FX Forecast Update: Fed's Dollar Garage Sale
- We expect the dollar to suffer further when the Fed confirms its quantitative easing programme on 3 November. We pencil in a rise to 1.50 on a 12-month horizon for EUR/USD.
- The BoJ will not be successful in keeping USD/JPY above 80 and we expect to see the cross below the all-time low of 79.75 sooner rather than later.
- GBP to suffer together with the dollar - not least as the BoE is expected to do more quantitative easing in November.
- The Scandies still represent value - SEK most in the short term, as the Riksbank continues its hiking campaign. The market is long the NOK and the 27 October policy meeting poses a risk. But more value expected in 2011.
It has been a hectic month since the last issue of FX Forecast Update. The Fed has made a big step towards a new round of quantitative easing (QEII), the Brazilian finance Mantega has "re-invented" the term "currency war", the ECB has stepped-up its "exit" process in respect of draining liquidity in the money market and risk appetite has recovered strongly pushing equities and commodities higher.
It is now evident that global monetary policy is moving in different direction. The Fed, BoE and BoJ are expected to engage in, or continue, quantitative easing, whereas countries like Sweden, Norway, Australia, Switzerland will continue or start monetary tightening, and finally the ECB will continue its exit-strategy. In this environment, GBP and USD are expected to suffer, whereas the euro, scandies and commodity currencies are expected to perform.
In light of the divergent monetary policy outlook, we have accordingly changed our EUR/USD forecast markedly and predict that EUR/USD will continue higher to 1.45 (1.36), 1.48 (1.36) and 1.50 (1.38) on a three, six and 12-month horizon. We have also pencilled in further sterling weakness and forecast that USD/JPY will drop below the April 1995 all-time low of 79.75. We forecast that the scandies and commodity currencies will continue to perform not least against the dollar. The Swiss franc is expected to stay elevated against the euro and reach a record high against the US dollar.
We also recommend viewing our presentation FX Forecast Update: Fed's dollar garage sale also published today. It describes the different currency forecasts in detail and also provides forecast tables with DKK, SEK and NOK as base currencies.
The US to win the "currency war" as EUR/USD heads higher
The 21 September FOMC statement was surprisingly dovish and it was the first clear evidence that the Fed is moving towards a new round of policy accommodation (QE2), and the minutes released this week gave no reason for the market to change its expectations.
Investors can now rely on the Fed supplying cheap funding for a prolonged period even in a situation where the US economy is not heading for a double-dip. It is pivotal to note that the reason behind the new round of quantitative easing is not double-dip concerns, but mainly deflation scares. Risky assets have already rallied strongly and the dollar has suffered significantly on the positive combination of cheap dollar funding and decent global growth numbers, e.g. from Asia and a US apparently not heading for a double-dip.
However, we believe the positive sentiment can be sustained and that the dollar will suffer further when the additional policy accommodation is confirmed on 3 November at the next FOMC meeting.
The QEII move from the Fed is expected to be announced just one week before the important G20 meeting in Seoul, South Korea. High on the Agenda is the ongoing "currency war". Our China economist believes that China will continue to let the yuan appreciate against the dollar ahead of the meeting. We also believe that the BoJ will not be able to withstand the yen appreciation pressure; see USD/JPY trading below the all time low of 79.75. In other words, we expect the US to win the so-called currency war – at least if we judge by who will manage to get the biggest drop in the value of the currency looking at a three-to-six month horizon.
The euro on the contrary has been the best performing G10 currency of the month, backed by the ECB's so-called exit that has resulted in tighter liquidity and higher money market rates in the euro zone. Bundesbank President Axel Weber, in many market observers' view the next president of the ECB, has lately been very hawkish and said that 'the ECB could lift rates before emergency measures ends' and that it is 'necessary not to postpone the exit for too long'. We believe the ECB will continue to phase out its generous allotments in 2011, resulting in money market rates moving closer to the refi-rate at 1.0%.
It is, however, still too early to speculate on actual rate hikes from the ECB and we see the refi-rate unchanged throughout our forecast horizon. That said, markets could start to price higher rates over the summer next year. Rapidly rising food prices, as we observe at present, can, however, prompt a policy response from the ECB. The ECB is, compared with the Fed, expected to react more hawkishly to a possible spike in headline inflation.
Even though fears of another round of debt woes in the euro peripherals remain, our judgement is that the impact on EUR/USD has faded somewhat as most countries have met funding requirements until Q2 11. Ireland is still struggling because of the problems in the banking sector but Greece seems on track with only a 7% budget deficit expected next year. We remain cautious on Spain but the credit downgrade by Moody's did not create any panic in the debt markets. We note that the US debt burden continues to rise fast and will not be surprised if investors start to price a risk premium on the dollar by the end of our forecast horizon.
The loose US monetary policy fuels demand for riskier assets. It is difficult to say for how long risk appetite will stay elevated but higher equity prices and oil prices are likely to coincide with higher demand for euros and less demand for US dollars.
We forecast that EUR/USD will trade at 1.45, 1.48 and 1.50 on a three, six and 12-month horizon. Even though this is substantially higher than, for example, the long-term fair value level of around 1.25, we feel that the forecast can be justified due to the divergent monetary policy between the euro zone and the US.
A risk to our bearish dollar forecast is that the weak US economy and the strong euro hurts European growth so badly that the ECB decides to abolish its exit strategy (like the Fed did) and push short rates down again. There is also a risk – even though we see it as small – that the current currency disputes leads to protectionism, capital constraints and henceforth rising risk aversion, which have the potential to reverse the direction for EUR/USD. We also note that the market is already positioned for a weaker dollar. The weekly IMM data shows that speculative short dollar positions are very crowded at the moment.
Finally, the biggest downside risk for our EUR/USD forecast, not least on a 3M horizon, is that the Fed disappoints the market and do not engage in a new round of quantative easing or delivers significantly less stimuli that currently expected.
Scandies to catch up with risk appetite
If we take into account the strong risk appetite in financial markets over the last month, we are a bit puzzled that EUR/SEK and EUR/NOK are not trading at lower levels than is actually the case.
It might be that the spike in short rates in the eurozone has left the scandies somewhat behind. However, we believe that both the NOK and the SEK will catch up over the next couple of months. In fact, we expect both the NOK and SEK to trade in overvalued territory against EUR relative to our PPP estimates throughout the forecast horizon.
Swedish data has been robust and better than the market had hoped for and Swedish rate expectations have risen accordingly. Despite the Fed moving towards further policy accommodation there is no concern at the Riksbank. The Riksbank continues to hold a hawkish stance and we expect it to fulfil market expectations.
The Riksbank will probably raise growth projections once again at the 26 October policy meeting. Published data suggests a strong Q3 and a good starting point for Q4. Furthermore, we do not see today's SEK valuation as a big problem for exporters or a policy restriction for the Riksbank. We therefore continue to expect the Riksbank will continue to hike, with 25bp steps as the most likely pace. Hence, the Riksbank still seems to be the only non-commodity central bank to hike rates in Q4. Overall, it seems to us just a matter of time before EUR/SEK drops towards our three month-forecast of 9.00.
Norwegian data has on the contrary been nowhere near as strong. Manufacturing production, retail sales and not least core inflation has surprised on the downside over the last two weeks. Furthermore, we have seen money market rates falling after Norges Bank said that it will change the Norwegian money market system in the second par of 2011 to push NIBOR rates closer to the actual policy rate.
We should also expect Norges Bank to revise its closely followed interest rate path lower, when the next Monetary Policy Report is released on 27 October. However, Norges Bank is still expected to signal rate hikes in 2011 giving support to the NOK on a medium-to long-term horizon. Hence, we continue to see EUR/NOK trading well below the current level in 2011 and continue to pencil in 7.75 on a 12-month horizon. However, short term, the outlook is more uncertain given the still many long NOK positions in the market and the risk of a sell-off if the Norges Bank interest rate path is revised lower on 27 October - even though this is certainly already presumed in the current money market pricing.
Further potential in NZD, AUD and CAD
The current financial environment of easier global monetary policy, buoyant risk appetite and rising commodity prices is very bullish for the $-block currencies. But it also raises the question about how much more potential is left in the already overvalued AUD (37%), NZD (24%) and CAD (18%) - estimated long-term misalignment vs USD - and whether a correction is on the cards. We do not think so!
With the Fed opting for a further easing of monetary policy, most likely at its November meeting, the non-US economies are faced with three options: (i) see a tightening of monetary conditions via FX appreciation; (ii) ease monetary policy (adopt the US policy stance); (iii) impose capital restrictions and/or intervene in the currency market. We expect Australia, New Zealand and Canada to go for the first option, allowing their currencies to appreciate in response to a stronger domestic economy and lower rates in the US. Hence, even as a stronger currency may delay interest rate hikes, not least in Canada, investor demand is likely to remain strong - driving AUD, NZD and CAD into even more overvalued territory. Unlike the emerging market economies, we do not expect the monetary authorities to attempt to cool 'hot money' inflows, as the mature markets of the $-block are not as exposed to the risks associated with volatile capital flows. Hence, new all-time highs against the dollar are on the cards. In terms of relative strength, we look for AUD and NZD outperformance, due to the close interlinks between the US and Canadian economies and due to the fact that AUD and NZD remain the most attractive emerging Asia proxies among the G10 currencies.