Why Defensive Currencies are Still your Friends
Summary: FX markets have experienced pronounced shifts on the back of the worsening financial crisis. From implied volatilities we note that investors expect FX movements to remain substantial in the coming months (see chart 1). In this note we answer two essential FX related questions: 1) How should we inter-pret the approval of the US Troubled Asset Relief Programme (TARP) in relation to European govern-ments' attempts to ensure financial stability? Here we conclude that EUR/USD can fall further. 2) Are re-cent FX movements (stronger JPY, USD and CHF) overdone, and will we see a retraction soon? By revisit-ing both short- and long-term models we find that the answer is ‘no', and argue that we can see a further strengthening of safe-haven currencies.
US on least-wrong course: One week ago we outlined the possible implications of the US TARP (What does TARP mean for FX?), which was finally approved by the House of Representatives last Friday. The substance of the package is essentially the $700bn to purchase assets for which no liquid market exists. If the TARP works, it will price the assets above current fire-sale values and provide a safety net to trou-bled US banks. Fears persist, however, that the bail-out plan still is not enough to ensure stability and re-store trust among banks. It is important to emphasise that the plan cannot fully prevent an economic slowdown in the coming quarters, but it does establish a market for so-called toxic financial assets. We retain our positive stance towards TARP, as the US authorities have shown a real dedication to resolving the financial crisis and limiting the damaging impact on the real economy. On the back of the far-reaching US measures, the USD prospects look relatively positive.
Euroland trying to find its legs: The financial crisis in Europe is worsening and the growth outlook is very dim. With regards to nationalising collapsing or ailing financial institutions, the UK took the lead, first with Northern Rock and later with Bradford & Bingley. Over the weekend, Germany's government and financial institutions agreed on a €50bn rescue package for Hypo Real Estate, a commercial property lender, while BNP Paribas, France's biggest bank, took control of Fortis bank after the governments of Holland, Belgium and Luxembourg failed to ensure its stability. At this stage, a joint euro-area financial rescue package ap-pears far off, simply because the euro area is not designed to deal with such issues on a supra-national level. It seems, in our view, more likely that governments will deal with the problems on a national level – as already has been the case in Ireland, Italy, Portugal and Greece – where governments have guaranteed deposits and bank liabilities. One result could be uneven financial conditions across Europe. It seems in-evitable that the euro zone will sink into recession: the economy shrank 0.2% in Q2 and most indicators point to another quarter of contraction. We are not positive on Euroland growth in 2009 either, and fore-see growth of just a modest 0.7%. We find it hard to believe that the EUR will stay overvalued, with finan-cial conditions not yet clarified and the economy facing a full-scale downturn. We remain therefore nega-tive on the EUR.
Which scenario? We discussed three possible scenarios in last week's edition of FX Crossroads: In sce-nario 1, we assumed that the financial crisis would continue unabated at least until year-end; that the US and Euroland would slip into recession, and credit and money markets would remain in deeply frozen for the foreseeable future. Scenario 2 – our base scenario – featured a further slowing in both the US and European economies, but also mild upturns in 2009 with financial conditions gradually improving. Sce-nario 3 combined a swift and successful response to end the financial crisis, increased risk-taking overall and global growth slowing only to trend level. Scenario 1 suggested further USD appreciation against EUR, scenario 2 was compatible with a minor rise in EUR/USD, while scenario 3 implied a strong rise in EUR/USD. Here, just a few days after, balance has tilted more to scenario 1 than to scenario 3, although it is too early to draw any firm conclusions.
Closer to PPP. One key observation that has come to our attention during the past year's financial crisis is that spikes in uncertainty (i.e. spikes in volatility) have usually been associated with currencies moving towards long-term fair value levels – at least in the G10 currency universe. This was the case during the fall in risk appetite around the Bear Stearns rescue in March, and has also been the case in the past few weeks. Chart 2 shows the deviation from purchasing power parity (PPP) on 26 September (i.e. the last trading day prior to the US Congress rejecting the US bailout package on 30 September) and the subse-quent spot movements of the main G10 currency pairs. From the chart it can be seen that: (i) all nine cur-rency pairs, except the Scandies, have moved towards long-term fair value, and (ii) the greater the devia-tion from PPP prior to the spike in uncertainty, the greater the subsequent spot movement. Does this mean that we should use deviations from PPP as a short-term indicator? No, we do not believe so! But the relation does indicate to us that even though spot movements in the past week have been significant, at least they do not appear excessive by long-term valuation standards.
What do short-term models imply? Another metric to measure the latest spot movements by are our short-term financial models (STFM). Chart 3 shows the deviation of the current spot from the model es-timates, which are based on Friday's data. From the chart it can be seen that today's falls in both EUR/USD and USD/JPY and today's rise in USD/CAD have taken the pairs back to fair value. The largest misalignments are currently found for NZD/USD and EUR/SEK, which are both well above the model pre-diction. The rise in EUR/SEK, however, can be fully explained if, for example, equity price volatility is in-cluded in the model. Conversely, EUR/GBP and AUD/USD are both below the model estimate. However, if today's movements in equity prices, the oil price and relative interest rates are included in the models, the current spot can be explained for both currency pairs.
Our view going forward? The answer is simple: More of the same. This includes a further reduction of speculative FX positions, flight-to-safety and safe-haven buying. The JPY and CHF are natural winners in such an environment, as both correlate positively with risk aversion. Although having depreciated heavily in the past weeks, carry-target currencies, AUD and NZD, remain at risk (see chart 4). Moreover, the USD has re-established some of its past status as a strong defensive currency. Furthermore, extreme USD moves tend to be slightly stronger than what we have already observed. Specifically, we see EUR/USD po-tential down to 1.32 (the level implied by scenario 1), EUR/CHF potential down to 1.53 (our STFM fore-cast) and USD/JPY potential down to around 100 (EUR/JPY in 132).
Danske Bank
http://www.danskebank.com/danskeresearch
Disclaimer
This publication has been prepared by Danske Markets for information purposes only. It is not an offer or solicitation of any offer to purchase or sell any financial instrument. Whilst reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and no liability is accepted for any loss arising from reliance on it. Danske Bank, its affiliates or staff, may perform services for, solicit business from, hold long or short positions in, or otherwise be interested in the investments (including derivatives), of any issuer mentioned herein. Danske Markets´ research analysts are not permitted to invest in securities under coverage in their research sector. This publication is not intended for private customers in the UK or any person in the US. Danske Markets is a division of Danske Bank A/S, which is regulated by FSA for the conduct of designated investment business in the UK and is a member of the London Stock Exchange. Copyright (©) Danske Bank A/S. All rights reserved. This publication is protected by copyright and may not be reproduced in whole or in part without permission.
|
