Dollar and Emerging Market FX to rise, Euro to Weaken: Morgan Stanley Exchange Rate Forecast Update

New FX forecasts have been released by investment bank Morgan Stanley.

They continue to reflect a bullish view of the Dollar but more against lower yielding developed market currencies such as the Euro and Yen than emerging market (EM) FX.

EM currencies are forecast to remain robust as they continue to benefit from carry-trading, a type of investment which sees traders borrow money in lower interest rate countries and use it to buy currencies in higher interest rate countries – pocketing the difference between borrowing costs and interest gained.

“The commodity and EM block should remain bid for now, with low DM real rates and yields acting as the catalysts for pushing funds into higher-yielding EM asset classes,” said Morgan Stanley’s head of strategy Hans Redeker.

The Euro is the big loser in all this as political risk is expected to keep the European Central Bank (ECB) from raising interest rates despite signs of growth and inflation.

The rise in inflation will erode the ‘real’ yield or the return investors can expect once inflation has been deducted from interest payments.

The relatively lower real yield of the euro will reduce demand for it, leading to further weakness.

It will also continue to be borrowed and sold as a low interest funding currency to purchase higher yielding EM FX in carry-trading, another source of weakness.

Caution from the Fed in the first half of 2017 may lead to an inflation overshoot in the second half and a more aggressive interest rate hiking approach from the Federal Reserve later in the year, which could translate into a steeper appreciation of the Dollar in Q's 3 and 4.