Important week for carry trade
In contrast to the USD, the JPY and CHF were the best performing currencies overnight. Normally this would be associated with broad selling of the carry crosses, but there has limited evidence of that in recent sessions. Emerging market currencies continue to trade with a relatively firm tone, while within G10 currencies, the AUD and NZD have performed almost as well as the funding currencies. This reflects the fact that interest rate expectations have been a more dominant driver of the FX market than equities over the past week.
According to our financial fair value models, the effect of interest rate differentials outweighed the effect of equity price moves last week. In Australia, for instance, the market continues to see the risk skewed in favour of a rate hike rather than easing, in contrast to most other G10 central banks – the Aussie bills market sees about a 50% chance of a rate hike in February. We think these expectations could be disappointed following the Q4 CPI inflation data on Jan 23. A Reuters poll of market economists suggests that an average reading in the RBA’s underlying measures of 0.9% Q/Q or above would trigger a rate hike by the RBA. We expect CPI tocome in slightly below that rate at 0.8% Q/Q and together with the softening in US growth, will stay the RBA’s hand in February. With equity markets likely to remain weak over the next month, the AUD presents an attractive selling opportunity at these levels particularly against the low-yielding currencies, and potentially against the EUR as well, with the ECB showing little sign of backing away from its hawkish stance so far. This week equities are likely to be more important for the FX market, particularly the JPY and CHF crosses, with several large banks reporting their earnings this week. The financial markets are already somewhat prepared for weak Q4 earnings results, so it will be the outlooks that the market focuses on.
We continue to see that current consensus forecasts for the US equity market in the coming quarters (as well as in Q4) are too optimistic and look for a further fall in the market by 10% in Q1, which will weigh on the JPY crosses in the quarter.
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