current account deficit of just 5.2bn USD in Q3 2013. Not only is this a huge improvement over the $21.8bn deficit seen in Q2, we see scope for the Q4 figure to print closer to zero! Last week brought more good news for the currency with the exit polls from the local elections suggesting a strong result from the BJP (Bharatiya Janata Party).
            We continue to believe that the INR will provide investors with a positive total return this year. However, with tapering expected to start in Q1 and with the potential for cyclical factors to cause a modest widening of the current account deficit in Q1, there could be volatility ahead. For this reason, we like using the INR’s rally to take partial profits on tactical longs.

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