Forex and Interest Rate Outlook

13th February 2014

AIB Treasury Economic Research Unit

Improving economic growth but recovery not yet secure. Economic and financial risks in
emerging markets a concern. Very low inflation in many advanced economies

Central banks look to contain rise in market interest rates via forward guidance that rates
can stay low for an extended period. Indeed, its possible that ECB may cut rates again

Renewed upward pressure on swap rates and bond yields expected as stronger growth
likely to fuel expectations that UK and US central banks will eventually tighten policy

We expect rate rises in the UK and US next year but not in the eurozone or Japan

Dollar and sterling should appreciate somewhat if expectations continue to build that
rates will be hiked in US and UK but remain on hold in the eurozone and Japan in 2015
Oliver Mangan
Chief Economist

John Fahey
Senior Economist
www.aibeconomicresearch.com

Dara Turnbull
Economist

Global Economic Outlook

Growth picks up in advanced economies but downside risks remain
Growth in the world economy has been sluggish and uneven since the end of the Great Recession of 2008-09.
The IMF estimates that the world economy grew by some 3% in both 2012 and 2013. Growth in advanced
economies was below 1.5% in both years. Meantime, there was markedly slower growth in activity in many
emerging economies in 2012-13, including the four BRIC economies, compared to 2010-11.
At least, though, growth in advanced economies did pick up over the course of last year. Both the IMF and OECD
expect this trend to continue, with a further moderate strengthening of activity forecast for advanced economies
in 2014-15. This is expected to be driven by a stronger US economy, a reduced drag from fiscal tightening, low
inflation which boosts spending power, and the continuing highly accommodative stance of monetary policy.
Most leading indicators continue to rise, suggesting that the recovery is gaining momentum.
However, considerable downside risks remain. The slowdown in emerging economies, continuing financial market
fragilities and imbalances in these economies, as well as on-going deleveraging and constrained credit conditions
are all risks to the global recovery. To quote the IMF, the world economy is not out of the woods yet.

AIB Treasury Economic Research Unit

In terms of the US economys performance, GDP growth is expected to pick up from below 2% last year to
around 3% in 2014-15. Fiscal policy will have a far less dampening effect on activity compared to 2013.
Deleveraging is also quite well advanced in the US. Rising employment and the marked fall in inflation should
boost consumer spending, with a further rise expected in housing construction to meet pent-up demand.
Business investment should also pick up after its subdued growth in 2012-13.

Global Composite PMI (JP Morgan)

65
60
55
50
45
40
35
Jan-05

Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Source: Thomson Datastream

GDP (Vol % Change)

World

2012
3.1

There was a marked pick-up in activity in the UK during 2013, after the economy stagnated in 2012. The
continued strength of leading indicators, improving labour market trends and easing inflationary pressures, all
suggest that the recovery will prove sustained. As in the US, though, business investment needs to pick up to
put the recovery on a more secure footing, while exports need to improve also. The OECD is forecasting that UK
GDP will expand by around 2.5% in 2014 and 2015, even though the economy still faces some headwinds.

Advanced Economies
US
Eurozone
UK
Japan

1.4
2.8
-0.7
0.3
1.4

1.3
1.9
-0.4
1.9
1.7

2.2
2.8
1.0
2.4
1.7

2.3
3.0
1.4
2.2
1.0

In the eurozone, activity has been depressed by a combination of deleveraging by the private sector, tight credit
conditions and a sharp tightening of fiscal policy. The economy emerged from an 18-month long recession in Q2
2013. However, the recovery has been very weak and uneven since then. Growth is expected to remain modest,
with GDP forecast to grow by just 1% in 2014 and 1.5% in 2015. Therefore, the recovery in the eurozone is
expected to continue to lag well behind elsewhere. Furthermore, unemployment is expected to remain very high
at around 12%, in contrast to the US and UK, where the jobless rates have declined to the 6.5-7.0% range.

Developing Economies
China
India

7.7
3.2

7.7
4.4

7.5
5.4

7.3
6.4

Advanced Economies
Inflation (%)
External Trade (Vol %)

2.0
1.0

1.4
1.4

1.7
3.4

1.8
4.1

The Japanese economy has performed quite well in the past two years, helped by very expansionary fiscal and
monetary policies. Fiscal consolidation, though, is likely to see a slowdown in growth in 2014-15, even though
exports should be supported by the yens sharp fall. Meanwhile, GDP growth in China looks to be stabilising at
around 7.5-8.0% but the economy bears close watching. Meantime, the other emerging economies now account
for close to 25% of world GDP and a watchful eye needs to be kept on them also, given their recent difficulties.

2013 (e) 2014 (f)

3.0
3.7

2015 (f)
3.9

Source: IMF World Economic Outlook (Update), January 2014

Interest Rate Outlook

US Interest Rate Forecasts (to end quarter)

Rates to stay on hold in 2014 but renewed curve steepening likely

The impact of the Great Recession, and the sluggish and uneven pace of recovery from it, saw central banks cut
interest rates to record low levels, as well as engage in non-standard measures of monetary policy easing,
including QE. Last summer, both the ECB and BoE joined the Fed in providing forward guidance that interest
rates could remain at low levels for a prolonged period, despite signs of a strengthening of economic activity.
Central banks are keen to give the recovery in the world economy every chance to gain significant traction. Their
loose policy bias has been reinforced by the marked decline in inflation during the past year.
The Central Banks forward guidance policy is aimed at containing the rise in market interest rates as economic
growth picks up. It has enjoyed reasonable success. While long term bond yields rose last year, short-term
interest rates have generally remained well anchored. Indeed, bond yields have fallen to date in 2014 as a result
of a flight to quality out of volatile emerging markets and nervous stock markets.

Fed Funds

3 Mth

1 Year

2 Year *

5 Year *

Current

0.125

0.24

0.55

0.45

1.63

Mar '14

0.125

0.25

0.55

0.50

1.70

Jun '14

0.125

0.25

0.60

0.60

1.80

Sept'14

0.125

0.30

0.65

0.70

1.95

* Swap Forecasts Beyond 1 Year

Central banks, though, have had to fine tune their forward guidance. In the US, the Fed has strengthened its
forward guidance by indicating that it is likely to be appropriate to maintain the Fed funds rate at its current very
low level for a considerable time after its QE programme ends, which is likely to be later this year, and also well
past the time that the jobless rate falls below 6.5%, especially if projected inflation continues to run below its
2% goal. Thus, markets are pricing in just a modest rise in US rates from 2015.

AIB Treasury Economic Research Unit

In the UK, the BoE has broadened the range of factors it considers in making decisions on interest rates,
dropping its previous sole focus on the unemployment rate. It has stressed, though, that any rate increase is still
some way off. Thus, markets are looking for just a gradual rise in the UK bank rate, starting in H1 2015.
Meanwhile, having cut the refi rate by a further 25bps to 0.25% in November, the ECB retains a clear easing
bias in the face of a decline in inflation to below the 1% level. It has also strengthened its forward guidance by
strongly emphasising that key ECB interest rates are likely to remain at present or lower levels for an extended
period of time. The market believes that there could be a further small ECB rate cut this spring. Other measures
could also be announced, including a new LTRO or suspending the sterilisation of the SMP programme.
Whether the ECB actually eases policy further is uncertain. Much will depend on inflation data in the next couple
of months and trends in the real economy. It seems clear, though, that the ECB will maintain a very loose
monetary stance for at least the next two years, given the forecasts for modest growth and low inflation in 201415. The same applies in Japan, where the central bank continues to pursue an aggressive QE programme.
Overall, though, if forecasts for strong growth by the UK and US economies in 2014 prove correct, with an
accompanying further fall in unemployment, it will prove quite challenging for their central banks to prevent a
renewed rise in market interest rates, especially if the turbulence in emerging markets and associated flight to
quality abates. Even with policy staying on hold in 2014, markets will become increasingly certain that rate hikes
are on the way in 2015. Thus, we are likely to see a renewed steepening of curves in these circumstances. Ten
year gilt and Treasury yields are likely to rise to over 3%, which is likely to push bund yields to above 2%.

Eurozone Interest Rate Forecasts (to end quarter)

Refi Rate

3 Mth

1 Year

2 Year *

5 Year *

Current

0.25

0.26

0.51

0.43

1.02

Mar '14

0.25

0.25

0.55

0.50

1.10

Jun '14

0.25

0.25

0.55

0.55

1.20

Sept'14

0.25

0.25

0.60

0.60

1.30

* 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

0.52

0.89

1.00

2.00

Mar '14

0.50

0.55

0.90

1.05

2.05

Jun '14

0.50

0.55

1.00

1.15

2.20

Sept'14

0.50

0.60

1.10

1.25

2.35

* Swap Forecasts Beyond 1 Year

Current Rates Sourced From Reuters, Forecasts AIB ERU

Forex Market Outlook

US Dollar Trade Weighted Index Versus Majors

Range trading still dominates but dollar could make modest gains v euro
Tight trading ranges for the main currency rates were a key feature of forex markets for much of 2013. This is
not to say that we did not experience some volatility and movement out of ranges last year. Sterling fell early in
the year before recovering again, while the yen lost considerable ground during 2013. However, apart from the
weak yen, the main FX pairs were quite range bound for most of last year. The EUR/GBP rate was largely
confined to a 0.83-0.87 range, while EUR/USD spent most of 2013 trading in a $1.28-1.36 band.
Narrow trading ranges have remained a key feature of currency markets in the opening weeks of 2014. The
EUR/USD rate has been confined to a $1.35-1.38 range and lacks any clear direction, while EUR/GBP has been
even more range bound, generally trading between 0.82-0.835, with cable stuck between $1.63-1.665. Even
the rise in the yen, on the back of a flight to quality on increased risk aversion, has been modest enough, with
dollar/yen currently trading at around 102 compared to 105 at the start of 2014.
The task of trying to predict when and how the major currencies will break out of their ranges is not an easy
one. This is because the outlook for FX markets is set against a backdrop of central banks being in forward
guidance mode and trying to convince markets that rates can remain at low levels for an extended period of
time. Central banks are expected to keep rates unchanged in all the main economies in 2014, with the markets
pricing in modest rate hikes in the UK and US in 2015.
An important factor on FX markets going forward will be the relative growth performances of economies, which
in turn will determine the respective monetary policy stances of the main Central Banks over the medium term.
Monetary policy looks set to remain very loose in the eurozone and Japan over the next two years because of the
weakness of their economies and prospects of just moderate growth.

(March 1973 =100)

90
85
80
75
70
65
Jan-06

Jan-07

Jan-08

Jan-09

Jan-10

Jan-11

Jan-12

Jan-13

Jan-14

Source: Thomson Datastream

Euro / Dollar Exchange Rate

US$

1.45

1.40

1.35

1.30

1.25

AIB Treasury Economic Research Unit

However, the US and UK economies are regaining momentum. If expectations of strong growth by both these
economies in 2014-15 prove correct, this should see a firming of market expectations that we will get a
tightening of monetary policy by the Fed and BoE from next year on. Interest rate spreads should move in
favour of the dollar and sterling in these circumstances, pushing them higher against the euro and the yen.
The euro, though, has proved to be a very resilient currency in recent times. Indeed, it was the best performing
of the major currencies in 2013, despite the fact that the ECB cut rates in May and November. It is supported by
a current account surplus, as well as good capital inflows following the abatement of the eurozone debt crisis and
improvement in the economy. However, the euro has failed to make a sustained break above the $1.38 level
against the dollar on a couple of occasions in recent months. It has also lost ground to sterling since the
summer, suggesting some possible downside risk for the single currency.
The weakness of the eurozones recovery relative to both the US and UK, combined with the fact that the ECB
remains in policy easing mode, while both the Fed and the BoE could tighten policy in 2015, well before the ECB,
could result in some downward pressure on the euro later this year. A sustained pick up in the US economy and
labour market that sees the Fed wind up its QE asset purchase programme this year, should also benefit the
dollar. Thus, the EUR/USD rate could move down to around $1.30 later in the year.

1.20
Feb-12

Aug-12

Feb-13

Aug-13

Feb-14

Source: Thomson Datastream

US$

Sterling / Dollar Exchange Rate

1.70

1.65

1.60

1.55

1.50

1.45
Feb-12

Aug-12

Feb-13

Aug-13

Feb-14

Source: Thomson Datastream

Forex Market Outlook

Sterling benefits from the improving macro picture

Euro / Sterling Exchange Rate

0.89

Improving labour market figures, robust PMI readings and strong GDP data have seen the markets begin to
discount that BoE policy tightening will commence in H1 2015. As a result, sterling has performed well in recent
months, with cable climbing to around $1.65 and the EUR/GBP rate trading around the 82-83p level.

0.86

0.83

Sterling is likely to continue to be supported by the improving macro backdrop. The relative strength of the UK
recovery compared to the eurozone, and the likelihood that the BoE will hike rates well before the ECB, provides
the potential for further gains by sterling versus the euro. Sterling faces some strong resistance at the 82p level
but if this gives way, we could see a move to the 80p level later in 2014.

0.80

0.77
Feb-12

Meanwhile, with both the UK and US economies on similar trajectories and both their Central Banks expected to
tighten policy next year, cable could be quite stable in 2014. The are risks to the upside, though, as there is the
possibility that the BoE may start to hike rates ahead of the Fed. However, there is major resistance at around
the $1.67-1.69 range, which may prove difficult to overcome as it would see cable returning to levels not seen
since the collapse of sterling back in 2008. Furthermore, the persistence of a large UK current account deficit
remains a negative for sterling over the medium term. It could pose a risk to the currency in particular, if
relatively strong growth in domestic demand in the UK caused the BoP deficit to widen from already high levels.

Aug-12

Feb-13

Aug-13

Feb-14

Source: Thomson Datastream

Dollar / Yen Exchange Rate

Yen

110
105
100
95

AIB Treasury Economic Research Unit

Yen vulnerable if risk appetite picks up again

The yen has fallen sharply since the autumn of 2012, as a new Japanese government got the Bank of Japan to
embark on an aggressive easing of monetary policy. The yen slumped from 78 to 105 against the dollar and
from 95 to 145 versus the euro between September 2012 and the end of 2013. Risk appetite, though, remains
a key influence on the Japanese currency. The risk aversion evident in markets year to date and flight to quality
out of emerging markets has seen the yen make some modest gains. It is now trading at around 102 versus
the dollar and close to the 140 level against the euro.

90
85
80
75
Feb-12

Aug-12

Feb-13

Aug-13

Feb-14

Source: Thomson Datastream

Euro / Yen Exchange Rate

Yen

150

The negative forces, though, that triggered the sharp fall of the yen remain in play, in particular, the marked
expansion in Japanese money supply caused by the on-going QE programme. Higher interest rates in the other
main markets are also making yen investments less attractive. Meanwhile, the need for considerable fiscal
consolidation in Japan suggests that monetary policy will have to remain very loose for a long period after the
BoJ concludes its QE programme next year.
Thus, if as we expect, there is a pick up in risk appetite in markets during the year and market interest rates rise
elsewhere, downward pressure is likely to resume on the Japanese currency. However, given the extent of its fall
since autumn 2012, further declines may be limited from here. Thus, we look for the yen to move down to
around 110 versus the dollar by the end of 2014.

140

130

120

110

100

90
Feb-12

Aug-12

Feb-13

Aug-13
Source: Thomson Datastream

Feb-14

Summary of Exchange Rate Forecasts

(Spot Forecasts for end Quarter can be taken as Mid-Point of Expected Trading Range)
Current

Q1-2014

Q2-2014

Q3-2014

Q4-2014

Euro Versus

Euro / Dollar Exchange Rate

US $

1.65
1.50

USD

1.367

1.33-1.39

1.31-1.37 1.29-1.35 1.27-1.33

GBP

0.821

0.80-0.84

0.79-0.83 0.78-0.82 0.77-0.81

1.35
1.20
1.05

JPY

139.37

138-144

139-145

140-146

140-146

CHF

1.22

1.22

1.22

1.21

1.21

0.90
0.75
Jan-00

Jan-02

Jan-04

Jan-06

Jan-08

Jan-10

Jan-12

Jan-14

Source: Thomson Datastream

US Dollar Versus
Euro / Sterling Exchange Rate

Stg

JPY

101.95

101-107

103-109

105-111

107-113

GBP

1.666

1.62-1.68

CAD

1.10

1.10

1.11

1.12

1.13

AUD

0.90

0.89

0.88

0.87

0.86

NZD

0.83

0.83

0.82

0.81

0.80

CNY

6.06

6.06

6.04

6.02

6.00

1.00

0.90

1.62-1.68 1.62-1.68 1.62-1.68

0.80

0.70

0.60

0.50
Jan-00

Jan-02

Jan-04

Jan-06

Jan-08

Jan-10
Jan-12
Jan-14
Source: Thomson Datastream

Sterling / Dollar Exchange Rate

US$

AIB Treasury Economic Research Unit

2.2

Sterling Versus
2

JPY

170

172

175

178

181

CAD

1.83

1.82

1.84

1.85

1.86

AUD

1.86

1.85

1.88

1.90

1.92

1.8

1.6

1.4

1.2
Jan-00

NZD

2.00

1.99

2.01

2.04

Jan-02

2.06

Jan-04

Jan-06

Jan-08

Jan-10

Jan-12

Jan-14

Source: Thomson Datastream

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