What to expect in the week ahead in the FX markets

Global policymakers will remain at the forefront of attention in the coming week and continue to steer FX markets. Three G10 (BoE, RBNZ and BoC) and several EM central banks will be setting policy next week and are broadly expected to stay on the dovish side, given the recent market turmoil and growing uncertainty about a material slowdown in China. Analysts expect the RBNZ (Wednesday) to cut rates further, by 25bp to 2.75%, and the BoC (Wednesday) and BoE (Thursday) to keep rates on hold, but remain on the cautious side of expectations. In the case of the BoE, the policy minutes is expected to be released simultaneously with the rate decision, to focus on recent financial market volatility, global growth risks and the downside risks to UK inflation from a still overvalued GBP.

The extent and possible side effects of a China slowdown remain rather unclear, and market participants will be eagerly looking for clarifications during the G-20 MF/CB meeting in Turkey. Recent stability in CNY has helped stabilize the EM Asia sell-off, although weak risk sentiment and commodity prices are exerting downward pressures on higher beta currencies in the region. However, this apparent success may have come at a heavy cost, with our estimates suggesting that FX intervention in recent weeks has been sizeable. On that note, China's August FX reserves will likely be released on 7 September (Monday) and will be closely watched by the market to gauge the extent of FX intervention and, consequently, capital outflows. 

"We continue to expect further CNY depreciation and recommend getting exposure through USDCNH call spreads. We also look for pronounced EM Asia depreciation versus the USD and continue to expect high beta commodity currencies (AUD and the NZD) to remain under pressure in the coming quarters," wrote Barclays on its research note.

While the ramifications of a possible China slowdown are assessed by global policymakers, the ECB may be the first major central bank to announce further accommodation by year-end, reflecting a weaker growth and inflation outlook, stemming to a large extent from the recent slide in energy prices and external downside risks to growth from an EM slowdown. 

"We think the ECB opened the door for more QE by year-end during its policy meeting last week, following its decision to increase the issue share limit for the PSPP from 25% to 33% (subject to case-by-case verification that this would not create blocking minority power) and reiterating that it can use "all instruments available within its mandate". We continue to expect material EUR depreciation in the coming quarters, on the basis of poor returns to capital and sluggish growth and inflation environments, and recently re-initiated our short EURUSD spot position. Further ECB easing would re-enforce the US/EA economic divergence, which we think would help break the range-trading in G4 FX over the past six months," Barclays said.

"In the context of elevated market volatility, we remain of the view that the USD will be the general outperformer and that the US is one of the few places capable of generating inflation. Indeed, despite some disappointment in headline payroll growth last week, the US labor market continued to tighten, which, on balance, we read as consistent with ongoing improvement in labor market conditions. We continue to expect the Fed to start raising rates in March, but on a relative basis expect the USD to outperform," added the report.