Forex and Interest Rate Outlook 26th August 2015 Moderate recovery continues in advanced economies, but a weakening of activity in emerging economies is adding to global deflationary pressures Further significant monetary easing globally in 2015, while expected rate hikes in US and UK are delayed as very low inflation persists and markets are hit by turbulence Very low inflation means that expected rate hikes in US and UK should prove very modest Rising risk aversion and turbulence on financial markets see the euro and yen recover some lost ground as US and UK rate hike expectations get scaled back We don t see the euro going above recent highs. However, gains by the dollar and sterling likely to be limited as rate hikes are expected to be very modest in the US and UK. Oliver Mangan John Fahey Dara Turnbull Chief Economist Senior Economist Economist www.aibeconomicresearch.com
Global Economic Outlook Global upswing to continue at moderate pace but with downside risks Both the IMF and OECD in their summer updates noted that, while growth has picked up in advanced economies in recent times, it remains quite modest relative to previous cycles. It is also uneven in pace, with the first quarter seeing the weakest global growth since the end of the financial crisis. This was largely due to temporary factors in the US and UK and activity rebounded in both economies in the second quarter. However, growth slowed slightly in the Eurozone and contracted in Japan in Q2, highlighting the unevenness of the recovery. Overall though, growth in advanced economies has gained some momentum in the past couple of years. This is largely attributable to a pick-up in activity in the Eurozone. Nonetheless, the Eurozone continues to lag well behind the recoveries in the US and UK. Meanwhile, growth in Japan remains erratic, despite an ultra-loose monetary policy and big decline in the yen over the past three years. Meantime, there has been a slowdown in growth in many emerging economies, most notably China. This is offsetting the pick-up in advanced economies. Thus, the overall growth rate of the global economy has remained static in recent years. The expectation is that the global recovery will prove sustained despite downside risks such as the slowdown in China and turbulence on financial markets. There are a number of factors supporting the global economy. Oil prices have moved lower again over the summer months which, combined with the effects of a further easing of monetary policy this year should help boost growth in many economies. Both the IMF and OECD see significantly lower energy costs as providing a boost to consumption in most oil-importing countries. Meanwhile, more than half of the world economy has experienced further monetary policy easing this year. In addition to these factors, fiscal policy is turning less restrictive in most advanced economies. Labour market conditions are also improving in the major economies, including the Eurozone and Japan. Confidence has also improved, while lead indicators, such as PMI surveys, point to a continuation of the upswing in activity. The IMF and OECD expect a further modest acceleration in growth in advanced economies next year, helped by a pick-up in investment which has been very subdued in this upturn. One-off factors which restrained growth earlier this year, should not recur either. They are also hopeful that there will be an improvement in economic conditions in a number of distressed emerging economies next year. Thus, global growth should strengthen. However, expectations for stronger global growth have failed to materialise in recent years and there is little sign yet of any pick up in activity in emerging economies. Indeed, downside risks are rising for the world economy. There are concerns that the current turbulence on financial markets could hit global growth, as could the economic slowdown in China. Thus, uncertainty remains high about the outlook for the world economy. The fact that official interest rates remain at virtually zero in many economies, six years after the financial crash of 2008-09, and inflation is also around zero, indicates that we are still far from a return to normal economic conditions. Thus, we are not that confident that global growth will pick up in 2016 as forecast by the IMF and OECD. 60 55 50 45 40 Global Composite PMI (JP Morgan) 35 Jul-06 Jul-07 Jul-08 Jul-09 Jul-10 Jul-11 Jul-12 Jul-13 Jul-14 Jul-15 GDP (Vol % Change) 2013 2014 2015 (f) 2016 (f) World 3.4 3.4 3.3 3.8 Advanced Economies 1.4 1.8 2.1 2.4 US 2.2 2.4 2.5 3.0 Eurozone -0.4 0.8 1.5 1.7 UK 1.7 3.0 2.4 2.2 Japan 1.6-0.1 0.8 1.2 Developing Economies China 7.7 7.4 6.8 6.3 India 6.9 7.3 7.5 7.5 World Trade Growth (%) 3.3 3.2 4.1 4.4 Advanced Economies Inflation (%) 1.4 1.4 0.0 1.2 Source: IMF 'World Economic Update', July 2015
Interest Rate Outlook Further monetary easing globally while expected rate hikes are delayed This year has been characterised by a further widespread loosening of monetary policy in many countries across the world and a scaling back of rate hike expectations in economies where policy tightening had been expected to commence. The main reason for this has not been economic weakness per se, as the world economy has continued to expand at a moderate pace, but rather very subdued inflationary pressures. Many central banks have taken advantage of the sharp fall in inflation, caused by the collapse in oil and other commodity prices over the past year, to move to an even more accommodative monetary policy stance. The OECD estimates that monetary easing has occurred this year in countries accounting for more than half of global GDP. Meanwhile, central banks that were contemplating monetary tightening have stayed on hold, with markets scaling back the timing and extent of likely rate hikes. Both the US Fed and Bank of England have sounded some warnings that rates may have to rise in the not too distant future. The Fed has indicated that we are approaching the point where economic conditions will warrant some policy tightening. However, even though the economy is now close to full employment, it would appear that many Fed officials are still reluctant to hike rates given the continuing very subdued inflationary environment, rising external risks to growth as well as the current turbulence on financial markets. The most recent FOMC minutes suggest that there is a divergence of views emerging within the Fed on what it should do. Markets, which at the start of the year had been pricing in three 25bps rate hikes in 2015, are no longer discounting even one such rate increase, and now think that rates may not start to rise until the spring. The Bank of England is also showing a reluctance to raise rates despite the tightening in labour market conditions. It recently revised down its forecast path for inflation in the near term and its projections suggest that it does not envisage hiking rates until the second quarter of next year, despite a warning from the BoE Governor that the timing of interest rate increases is moving closer. Both the Fed and BoE have also repeatedly emphasised that, when they do start to tighten monetary policy it will be at a very moderate pace. With inflation staying very low, markets are now pricing in that official rates will not have even risen to 1% in either the US or UK by the end of 2016. Meanwhile, any monetary tightening in the Eurozone or Japan is still years away, with the Central Banks there continuing to loosen policy through their large QE asset purchase programmes. The ECB continues to emphasise that its QE programme will last until at least September 2016 and could be extended beyond that point. Thus, markets are clear that monetary policy will remain very loose in both these economies for a long time to come. There remains considerable uncertainty in markets, though, about when the Fed and Bank of England will start to increase interest rates. Very low inflation and rising global risks to growth suggest that policy will be kept on hold near term. However, continuing solid domestic economic growth and tightening labour market conditions, indicating that spare capacity will soon be used up, suggest that rates should soon rise from their current very low levels. Thus, provided financial markets settle down, we think that the Fed is still likely to raise rates by the end of this year, as indicated by a number of Fed officials, including Janet Yellen. We expect that UK rates will be increased by next summer, especially given the warnings on the need for rate hikes from the BoE Governor. US Interest Rate Forecasts (to end quarter) Fed Funds 3 Mth 1 Year 2 Year * 5 Year * Current 0.125 0.33 0.83 0.79 1.52 Sept '15 0.125 0.35 0.90 0.95 1.70 Dec '15 0.375 0.60 1.15 1.20 2.00 Mar '16 0.625 0.85 1.40 1.50 2.30 * Swap Forecasts Beyond 1 Year Eurozone Interest Rate Forecasts (to end quarter) Refi Rate 3 Mth 1 Year 2 Year * 5 Year * Current 0.05-0.03 0.16 0.09 0.41 Sept '15 0.05-0.02 0.18 0.12 0.50 Dec '15 0.05-0.01 0.20 0.15 0.60 Mar '16 0.05 0.00 0.23 0.20 0.65 * Swap Forecasts Beyond 1 Year UK Interest Rate Forecasts (to end quarter) Repo Rate 3 Mth 1 Year 2 Year * 5 Year * Current 0.50 0.58 1.05 1.01 1.56 Sept '15 0.50 0.60 1.10 1.10 1.70 Dec '15 0.50 0.65 1.20 1.25 1.90 Mar '16 0.50 0.70 1.30 1.40 2.15 * Swap Forecasts Beyond 1 Year Current Rates Sourced From Reuters, Forecasts AIB ERU
Forex Market Outlook Euro rises as markets turn very risk adverse There have been some significant moves in FX markets in the recent days as a pronounced pick up in risk aversion sees currencies break out from well defined trading ranges. The four major reserve currencies (dollar, euro, yen and sterling) had been confined to relatively narrow trading ranges against each other over the past few months, following big exchange rate moves in the second half of last year and opening quarter of 2015. The euro found a floor in the spring and became much more stable, after having suffered big losses in the second half of 2014 and early 2015. It had been trading in a $1.08-1.14 range versus the dollar since mid- April. However, it has risen sharply over the past week climbing from $1.10 to a seven-month high of $1.17. The euro also rose by four pence against sterling in the past week, climbing from just over 70p to 74p. 95 90 85 80 75 70 US Dollar Trade Weighted Index Versus Majors (March 1973 =100) The euro is benefiting in a number of ways from the increased risk aversion in financial markets. Traders had been using the euro as a funding currency because of its very low interest rates, but these trades are now being closed out, with the euro spiking higher on the short covering. Meantime, there are growing concerns about the slowdown of the Chinese economy and sharp falls in global equity markets, most notably the very big declines in Chinese stocks over the summer. Meanwhile, the recent flight to quality has seen a marked fall in bond yields. The slowdown in China and associated financial market turbulence is seen as delaying the timing and extent of expected rate hikes in the US and UK. The renewed fall in commodity prices over the summer, which has been partly caused by the weakening of activity in emerging economies like China, is also having a similar effect on rate hike expectations. Inflation has fallen to around zero in many economies and near term inflation forecasts have had to be lowered further as a result of a renewed marked decline in commodity prices, in particular oil prices. As a result, inflation is set to remain around zero for longer than had been expected. This very subdued inflation outlook and the growing downside risks to global growth, as well as turbulent financial markets are all making it increasingly difficult for Central Banks like the Fed and Bank of England, to begin tightening monetary policy despite the strength of their own economies. As a result, markets have greatly scaled back their expectations of rate hikes in both the US and UK. At the start of 2015, the markets were looking for up to three 25bps rate hikes in the US this year. Even up to recently, there was an expectation that the Fed could hike rates in both September and December. Now though, markets think that the Fed will keep policy unchanged this year and won t hike rates until the spring. Meanwhile, UK rates are now not expected to start rising until the middle of next year. All of this is helping to support the euro, where rates had been expected to remain very low for a considerable period of time in any event. Thus, there were no major rate hike expectations to scale back here. Furthermore, the Eurozone economy has gained some momentum in the past year. Growth has picked up to 0.3-0.4% in recent quarters. It may not be very strong growth but it is a much improved performance on recent years. The euro is now well off its floor of $1.05 against the dollar reached earlier in the year. The EUR/USD rate looks like it might have moved into a new trading range of $1.11-1.17 but seems unlikely to go any higher. 65 Aug-07 Aug-08 Aug-09 Aug-10 Aug-11 Aug-12 Aug-13 Aug-14 Aug-15 Euro / Dollar Exchange Rate US$ 1.45 1.40 1.35 1.30 1.25 1.20 1.15 1.10 1.05 1.00 US$ Sterling / Dollar Exchange Rate 1.75 1.70 1.65 1.60 1.55 1.50 1.45
Forex Market Outlook Modest rate hikes point to only modest gains for dollar and sterling vs euro Given its solid performance since the spring, the sharp fall of the euro against the dollar and sterling would now appear to be over. The euro looks to be well underpinned in the near-term, given the heightened level of risk aversion in markets. However, could the rate increases still expected in the US and UK trigger fresh gains for the dollar and sterling against the single currency over the next year? Our inclination is that if the rate hikes are very modest, the upside for the dollar and sterling may prove limited. 0.89 0.86 0.83 0.80 0.77 Euro / Sterling Exchange Rate Both the Fed and Bank of England have repeatedly emphasised that the pace of policy tightening is expected to be very slow so rate hikes seem likely to prove very modest. Markets are not even discounting that official rates will reach 1% in either the US and UK by the end of next year. Thus, rates are expected to remain very low. If this proves to be the case, it seems unlikely that the dollar and sterling will make significant fresh gains against the euro. It should be borne in mind that the big gains made by both currencies in H2 2014 and early 2015 were in a period when the ECB was moving to a much looser policy stance while, at the same time, significant rate hikes were being priced in for the US and UK. This is no longer the case. On the other hand, though, the ECB s QE programme and very low Eurozone rates should limit the upside for the euro. Thus, we could see EUR/USD trade in a $1.11-1.17 range near term. We still believe that the Fed will hike rates before year end if financial markets settle down, with further modest hikes in 2016. This should allow the dollar rise somewhat against the euro but we do not expect it to surpass the highs hit in early 2015. Meanwhile, the euro is likely to edge back down towards the 70p level against sterling as we get nearer to UK rate hikes. One important consideration to bear in mind regarding sterling s prospects is the referendum on the UK s continued membership of the EU, to be held before the end of 2017. The markets have taken their cue from opinion polls pointing to a comfortable majority in favour of the UK staying in the EU. Thus, the issue has not been impacting sterling. However, if the gap in the polls closes, it would introduce a considerable amount of uncertainty and probably put the UK currency under some downward pressure. Thus, it bears watching. The yen has shown signs of stabilising this year, having fallen sharply in the previous couple of years. Certainly the pace of decline has slowed a lot in 2015, and the increased risk aversion in markets has seen the dollar fall back to around 120 from a high of 125. The dollar has risen above 125 on only two occasions in the past two decades, so it is not surprising that the yen has found support at this level. The BoJ has also hinted that the yen may have fallen far enough. Overall then, the yen may have found a bottom at around the 125 level. Finally, China has made a significant change to its exchange rate policy recently, loosening the peg with the dollar and letting its currency depreciate by allowing market forces have a greater say in determining its level. The fall in the currency has not been that great to date at around 3%. With the economy weakening and exports under pressure following a sharp rise in the currency over the past year, the Chinese authorities may well be prepared to let the exchange weaken further, but at a very gradual pace. 0.74 0.71 0.68 Yen Dollar / Yen Exchange Rate 130 125 120 115 110 105 100 95 90 Yen Euro / Yen Exchange Rate 155 150 145 140 135 130 125 120
Summary of Exchange Rate Forecasts Euro Versus ( Spot Forecasts for end Quarter can be taken as Mid-Point of expected Trading Range) Current Q3-2015 Q4-2015 Q1-2016 Q2-2016 US $ 1.65 Euro / Dollar Exchange Rate USD 1.142 1.11-1.17 1.09-1.15 1.07-1.13 1.05-1.11 GBP 0.730 0.71-0.74 0.70-0.74 0.69-0.73 0.68-0.72 JPY 136.52 134-140 134-140 133-139 132-138 CHF 1.08 1.08 1.09 1.10 1.10 1.50 1.35 1.20 1.05 0.90 0.75 Aug-01 Aug-03 Aug-05 Aug-07 Aug-09 Aug-11 Aug-13 US Dollar Versus JPY 119.53 117-123 119-125 121-127 122-128 GBP 1.564 1.54-1.60 1.53-1.59 1.52-1.58 1.51-1.57 CAD 1.33 1.33 1.34 1.35 1.36 AUD 0.71 0.71 0.70 0.69 0.68 Stg 1.00 0.90 0.80 0.70 0.60 Euro / Sterling Exchange Rate NZD 0.65 0.65 0.64 0.63 0.62 0.50 Aug-01 Aug-03 Aug-05 Aug-07 Aug-09 Aug-11 Aug-13 Aug-15 CNY 6.41 6.45 6.55 6.60 6.65 Sterling Versus JPY 187 189 190 192 193 CAD 2.08 2.09 2.08 2.09 2.10 AUD 2.19 2.21 2.23 2.25 2.26 NZD 2.40 2.42 2.44 2.46 2.48 2.2 2 1.8 1.6 1.4 US$ Sterling / Dollar Exchange Rate 1.2 Aug-01 Aug-03 Aug-05 Aug-07 Aug-09 Aug-11 Aug-13 Aug-15 This publication is for information purposes and is not an invitation to deal. The information is believed to be reliable but is not guaranteed. Any expressions of opinions are subject to change without notice. This publication is not to be reproduced in whole or in part without prior permission. In the Republic of Ireland it is distributed by Allied Irish Banks, p.l.c. In the UK it is distributed by Allied Irish Banks, plc and Allied Irish Banks (GB). In Northern Ireland it is distributed by First Trust Bank. In the United States of America it is distributed by Allied Irish Banks, plc. Allied Irish Banks, p.l.c. is regulated by the Central Bank of Ireland. Allied Irish Bank (GB) and First Trust Bank are trade marks used under licence by AIB Group (UK) p.l.c. (a wholly owned subsidiary of Allied Irish Banks, p.l.c.), incorporated in Northern Ireland. Registered Office 92 Ann Street Belfast BT1 3HH. Registered Number NI 018800. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. In the United States of America, Allied Irish Banks, p.l.c., New York Branch, is a branch licensed by the New York State Department of Financial Services. Deposits and other investment products are not FDIC insured, they are not guaranteed by any bank and they may lose value. Please note that telephone calls may be recorded in line with market practice. AIB Bankcentre, Ballsbridge, Dublin 4 Tel: 353-1-6600311 www.aibeconomicresearch.com