Further pain for euro on divergent economic policies

With growth waning, the biggest problem facing the European Union is the risk of deflation. Ralph Orlowski / Reuters

Much of the FX pricing action last year was driven by interest differentials, and that trend is set to continue this year as well, particularly for the euro crosses.

With the US Federal Reserve adopting a more hawkish tone towards future interest rates and the European Central Bank (ECB) taking a more dovish stand with more monetary stimulus lined up for the European Union, the divergence in policy will continue to weigh on euro forecasts in 2015 as the favourable yield spread will see traders gravitate towards the dollar.

Markets can poise themselves for the first US rate hike during this summer, and the wait-and-see rhetoric from the Fed will continue to see volatility remain high in the lead up. However, when the hike materialises, we expect to see large gains for the greenback against the euro.

The euro-dollar closed last year almost 12 per cent lower, and the initial pricing action of the New Year saw the cross test and break several key technical levels. Yesterday’s break of the June 2010 low of 1.1877 (which also forms the backbone of the 200 month moving average) sees the euro at almost nine-year lows against the greenback.

Fundamentally, the ECB faces a tough road ahead this year. With growth already on the wane, the biggest threat to the euro-zone is deflation. The mandate of price stability remains the top priority for any central bank and with November’s inflation data coming in at 0.3 per cent, deflation risks are highly escalated. The recent crash in energy prices will also weigh on price forecasts – and this week’s inflation data will highlight this – expectations are for a negative reading of -0.1 per cent for last month and this will continue to pile the pressure on the ECB chief, Mario Draghi, to introduce another round of QE measures as early as this month, when the ECB meets in Frankfurt on January 22.

With the euro trading at close to nine-year lows, we expect support to come in at 1.16 against the dollar this month with a strong ceiling forming at 1.22 levels.

The recent pricing action of the euro will also put pressure on the Swiss National Bank (SNB). The SNB’s forced floor at 1.2 for the euro-Swiss franc could be strongly tested as the euro continues its slide. With around 60 per cent of the SNB’s reserves in euro, the Swiss central bank could be forced to intervene and sell a large portion of their reserves to protect that 1.2 floor.

Across the Atlantic, two of the biggest data points this month will be the US non-farm payroll report due to be out on Friday and the federal open market committee (FOMC) meeting taking place on January 27 and 28.

If we start with the former, November’s jobs reading trumped the highest estimates on the street and surprised markets with a reading of 321,000 – its strongest print in two years. Although hiring would have increased during the holiday season, we do not expect the strong gains to continue with a reading of 230,000-250,000 more likely for last month. The unemployment rate is expected to remain unchanged at 5.7 per cent.

Based on our expectations, the numbers would not warrant a change in the FOMC rhetoric when they convene at the end of this month. During the last rate decision, we saw the Fed chairwoman, Janet Yellen, adopt a less than hawkish tone which lent support to the dollar – and we expect more of the same when the Fed makes their announcement after their two-day meeting on January 28.

The US Dollar Index completed our upside target of 90 and we now expect a test of 92.32 and 92.63 for the index in January.

And finally, with the bullish trend of the dollar expected to gain momentum this month, we expect to see further weakness in the Indian rupee.

Inflationary data, due to be out on January 12, is expected to slow below the previous reading of 4.3 per cent. A significant enough drop in consumer prices would stoke speculation that the Reserve Bank of India would have to cut rates at their next meeting in February. Also, on January 12, the industrial production figure for November will be released. Following a drop to -4.2 per cent in October, we expect a slight bounce back in the figure.

Technically, we expect the January DGCX rupee-dollar contract to test 154.70-155 (dollar-rupee 64.50-64.65) levels in the month ahead.

Gaurav Kashyap is the head of futures at Alpari Middle East.

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