April 2014 EXCHANGE RATE FORECASTS MODEST ROOM FOR A STRONGER U.S. DOLLAR IN 2014-2015 AFTER 2013 S LARGE GAINS U.S. Dollar: The dollar index has inched higher in 2014 as the dollar strengthened against the Canadian dollar and Chinese yuan and softened against the euro and pound. The greenback s fundamentals are clear and stable: a downtrending U.S. unemployment rate, and a Federal Reserve Board that is slowly but surely moving monetary policy toward an exit from recent years unprecedented stimulus. The Fed will likely end net new purchases of long-term securities under its quantitative easing program by the fourth quarter of 2014, and then pause before making a first hike to the Federal funds rate in the fourth quarter of 2015. The U.S. dollar has strengthened substantially in the last few years as expectations for a stronger U.S. recovery and more normal benchmark interest rates were priced into the currency. Some addition strengthening seems likely in coming quarters as well, although the large weight in the dollar index of the Canadian dollar and Chinese yuan, two currencies that also have room to strengthen, means further USD appreciation will likely be modest in 2014-2015. Australian Dollar: The Reserve Bank of Australia has stated in recent monetary policy decisions that its benchmark cash rate could remained unchanged at 2.5 percent for some time as long as domestic growth and price pressures remain tame and the unemployment rate elevated. The RBA reaffirmed this view in its April decision. Australia s resource investment boom has slowed; in addition, slower emerging market growth and demand for Australian natural resource exports in 2014 is holding commodity prices lower. The net effect points to a weak Australian dollar for the next few quarters. The Aussie dollar and the Canadian dollar have weakened in parallel in late 2013 and early 2014; on balance, the Australian economy, with higher unemployment and a larger exposure to China s slowdown, seems likely to stay weaker longer than the Canadian economy does. 105 U.S. dollar broad index, Jan. 1997 = 100 104 103 102 101 100 99 98 97 96 95 1.15 U.S. dollars per Australian dollar 1.05 1.00 0.95 0.90 0.85 0.80
Canadian Dollar: The Loonie broke above $ per U.S. dollar in January 2014 on the combination of a weak December jobs report, low inflation, and Governor Poloz s dovish guidance, which markets interpreted as opening the door to a rate cut. While Poloz has avoided explicitly talking down the Canadian dollar, its weakness is favorable to the rotation of demand that Poloz advocates a strategy of boosting exports and non-residential investment to compensate for more modest household consumption and residential investment growth. With annualized core and headline CPI inflation both close to the Bank of Canada s 2.0 percent target in January and February, and the 6.9 percent unemployment rate in March equal to its average between 2000 and 2007, the BoC s next move looks to be a rate hike, most likely occurring in the first half of 2015. Its approach should help the Loonie recover some of its recent losses against the greenback, but Poloz s amenability to a weak Loonie makes a return to parity unlikely anytime soon. Chinese Yuan: From mid-january to mid-march, the yuan depreciated 3.0 percent against the U.S. dollar, the largest drop in over 20 years. The central bank seems to have engineered this drop to prep markets for its March 15 decision to widen the band around the dollar-yuan daily reference rate in which the exchange rate is allowed to fluctuate the band is now two percent around the fix, up from one percent before March 15. The weaker yuan also coincides with a weakening in Chinese economic data in the first quarter of 2014; this slow patch is likely to pass later this year as recent faster loan growth (January saw the most new loans on record created in China) spurs a recovery of investment. With the U.S. dollar expected to strengthen against the euro and yen in the second half of 2014, Chinese policymakers will likely limit yuan appreciation, and encourage more bilateral exchange rate volatility than in years past. Brazilian Real: Matching PNC s November 2014 forecast, the Banco Central do Brasil (BCB) hiked its benchmark Selic rate to 11.0 percent in early 2014, helping the real recover some of its late-2013 losses against the U.S. dollar. In fact, the real strengthened a surprising degree, briefly breaking below 2.2 per U.S. dollar in late March. Market expectations that the BCB would continue to hike the Selic rate in the second quarter of 2014 aided the real. Weaker poll numbers for President Dilma Rousseff, who markets (fairly or otherwise) blame for the deterioration in Brazilian economic growth since 2011, have also boosted the real; the retrenchment of U.S. long-term interest rates has not hurt either. These idiosyncratic, and probably temporary, forces have kept the real at the strong end of the 2.2 to 2.4 per U.S. dollar range that it has established since mid-2013. When U.S. interest rates resume their upward trend, the real seems likely to revert to the middle of the 2.2-2.4 range. 1.15 1.05 1.00 0.95 0.90 0.85 6.50 6.40 6.30 6.20 6.10 6.00 2.60 2.40 2.20 2.00 1.80 1.60 Canadian dollars per U.S. dollar Chinese yuan per U.S. dollar Brazilian real per U.S. dollar
Euro: The euro strengthened steadily in 2013 and early 2014 despite the common currency area s meager growth prospects, record unemployment, and the downward drift in CPI inflation below the European Central Bank s (ECB s) 2.0 percent target. Inflation by several measures reached the lowest levels since 2009 in early 2014, prodding the ECB to adopt more dovish forward guidance that commits it to unconventional easing measures if inflation remains at current low levels. With the Fed tapering and the ECB presumably on the verge of easing, the only leg of the FX stool still supporting a strong euro is the continued inflow of foreign capital to Eurozone commercial banks as financial investors, who fled the currency area in 2011-2012, increase euro exposure in their investment portfolios. After this re-allocation is complete, divergent economic prospects should lead the euro lower against the U.S. dollar eventually. 1.50 U.S. dollars per euro 1.40 1.30 1.20 Indian Rupee: The rupee stabilized in early 2014, breaking below 60 per U.S. dollar in late March for the first time since July 2013. As in Brazil, a stronger currency is due to more hawkish monetary policy and interest rate hikes; an improved political backdrop going into the April-May national elections; and less shaky economic data that suggest the worst of India s stagflation could be behind it. If inflation and growth continue to stabilize, the currency could likely hold its value at or just below 60 per U.S. dollar, which would leave the currency quite competitively valued on a trade-weighted and inflation adjusted basis. Risks nevertheless seem weighted toward a weaker rupee: with U.S. interest rates expected to turn a corner and rise again in coming months, the driver of India s awful August of 2013 will be back in the picture. 72 Indian rupees per U.S. dollar 68 64 60 56 52 48 44 40 Japanese Yen: The yen s appreciation took a pause in early 2014 ahead of the April 1 increase in the value added tax from 5 percent to 8 percent. The value added tax hike is expected to drag on growth in coming quarters, keeping the door wide open for the Bank of Japan to continue full speed with its highly expansionary program of Quantitative and Qualitative Easing QE-Squared. With the Federal Reserve s taper well underway in the second quarter of 2014, the divergence of Japan s outlook from the United States s has yet to translate into a weaker yen most likely because the Japanese exchange rate is inversely correlated with the Japanese stock market, and Japanese stocks sold off 11 percent in the year-to-date in anticipation of a post-tax hike slowdown. At some point, the capital market tail should stop wagging the exchange rate dog and when that happens, the yen is likely to resume its trend weakening vis-à-vis the U.S. dollar. 115 Japanese yen per U.S. dollar 110 105 100 95 90 85 80 75
Korean Won: The Korean won appreciated sharply in April 2014 after the International Monetary Fund called the currency moderately undervalued in the range of 2-8 percent, with the upper end of the range seeming more plausible. The IMF is on the Bank of Korea s (BoK s) back to allow a stronger won since the country s current account surplus has widened recently, and the growth outlook (the BoK expects real GDP growth to accelerate from 3.0 percent in 2013 to 4.0 percent in 2014) is also consistent with a strengthening currency. However, the won s strength may seem less justified if U.S. long-term interest rates resume their rising trajectory in the second half of 2014, as we forecast. As the currency of a net borrower economy, the won is highly sensitive to fluctuations in global capital market conditions, which are likely to favor a weaker won, paralleling the weaker yen, in coming quarters. Mexican Peso: Growth is gaining traction in the first half of 2014, although slower than hoped. Manufacturing output is a bright spot, reaching a record high in February 2014, 7.6 percent above its 2008 pre-recession peak. Construction, by contrast, was in February 2014 still 5.9 percent below the peak of July, 2012, the month of the Presidential election; postelection reforms to construction subsidy programs sent the sector into a sharp correction from which it is only now recovering. With an economy not yet firing on all cylinders, Mexico s substantial labor market slack is only gradually being absorbed: Wage increases will probably be modest in 2014, as will inflation. The Banco Central de Mexico in March 2014 downgraded its outlook for real GDP growth this year from a prior forecast for a 3.0-4.0 percent increase, and noted an improved balance of risks to inflation. The central bank s benchmark interbank rate will likely remain unchanged at 3.5 percent for the rest of this year. Longer-term, the growth outlook should brighten: maquiladoras are increasingly competitive against Asian manufacturers, and the 2013 oil industry reforms could transform this laggard sector into a leader. For the exchange rate, a stable interest rate outlook and positive growth outlook, as well as the exchange rate's well-defined trading range since mid-2013, suggest the peso is likely to be range-bound in the near term. Pound Sterling: The British economy s recovery has closely paralleled the U.S. recovery in 2013 and 2014: real estate made a large contribution to growth in 2013, and unemployment has fallen below the threshold set by the Bank of England beyond which an interest rate hike becomes a possibility. As growth continues above trend in 2014, and a stronger pound and lower global energy prices reduce headline inflation, the Bank of England is likely to take its time in normalizing interest rates. A first benchmark rate hike seems likely in the first half of 2015; from the second half onward, British interest rates will likely rise in tandem with U.S. rates. The economic and rate outlook justifies a stronger pound than was seen in 2013, but the appreciation of early 2014 seems overdone. A modest reversal would be unsurprising in coming quarters. 1,225 1,200 1,175 1,150 1,125 1,100 1,075 1,050 1,025 1,000 14.50 14.25 14.00 13.75 13.50 13.25 13.00 12.75 12.50 12.25 12.00 11.75 1.70 1.65 1.60 1.55 1.50 1.45 Korean won per U.S. dollar U.S. dollars per U.K. pound sterling Mexican pesos per U.S. dollar
Table and chart sources: Reserve Bank of Australia, Bank of Canada, China Foreign Exchange Trading Center, Banco Central do Brasil, Bank of Japan, European Central Bank, Reserve Bank of India, Bank of Korea, Bank of England, CEIC, The PNC Financial Services Group Visit http://www.pnc.com/economicreports to view the full listing of economic reports published by PNC s economists. Disclaimer: The material presented is of a general nature and does not constitute the provision of investment or economic advice to any person, or a recommendation to buy or sell any security or adopt any investment strategy. Opinions and forecasts expressed herein are subject to change without notice. Relevant information was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy. You should seek the advice of an investment professional to tailor a financial plan to your particular needs.