FX Crossroads: New FX Forecasts - USD Set to Strengthen Further
Summary and conclusions
- We have updated our FX forecasts. We anticipate the financial crisis will continue to dominate the agenda in the short term and have kept the global recession theme as the major driver in the longer term. We believe in a broad-based dollar strengthening 12-months ahead.
- IMF's COFER statistics covering Q2 08 confirmed two of the main trends seen in recent years: i) World reserves are growing fast, although growth decelerated in Q2, and furthermore; ii) There has been no marked change in the dollar share of total reserves, although there are tentative signs of a reduction in the share held in dollars in favour of the euro in particular.
- For the past three quarters, net capital flows into the US have been positive. If this trend can be sustained it will provide important support to the US dollar. The other side of the Atlantic, the eurozone has seen a substantial net capital outflow in recent months. If the US can manage to stabilise its financial markets in the coming months, capital flows should continue to point to lower EUR/USD levels.
- The global credit crisis is now spreading to the most leveraged economies in the world and it now looks like there will be renewed focus on the IMF's role in international crisis management. We identify the most likely candidates for an IMF visit.
- FX Crossroads is published every second Wednesday. Next publication date is October 29.
Danske Bank expected FX changes vs. USD, 3 and 12 months
IMF COFER data shows only a gradual reduction of the reserve share held in USD
G10: Better Safe than Sorry
We have updated our FX forecasts; please see FX forecast update for a full description. Here are our latest thoughts on the G10 currencies:
We believe EUR/USD will fall further. We argued last month that (i) the euro was overvalued at a time when the Euroland economy was deteriorating rapidly, (ii) Euroland was seeing a sharp outflow of capital and (iii) the USD typically has been a good defensive currency. All three arguments remain true today. In terms of net capital, not only are we seeing a further deterioration of the euro equation, we are also seeing an improvement in the US. We are now able to detect two additional weighty arguments: Firstly, while the Fed eventually is coming to an end of the easing cycle, the ECB has only just begun. We do see a non-negligible risk that the ECB needs to cut the benchmark rate substantially in order to stimulate the struggling economy and we find it likely that markets will price more rate cuts than the ECB actually will deliver. Secondly, the outlook for Eastern European countries is worsening, while the Latin American countries outlook is less frightening. FX historians might like to add that dollar cycles tend to be quite long. Dollar cycles have historically lasted for five years or even longer. We believe that EUR/USD will trade sideways throughout the year and have therefore lowered our threemonth forecast to 1.36. On the six-month horizon, we think that the EUR needs to depreciate further to reflect relative monetary conditions and we have pencilled a move to 1.32. In twelve months time, we see EUR/USD just above its long-term fair value level, i.e. at 1.26.
Arguments in favour a higher EUR/USD should not be overlooked: (i) Using technical yardsticks, the fall from 1.60 to 1.35 looks more like a downward correction than a violation of the strong upward trend that began in 2002. Our FX technicians see EUR/USD rebounding and look out for 1.70 in 12 months time; (ii) A stock market rally is most likely to be seen in combination with a higher move in EUR/USD; (iii) The US is still burdened by a substantial trade and current account deficit which is incompatible with the savings ratio; (iv) Speculative investors are now long USD, suggesting that chances of a further rapid dollar strengthening is reduced.
Let's face it: The star performance of the JPY is not due to domestic factors. Economic data out of Japan has disappointed over the past month and if it wasn't for the already super-accommodative monetary policy, Bank of Japan had to cut the target rate (currently at 0.5%). But due to a spike in risk aversion and a continued rapid deleveraging, the JPY has outperformed all other G10 currencies with lengths. Given that markets probably will be nervous throughout the year, we think the JPY can continue to be the darling of FX traders. But as the financial crisis draws to an end, some yen support will wane. Looking at the sharp deterioration of the Japanese trade balance that historically has moved closely with USD/JPY, very little downside potential for the pair remains in the longer run - suggesting a USD/JPY move towards 130. While this may sound a bit exaggerated, we think it points toward the true direction in the pair at the somewhat longer horizon. We have lowered our 3M USD/JPY forecast to 100; we have kept out 6M forecast unchanged at 105 and raised our 12M forecast to 108.
CHF potential remains in place. Since our latest FX Forecast update, CHF has strengthened significantly against EUR taking EUR/CHF to a new multiyear bottom at 1.5079 on 10 October. As a result EUR/CHF is currently trading below our old 12 month forecast of 1.56. Despite this appreciation, we still see the fundamental case for a stronger CHF, as global financial deleveraging is set to continue, as CHF remains undervalued, and as relative economic growth, interest rates, inflation, and external balances continues to lend support. Given our (now even more) bearish view on EUR, we have opted to lower our 12 month EUR/CHF forecast to 1.52. However, we also see the risk of a short term correction on the market following the latest rescue packages - it will be difficult, though, for EUR/CHF to move above 1.60. Due to this shortterm risk, we are forecasting EUR/CHF at 1.56 in 3 months and 1.54 in 6 months. The main risk to our bullish CHF view is a marked improvement in market sentiment or potential distress in the Swiss banking sector.
The SEK has by and large been a function of risk sentiment in the last few months. In relative terms, however, Swedish equities have not underperformed and do not justify EUR/SEK at levels around 9.70. Neither is it clear that momentum in Swedish macro data has been worse than Euroland, rather the opposite and if anything Sweden is probably relatively well positioned from a fundamental perspective to deal with the current global crisis. The Swedish macroeconomic outlook is bleak though. We forecast almost zero GDP growth in 2009 and multiple rate cuts from the Riksbank, 150bp, by the end of next year. In Euroland we see recession looming. As long as currency markets are closely associated with the financial crisis outlook and risk sentiment we are not sure that lower central banks rates will necessarily weigh on the currency. A global recession scenario is likely to keep SEK on the weak side going forward. SEK selling in the last few days has partially been driven by rebalancing flows but as these fade EUR/SEK should stabilise. In our view EUR/SEK is becoming stretched on the upside and our short-term models suggest potential is for the downside.
Bleak domestic outlook puts GBP at near-term risk; better long-term outlook. Bank of England (BoE) participated in the coordinated rate cut among major central banks. And a rate cut in the UK was more needed than anywhere else. We have for several months pointed out that the UK is "burdened by a rapidly deteriorating growth outlook" and argued that "substantial monetary easing" was required when the peak in inflation was truly past. Inflation is indeed the last factor that should worry British policy makers at present; the spending outlook is extremely dim and the downturn in the real estate market is set to exceed the housing recession in the early nineties. Growth wise, we anticipate a negative H208 and do not expect 2009 to be a year to remember either. We think the BoE will cut the base rate down to 3.00% within the next six months - risk is skewed to the downside. Rate cuts of this magnitude will eventually nail the GBP as a carry target currency. The only reason why EUR/GBP isn't drifting higher is the bleak Euroland outlook. As we expect the dollar to advance vs. euro, so will sterling - just to a smaller extent. We have lowered our EUR/GBP profile and cut our 12- month forecast to 0.76.
Deleveraging, risk aversion, dollar appreciation and a decline in oil prices are an unhealthy cocktail for NOK. A strengthening of the Norwegian krone vs. the euro has in the past half year been one of our clearest calls. The forecast has been based on a booming Norwegian economy and underlying price pressure, forcing Norges Bank to keep monetary policy tight. We have underestimated the impact of the financial crisis on NOK and have had little idea on the forced selling / unwinding of assets' effect on Scandinavian currencies. We stick to our view of better economic conditions in Norway relative to other countries but do not see a widening of the Norway-Euroland policy spread anymore. We have raised our EUR/NOK forecast, mostly in the short-term, and now expect 3M 8.40, 6M 8.30 and 12M 8.10.
AUD and NZD have been oversold, but the fundamental outlook remains dim. The $-block currencies continued to weaken during the past month taking AUD/USD and NZD/NZD below our old 12 month forecast. The large depreciation of AUD and NZD implies that both currencies are no longer overvalued by long term valuation measures. Nevertheless, we still see a large current account deficit and a turn in the monetary policy and economic cycle as weighing on both AUD and NZD. That said we do see the latest AUD and NZD sell-off as overdone, which is likely to have increased the probability of a short term correction. We have therefore opted to lower our forecast profile for AUD/USD and NZD/USD, while leaving our 3 month forecast slightly above spot.
The marked fall in oil prices has been main driver behind the rise in USD/CAD. We see a good chance that movements in the oil price continue to be the driving factor for CAD. As we see risk of oil prices adjusting further down, more near-term USD/CAD upside potential emerges. In the somewhat longer term, relative economic prospects favour CAD to USD and we have therefore pencilled a ‘kinked' profile for USD/CAD.
Global FX reserves: Reaching USD7bn
Continued high growth in reserves
Last week, the IMF published COFER statistics covering Q2 08. For an introduction to the IMF COFER data, see FX Crossroads: New year, new worries, 9 January 2008. The Q2 data confirmed two of the main trends seen in recent years: (i) world reserves are growing fast, although growth decelerated in Q2, and furthermore (ii) there has been no marked change in the dollar share of total reserves, although there are tentative signs of a reduction in the share held in dollars in favour of the euro in particular.
The COFER data showed that growth in world reserves remained high in Q2. Total world FX reserves now for the first time stand at more than USD7trn after growing 22% y/y in Q2, which, however, was a small deceleration in growth from the previous quarter. There are thus so far no signs in the data of a marked transfer of reserves away from official FX reserves and into other funds such as sovereign wealth funds.
The very high growth in world reserves remains driven by vast reserve accumulations in the developing countries. In Q2 total reserves rose 28% y/y in the developing world, while growth was only 6% y/y in the industrial countries, where total reserve growth was actually negative over the quarter.
Considering reserve accumulation in individual countries, China and Russia are still the main drivers of the world reserve build-up (see table 1). However, the south-east Asian region in general has accumulated vast reserves in recent years and much more than would be expected given the trade flow into the region.
While the developments in overall reserves are interesting, the perhaps most interesting aspect of the IMF COFER data is that it provides an overview of the share of reserves held in the individual currencies.
For some time focus has been on the share of reserves held in dollars and whether we were experiencing a regime shift away from the dollar as the world reserve currency.
Data shows that the dollar share of world reserves has been broadly flat since 2000 and there are thus no signs of marked shift in world reserve allocations. However, recent data has shown that there might be tentative signs of a slow movement away from the dollar and mainly into the euro. This was also confirmed by the Q2 data, which showed that the dollar share of world reserves fell from 62.8% to 62.5%.
Another trend in the COFER data has been the reduction of reserve shares held in Japanese yen. Recently, however, there have been signs of a stabilisation in the yen share, which rose from 3.1% to 3.4% in Q2.
To conclude, the Q2 COFER data confirmed two of the main trends seen in recent years: (i) world reserves are growing fast, and (ii) there has been no marked change in the dollar share of total reserves, although there are tentative signs of a slow reduction in the reserve share held in dollars in favour of the euro in particular.
While there are signs of a fundamental flow of funds in the world reserve accumulation in favour of the euro against the dollar, it is not as large as some have argued and the process of reducing the dollar share in official FX reserves has so far been very gradual.
Info box: IMF's COFER data
Each quarter the International Monetary Fund (IMF) releases statistics on world foreign exchange reserves in its publication: Currency Composition of Official Foreign Reserves (COFER). Official FX reserves are the monetary authorities' claims on nonresidents in the form of foreign banknotes, T-bills, etc.
When considering the IMF COFER statistics, it is necessary to acknowledge some limitations to the data. Allocated reserves (i.e. FX reserves for which we know the allocation on currencies) only constitute 63% of total reserves, and more important is the fact that 47% of growth in world reserves is driven by accumulation in unallocated reserves.
USD: Flow of funds update, Q2 2008
Flow data points at lower EUR/USD
The US current account deficit widened modestly to USD 183bn in Q2, mostly thanks to rising energy prices to USD 176.4bn in Q1 from 167.2bn in Q4. More importantly, however, a surplus on the capital account left the US with a net inflow on the broad basic balance (current account, net FDI and net portfolio in-vestments) of USD 68bn. Though annual comparisons are burdened by the record capital flight in Q3 2007, three consecutive quarters of net capital inflows nonetheless suggest that the US is on track to record a record high surplus should current trends persist. Since the euro-area is experiencing a significant capital outflow, net flow of funds are currently negative for EUR/USD.
Firstly, the current account (C/A) deficit widened to USD 183.1bn in Q2 from 176.4bn in Q1 and 167.2bn in Q4, mainly due to rising energy prices. Seen over the past year, the deficit has narrowed to USD 699bn, or 5.9% of GDP. The deficit peaked at 7.1% of GDP in 2006.
Secondly, foreign direct investments (FDI) posted a small USD 0.7bn inflow in Q2 after a 64bn outflow during the past two quarters. In annual terms, net FDI flows are close to balance at USD 8.3bn.
Thirdly, net portfolio flows posted an inflow of USD 223bn in Q2, up from 208.6bn in Q1. As usual, the net inflow is split between a substantial net bond inflow (244bn) and a net equity outflow (-21.5bn). In annual terms, the 624bn inflow is well below the record high inflow of 954bn in Q2 2007 and is split between a net bond inflow of USD 643bn and a net equity outflow of 18.9bn.
All in all, the US posted a deficit on its basic balance (current account, FDI and net equity flows) of USD 176bn, down from 184.3bn in Q1. Including bonds, the broad basic balance (BBB) posted a surplus of 68.2bn, the third consecutive surplus. The dramatic capital flight experienced in Q3 2007 (189.8bn) still leaves the broad basic balance in deficit on an annual basis, but if we annualise the result of the past three quarters we end up with the largest surplus on record (USD 164bn).
For the past three quarters, net capital flows into the US have been positive. If this trend can be sustained it will provide important support to the dollar. Across the Atlantic, the euro-zone has seen a substantial net capital outflow in recent months. If the US can manage to stabilise its financial markets in the coming months, capital flows should continue to point to lower EUR/USD levels.
EM: IMF's busy travelling schedule
Contagion to leveraged markets
The global credit crisis is now spreading to the most leveraged economies in the world. Iceland was the first economy to fall victim to the global credit crisis and it now looks like the International Monetary Fund (IMF) will have to be called in to help Iceland recover from the country's worst financial and economic crisis ever. But it is not only Iceland that seems to be in need of a helping hand from the IMF. This week first Hungary was offered "technical and financial" support from the IMF and then the Ukraine later also asked for assistance. It is still unclear what role the IMF will play in resolving the economic and financial crisis in the three countries, but there is no doubt that the global credit crunch has triggered renewed focus on the IMF's role in international crisis management.
What do Iceland, Hungary and the Ukraine have in common? All three countries are struggling and have seen strong credit growth, increased reliance on foreign funding, and asset market bubbles in recent years. This makes these countries especially fragile in the present global financial environment. With the ongoing significant deleveraging of the global economy the most leveraged economy is coming under increasing pressures and this is what has created the need for IMF assistance in Iceland, Hungary and the Ukraine.
However, it is not only these three countries that are under pressure in the present environment and judging from the development in credit default swaps (CDS) other countries might soon have to ask for assistance from the IMF.
Over the past month CDSs have spiked in a number of mostly Emerging Markets indicating a significant increase in worries over funding problems in these countries on the back of the intensified credit crisis. The rise in CDS spreads has been the strongest in Argentina, Pakistan and Iceland. In the graph below we show the 20 countries that have seen the strongest rise in CDS spreads over the past month.
It is striking that that most of the countries in the "top 20" are countries that are either running large current account deficits - like Iceland, the Baltic States, Romania and Bulgaria - and/or countries that in recent years have had very strong credit growth.
It is also notable that a number of commodity exporters are now in the "top 20" - most notably Argentina and Venezuela. These countries have benefitted from rising commodity prices in recent years, but have failed to use the good years to save for bad years. Hence, since the commodity prices peaked in July CDS spreads have increased significantly in a number of commodity exporting countries.
Looking at the global map it is clear that a significant number of the countries in the "top 20" are EMEA countries - whether we talk about Iceland, Latvia or South Africa. Hence, out of the 20 countries that have seen the largest rise in CDS spreads, 13 are from the EMEA. LATAM is the second most "fragile" region with four countries in the "top 20". Asia is still rightly, in our view, being perceived as the safe haven in Emerging Markets. Only three Asian countries are in the "top 20".
As IMF is entering into dialogue with Iceland, Hungary and the Ukraine it is likely that the IMF's staffs in Washington DC are drawing up a travelling schedule for future missions. We suggest the IMF take a look at the "top 20" for the travel plan.
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