Welcome to Forex Friday, a weekly report in which we discuss selected currency themes mainly from a macro viewpoint, but we also throw in a pinch of technical analysis here and there. In this week’s edition, we discuss the potential for the EUR/USD to drop to parity, following the footsteps of CHF/USD.
Interest rate differentials continue to move FX markets in the way you would expect. Investors are buying currencies of countries where the central bank is expected to raise interest rates the most and selling currencies of countries where the central bank is expected to remain the most dovish. Here’s my colleague.
USD/JPY pauses at 130
We have already seen the USD/JPY surge to 130.00, rising some 1,500 pips in the space of a couple of months, as the divergence between the Bank of Japan and US Federal Reserve’s monetary policy stances grow ever larger.
It looks like we will get a few more 50 basis point rate hikes in June, July and September, before switching back to the standard 25bp hikes thereafter. It is likely that the Fed will pause hiking by early 2023, or even sooner should the economy turn sharply lower.
But owing to the fact that risk sentiment deteriorated, some of the yen pairs sold off and this helped to keep the USD/JPY in the balance this week, even as the dollar rose against other currencies.
USD/CHF breaks parity
One of those currencies mentioned above was the Swiss franc. As it sold off further, this saw the USD/CHF surged to above 1.000. It has tacked on some 9% or 830 pips in the space of 1.5 months. Impressive stuff. Traders expect the Federal Reserve to raise the fed funds target rate to nearly 2.00% by July and nearly 3.00% by the end of the year, as inflation in the US has surged to multi-decade highs of 8.5% before easing back a little in April to 8.3% – still higher than expected. This has kept the dollar in strong demand across the board, causing even gold to slump to $1800 today.
In sharp contrast, the Swiss National Bank has not altered its monetary policy at all, and why would then when inflation is just 2.5% when it was below the SNB’s target for a very long time. The SNB likes to track policy changes at the ECB, in order to prevent the EUR/CHF from weakening significantly. So, there is a good chance the SNB will follow the ECB’s footsteps to normalize its policy a little by exiting negative rates by the first quarter of 2023. The first rate hike is unlikely to be any time soon – Q3 at the earliest.
Against this fundamental backdrop, you would expect the USD/CHF to rise further over time, although it has now reached my main objective which was 1.000. If weakness in the global economy persists then this would discourage the SNB from raising rates above zero, which could then lead to more losses for the CHF.
What about the EUR/USD?
Well, the selling has paused for now around 1.0350 to 1.0400 area. But fundamentally nothing has changed to suggest a sharp rebound is on the cards. Incoming data from Germany, Europe’s largest economy, continues to deteriorate, even as we get closer and closer to the first rate increase from the ECB. But will investors start to think beyond short-term rate increases?
Investors are getting ready for a potential ECB hike in July, followed by another one in September. But beyond that, it is difficult to see whether the hikes will continue given the high levels of uncertainty surrounding the economic outlook. We may see the ECB front-loading the hikes like the rest of the banks who have started their own hiking cycles.
But one thing is for certain is that inflation is continuing to cause big headaches for the ECB officials. So, they recognise the need to ending net asset purchases and the era of negative deposit rates, but longer-term macro factors suggest any hiking cycle could be short-lived.
That is unless of course we see a massive rebound in economic activity, say, because of potential peace returning to Ukraine and oil prices plummet. We already know that demand for holidays in Europe is going to be strong, despite the surging prices, as people who have put off their holidays for the last couple of years hit to the beaches and sunny weather of Europe’s southern countries. This will increase demand for euros.
For this reason, I don’t expect to see much further weakness in the EUR/USD exchange rate, although can’t rule out a return to parity.