Forex market may see big churn in 2015

January 21, 2015 17:26
Currency markets are expected to remain volatile this year due to several factors. Photo: Bloomberg

The share of US dollar in global foreign exchange reserves has risen from 60.7 percent in the second quarter of 2014 to 62.3 percent in the third quarter, marking the highest level in three years, according to data from the International Monetary Fund. Meanwhile, the ratio of euro has dropped from 24.1 percent to 22.6 percent in the period, the lowest level in almost a decade.

The figures suggest that central banks around the world are adjusting their basket of foreign exchange reserve currencies by taking into account the future strength of various currencies.

Many central banks have stopped boosting their euro holdings given a gloomy outlook for the unit. Instead, they opted for an increase in holdings of the greenback or US-pegged currencies like the Hong Kong dollar. Therefore, the greenback is set to play a key role in the years ahead.

The CBOE EuroCurrency Volatility Index (EVZ) has spiked to 40 percent and even hit 70 percent at one point on January 16, which indicates that those who are holding euro-denominated assets are looking for hedging instruments. Therefore, the foreign exchange market will remain volatile.

It's quite certain that the US Fed will hike interest rates; the only issue is when and to what extent. That has helped pave the way for a stronger dollar in the long term. Nevertheless, the upside of the dollar may be limited in the near to medium term.

The US dollar index has already rallied 18 percent within last year to 92 at the moment. More importantly, overly strong dollar will inevitably be detrimental to US economic growth. Latest data shows that US Consumer Price Index fell 0.4 percent last month, the largest drop since December 2008.

CPI is one of the key inflation gauges for the Fed in making monetary policy decisions. And the central bank has always believed that once inflation falls below 2 percent, the economy will get hurt. Therefore, overly strong US dollar is the last thing the Fed wants to see.

By contrast, euro and Japanese yen are set to be under pressure as central banks in the eurozone and Japan are poised to pump more liquidity into the system to bolster economic growth.

Euro has slid from 1.3993 against the US dollar in last May to 1.1567 on January 16, a remarkable fall within eight months. Euro may soon weaken below 1.2 to dollar and hover in the range of 1.15 to 1.12.

Strong interest in dollar-denominated assets will also lure more capital into Hong Kong, which will somewhat help the H-share market. The government has suspended the investment visa program recently, but the move may have limited impact in fund inflow into the city.

The mounting expectation of increased volatility of renminbi coupled with stronger Hong Kong dollar against renminbi will attract more investors to place bet in H-shares.

The redback may continue to lose strength after the Swiss National Bank's decision last week to abandon its currency ceiling against the euro. The Swiss franc move has stimulated safe-haven demand, and capital is chasing US bonds and fleeing emerging markets like China.

If the capital outflow continues to gather momentum in China, the renminbi could face more pressure. The Chinese currency could ease to 6.4 or 6.5 to US dollar this year from 6.0 to 6.3 in 2014.

It's quite likely that the upward rally of the renminbi over the past decade may eventually end. A short-term depreciation in early 2014 may serve as a test, and the currency may switch to a depreciation pattern in the long term.

The renminbi will be under pressure as long as the US dollar index stays above 90. Besides, there is over 12 trillion yuan in offshore markets or Shanghai free-trade zone and Qianhai. Therefore, the exchange rate of the currency will be increasingly determined by overseas trading, mostly in Hong Kong.

This article appeared in the Hong Kong Economic Journal on Jan. 21.

Translation by Julie Zhu

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adjunct professor in the Department of Finance at HKUST Business School