Exchange Rate Forecasts: USD, EUR, JPY, GBP, CHF

Although USD staged a strong rebound in the first week of June amid speculations that the Fed will increase policy rate earlier than previously anticipated as economy has shown further signs of bottoming. However, the rally is expected to be short-lived.

Expectation that the Fed will hike rate later this year is premature. Although some leading indicators such as ISM index signaled improvement in coming quarters, absolute readings of the indices remained at low level and still suggested contraction.

Moreover, massive stimulus plans by the Fed and the Treasury have raised concerns about the safety of US debts. Talks of replacing USD's reserve currency status by SDR will continue to undermine investors' confidence on USD. While we believe that the process of taking this 'revolutionary step' will be complex and it will take a long time to put the change in practice. Ongoing discussions about reserve diversifications and doubts about the dollar's 'safety' indeed affect sentiment on the dollar.

The table below shows consensus estimates on 4 majors and crosses in different time frames. While USD is expected to weaken against the euro and the pound, it will probably rise against Japanese yen. Against Swiss Franc, the dollar may gain modestly towards the end of the year as SNB will probably intervene should it sees CHF appreciate. The euro will rise against the dollar and CHF on interest rate differentials and SNB's possible intervention. However, the single currency should weaken against the pound as the UK's economic prospect looks better and the BOE may start raising policy rates earlier than the ECB. After taking a look at the interrelations among currency pairs, it seems like long GBPJPY would generate the best return.

USD/JPY: The majority of analysts forecast Japanese yen will weaken against the dollar for the rest of the year as poor economic outlook and renewed deflationary pressure in Japan may drive possible government intervention. The Japanese economy relies heavily on exports and current global recession has left the country with huge output gap. Japan's GDP contracted -4% in 1Q09 with the contribution of net exports was -1.4%. From late 2007 to early 2009, Japanese yen gained more than 40% against the dollar due to carry trades and since then the currency has plunged by around 15% as investors' risk appetite improved. We believe the Japanese government welcomes depreciation in the yen and would intervene the currency market if it strengthens too much, just like what it did between May 2002 to March 2004. Moreover, we would not be surprised to see other countries help weakening the yen as they are not unwilling to see USD falling.

HSBC stated that 'returns on Japanese assets are likely to be very low going forward and the trade balance has moved into deficit. Japan's basic balance (current account and long term capital flows) has moved into deficit for the first time since early 1998, and this is likely to mean continued downward pressures on the yen'. Goldman Sachs is bearish on the yen. 'First, given that the Japanese economy has suffered the sharpest contraction of all the major economies, easier financial conditions would help shape a Japanese recovery. One way of achieving that is through a weaker Yen. Second, Japan's external balance has become a negative factor for the Yen. The current account surplus has deteriorated sharply due to the collapse in Japan's trade surplus. Continued Japanese buying of foreign assets is likely to keep Japan's broad balance of payments in deficit for the year'.

Credit Suisse were among those in the bulls camp with the view that exports will improve as global economy recovers. 'The rise in the new orders components of the US and Chinese PMIs points to a recovery in Japanese exports'. Moreover, the fiscal stimulus program taking effect this month 'will push Japanese GDP growth to over 4%, generating upward pressure on Japanese rates. As sentiment on Japan improves, we think that the yen may also become more appealing to official reserve managers'.

EURUSD: Views on the euro are slightly bullish. The positives are recent talks about reserve diversification as well as ECB's conservative stance in reducing interest rates. After China has on and off raised concerns about its US-denominated debts, Russia and Brazil has recently said that a portion of their reserves may be converted to IMF-issued bonds. IMF also said it may consider using Special Drawing Right to replace the dollar as the major reserve currency. The news threatened USD's status as the dominant reserve currency. While it's true that it may take a long time for the 'revolution' to be in practice and the actual effect on USD may not be that huge, it's the sentiment that matters. ECB decided to keep the main refinancing rate unchanged at 1% at June's meeting despite the fact the 16-nation region's economy remain weak and job markets may worsen. Compared with the 0-0.25% rate by Fed, rate differential should drive capitals further into the euro.

However, risk-return in the EURUSD pair has diminished after rising almost 10% over the past 2 months. Net buying of Euro has reached a peak in the near-term.

Concerning trades on rate differentials, Goldman Sachs believed 'the level of US growth will remain below trend and US rates will be kept low for a considerable period of time. At the same time the ECB sounded more hawkish again at the last meeting'... 'it is an opportune time to go tactically long EUR/$ after the recent correction and have recently initiated the trade with a target of 1.45'. Barclays Capital pointed out the short-term risk on EURUSD as in US Treasury yield, if the yields 'remain sufficiently high to compensate for the increasing risk premium associated with the USD, then EUR/USD should weaken over the next month'.

GBPUSD: Although the pound has started rallying against USD since late April, with the pace of appreciation accelerated towards mid-May, bullishness will likely continue as supported by signs of economic recovery in the UK. Growth in the nation will rebound after BOE aggressive monetary easing policies as well as the asset buying program over the past months (The BOE cut its policy rate to 0.5% in March and announced an asset buying program which has now been expanded to 125B pound). GBP is also anticipated to outperform euro as the BOE may increase interest rates earlier than the ECB.

Credit Suisse said that 'recent rise in the UK's composite PMI back above 50 supports our view that the UK economy is recovering faster and further than most of its G10 peers and particularly Europe (composite PMI of 44 in May)' and the pound may extend its recovery as 'economic data continue their rapid improvement and markets price an early end to the Bank of England's quantitative easing program'. By Contrast, HSBC believed GBPUSD 'has now corrected its excessive undervaluation, and there is little reason for it to appreciate significantly further'. Moreover, it viewed the UK and the US are in 'a similar economic position in many respects and there is no reason why GBP should be cheap or expensive relative to the USD for a protracted period.

USDCHF: Swiss Franc will likely move with neutral to slightly downward bias. The SNB explicitly said it would intervene to prevent CHF to appreciate against the euro at the March policy meeting. Since that meeting, EURCHF has been trading around 1.5 which is implicitly a floor for the currency pair. SNB is probably reluctant to see USDCHF to fall below 1.1, too. The next SNB meeting will be held on June 18.

On the economy-front, Switzerland's GDP growth eased to +2.4% yoy in 1Q09, although it's still better than negative readings in its European counterparts, a huge portion of the growth was driven by inventories. Other data such as unemployment rate and consumer and business confidence continued to deteriorate. These are in contrast with signs of improvements in other countries.

Morgan Stanley forecast Swiss Franc to remain 'relatively range-bound versus EUR post the SNB's move to target a stable to higher EUR/CHF cross. While the SNB has not followed up on its intervention, it has kept up the verbal rhetoric. The SNB meets for the first time since that change and may influence EUR/CHF if it changes policy. It is not expected at this point, and the cross should remain stable'. Barclays Capital remained bearish on CHF as while 'external conditions have improved, but the SNB is unlikely to rescind its commitment to currency intervention yet'.