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

The street remains generally bearish on USD with the US' fiscal stance, diversification talks by key reserve holders as well as diminished speculations about Fed rate hike being the key driving forces.

Although global economic contraction has shown signs of slowdown in recent months, the road to recovery is still long. At the G-8 summit, world leaders stated that the recovery is too weak for them to consider withdrawing from stimulus measures. In fact, news said that the US has plans for more stimuli which will widen its deficit further. Moreover, the White House's healthcare reform will add more pressure to the situation and the Congressional Budget Office (CBO) forecast the reform will result in a net increase in Federal budget deficits of about $1 trillion in 2010-2019.

Recent economic data were mixed. While surveys such as ISM index showed improvement, employment data were weaker than expected. Together with the Fed's reiteration to keep interest rate low for long period of time, strong speculations about Fed rate hike in early June were not seen anymore. Our forecast is that the Fed will leave current policy rate unchanged until 2011. A low interest rate environment is generally negative for the currency.

Although it's understood there's no easy way to replace the dollar's status as the dominant reserve currency, ongoing complaints from key holders of US debts and diversifications of portfolios away from USD indeed pose threat USD's outlook.

Morgan Stanley and Credit Suisse restated their bearish stance on USD. Morgan Stanley said that recent strength in USD was driven by market's indecisiveness in economic outlook and tradition quiet periods in recent months. However, 'while the Fed promises to be on hold for an extended period of time, the rise in yields may bring into question the Fed's credibility in controlling the curve; while fiscal policy remains a negative for the USD. The USD's reserve status also remains a headwind'. Credit Suisse continued to expect the dollar to 'struggle in an environment of normalized risk appetite and ultra low US yields. Reserve diversification away from the USD, while not as extreme as some press accounts might suggest, is still steady drain on the capital-dependent US currency'.

JP Morgan expected earnings surprises will affect USD' s movement in the coming month as the 'The dollar's sensitivity to earnings surprises is modest but highly consistent. It falls 85% of the time during the reporting season when earnings beat expectations, with an average decline of 2% trade-weighted and a range of 1% to 6.5%'. For other currencies, 'GBP, EUR, AUD and EM Asia are the most responsive to US earnings. JPY and Latin American currencies are the least'.

The table below shows the consensus forecasts for the 4 majors as well as the corresponding crosses, using closing prices on July 8, it seems going long for GBPJPY and EURJPY will generate the best return.

USDJPY: USD/JPY will probably continue to trade within a range of 90-100 for the coming 6-9 months as dollar's upside as driven by increase in US Treasury yield vs corresponding Japanese bond yield will likely be dampened by rise in yield volatility. Moreover, any upside on Japanese yen will be erased by the nation's weak economic outlook. However, judging from July 8's close of 92/93, upside is still seen for buying USDJPY.

Analysts on the street have different views on Japanese yen. While Morgan Stanley and Credit Suisse stayed bullish, Deutsche Bank suggested selling short. Morgan Stanley stated that Japanese yen will continue to 'benefit from concerns over the validity of the global recovery' as well as 'an increase in perception of home bias, with favorable legislation changes and less attractive carry trades. Central banks should also increase their JPY holdings'. Credit Suisse, on the other hand, believed the nation's economy had improved and 'the rebound in global trade and auto production we anticipate over the summer months' will increase 'exporter demand for yen as well as foreign investor interest in Japanese stocks'.

By contrast, Deutsche Bank believed both fundamentals and flow data indicated weakness in Japanese yen. While both the yen and USD should suffer as investors' optimism about economic recovery grows, the yen should underperform USD as a rebound in Japanese economy should be dependent on US recovery. Deutsche Bank also said that 'some exporters are waiting to hedge on USD/JPY around 99-100, but the quantities are likely to be limited for now'. Moreover, domestic investors in Japan also increased exposure in foreign investments and net capital outflow pointed to yen's weakness.

EURUSD: The euro will likely pull back from current level in the third quarter before rebounding in the fourth quarter and then rising higher next year. Current price level in EURUSD has been overvalued given the reduced interest rate differentials between the ECB and Fed's policy rates. Moreover, ECB's allotment of 442B euro in 12-month open market operation has pushed money market rates lower, making retreat in the euro justified. Credit Suisse said that 'the euro area yield curve remains under pressure to flatten bullish until later this year. This loss of yield spread support leaves the euro highly dependent on reserve diversification flows in the short term'.

However, in longer term, risk appetite will drive investors away from the dollar to higher yield currencies. Morgan Stanley biased to EUR upside and 'would look to add long EUR/USD on any fall towards 1.35' as 'the ECB remains committed to providing support to the economy while retaining control of the policy tools'. Conversely, Deutsche Bank was bearish on euro's outlook with the premise that recent key economic data pointed to the downside. Deutsche Bank said that negative surprise from the PMI was worrisome. 'Although the surveys continued to rise for the most part, the rise was less than expected and the levels continued to point to contracting activity'. Also, 'with the period of negative headline inflation just about the begin, despite the recent rise in commodity prices, the ECB is under no duress to exit its policy accommodation...over the next 3-6 months, the risk is that the policy stance has to ease further rather than tighten'.

GBPUSD: Strong rally over the past month looked excessive and profit-taking should be seen ahead and after BOE's meeting at July 9. That said, sterling's outlook remains positive in the long term as recent economic data showed recovery in the UK should come earlier than other advanced economies, in particular the Eurozone.

In the near-term, the majority of analysts forecast further retreat in GBPUSD. Morgan Stanley believe 'there are potential near-term downside risks for GBP, given the BoE's QE policy, fiscal expansion and generally weak economic starting position...against some G10 crosses, GBP remains weak'.

Credit Suisse believed the BOE may extend the current asset purchase program by 25B pounds and there's risk for the central bank to request authorization for an increase in the program beyond the current 150B pound ceiling. This will cause further selloff in the pound. However, in longer term, economic recovery and rate differential should be positive for the pair as faster recovery in the UK may lead 'the UK-US 2-year yield spread to rise from 20 bps at present to 100 bps by year-end'.

Goldman Sachs remained bullish on GBPUSD because the nation's economic growth should be supported by the large easing in financial conditions. Barclays Capitals also reiterate its bullishness on the pair: 'short-term prospects have supported GBP, and are likely to continue adding support; structural issues remain a GBP negative and will probably do so for some time, probably years; and risk and liquidity have improved and are likely to improve further... GBP is likely to benefit via all channels. We remain bullish on GBP in the medium term, more relative to the USD than the EUR over the next year, but more relative to the EUR over the next month or two'.

USDCHF: SNB's currency intervention remains the key factor directing the movement of Swiss Franc. At June's meeting, policymakers decided to keep the Libor target range unchanged at 0-0.75%. Moreover, as mentioned in the accompanying statement, the central bank will continue to supply liquidity and to 'purchase Swiss franc bonds with the aim of reducing risk premia on long-term bonds issued by private sector borrowers. The SNB will take firm action to prevent an appreciation of the Swiss franc against the euro'.

Although economic contraction in Switzerland was not as severe as that in its counterpart Eurozone and the US, its inflation rate has stayed well-below SNB's target level. Therefore, the central bank should continue to adopt expansionary monetary as well as unconventional easing policies, which suggested Swiss Franc's movement should have more downside than upside. The consensus forecast USDCHF will trade above 1.1 for the rest of 2009 and throughout the first half of 2010.

Morgan Stanley believed the SNB has turned more 'verbally aggressive in its commitment to keep EUR/CHF from falling below the perceived lower bound. They also reportedly intervened in USD/CHF, which has not been seen in the current period of currency target... the SNB are content to keep EUR/CHF in a range rather than seek a significant depreciation from present levels'.

Credit Suisse forecast although the SNB's 'anti-deflation policy stance will remain in place at least through 3Q09, it also seems 'to stress that it is not practicing a policy of competitive devaluation. Barring a sharp rise in EURUSD that threatens to push USDCHF below 1.06 ... the SNB will work to keep EURCHF in a 1.51-1.53 range'.