FX Crossroads: USD, Recessions, and Fed Easing Cycles

Summary and conclusions

• The past few days have seen much action on the financial markets. First, we had a significant sell-off in the equity markets, which sent JPY and CHF higher, and EUR/USD lower. Then, there was an inter-meeting response from the Fed - cutting rates by 75bp. This brought some relief to the market and Monday's movements in the FX market were reversed.
• In this edition of FX Crossroads we take a look at how USD has performed in periods following the initiation of an easing cycle by the Fed, and following the beginning of a US recession.
• We find that the current easing cycle so far resembles the 1989 cycle most in terms of the dollar's performance. That period was the only cycle where the dollar was weaker a full calendar year after the first rate cut. This historical evidence is consistent with our call for further dollar weakness in the coming months, but also with our expectation of a reversal to the dollar downtrend from around mid-2008.
• In Australia, Q4 inflation numbers were released last night and surprised on the upside, posting an increase in underlying inflation of 3.6% y/y. This is well above the Reserve Bank of Australia's official target zone and we renew our call for a 25bp hike at the 5 February meeting.
• FX Crossroads is published every second Wednesday. The next publication date is 6 February 2008.

USD: Recessions have implied weakness after 6 months and strength after 12 months

AUD: Core inflation surprised on the upside - and leaves the RBA in a dilemma

USD: What happens to the $ in a US recession?

Dollar patterns and the US economy

Back in September, we wrote about dollar patterns during the Fed rate cut cycles (please see our Between a Rock and a rate cut, of 19 September 2007). We concluded then that there was no standard pattern in the short term, but also that the dollar tended to have gained one year after the first cut in the cycle. This relationship was particularly pronounced for USD/JPY, with the exception of the 1998 easing cycle.

In this note, we compare again the dollar's performance to the previous easing cycle, but now with the added benefit of five months of history to the 2007 cycle. Since financial markets are increasingly worried about a US recession, we also consider the performance of the USD during the last three recessions (1981, 1990 and 2001).

We find that the current easing cycle so far resembles the 1989 cycle the most in terms of the dollar 's performance. That period was the only cycle where the dollar was weaker a full calendar year after the first rate cut.

US recessions tend to result in dollar weakness at least six months after the formal start to a recession. However, a year after the start the dollar is normally stronger across the board. The only exception is the continued decline in USD/JPY during the 1990 recession. USD/JPY peaked at 158 in April 1990, and fell to a low of 84 five years later.

This historical evidence is consistent with our call for further dollar weakness in the coming months, but also with our expectation of a reversal to the dollar downtrend from around mid-2008. That said, we would not ignore the evidence from the 1990 recession, suggesting that the dollar could remain weaker for longer than we currently forecast.

When the Fed cuts...

In the table below, we list easing cycles since 1989 and show the change in the Fed funds rate, in EUR/USD, in USD/JPY and in DXY. We show changes six and twelve months beyond the first cut. Changes are shown as percentage points for Fed funds and as percentages for currency changes.

Looking only at the historical relationships, a number of interesting patterns stand out:

• One year after the first rate cut, the dollar (DXY) was stronger in the 1995, 1998 and 2001 cycles, but not in the 1989 cycle.
• EUR/USD had fallen both six and 12 months after the first cut in the 1995, 1998 and 2001 cycles, but had risen after the 1989 easing cycle got under way.
• USD/JPY was higher one year after the first rate cut in 1989, 1995 and 2001. In the 1998 cycle, USD/JPY had fallen by 22% after 12 months.
• After six months the Fed funds rate had been cut by 50bp in 1995, by 75bp in 1989 and in 1998 and by 275bp in 2001.

In comparison, the current cycle has seen a 175bp rate cut and a widespread decline in the dollar. No previous cycle is completely identical to this outcome, but the one that comes closest is the 1989 easing cycle, which is also the only cycle where the dollar index was weaker a full calendar year after the first rate cut.

The 1989 easing cycle is also a relevant benchmark because 1) it preceded the 1989 recession, and 2) because the main economic problem was the considerable rise in debt exposure during the second half of the 1980s and the subsequent financial crisis that lasted well into the 1990s.

To summarise our findings so far, the widespread decline in the dollar since the first rate cut in September is unusual from a historical perspective.

The only other episode that resembles this performance is in the 1989 easing cycle. That cycle was the only period were the dollar continued to fall for another six months.

...and when the economy tumbles

But what if this is not just an easing cycle, but the beginning of a deeper recession? Former Fed chairman Greenspan seems to think this is the case. To explore the implications for the dollar, we have looked into the past three recessions in the US.

In the table below, we list recessions since 1981 and again show the change in EUR/USD, in USD/JPY and in DXY. We show changes three months prior to the official start to the recession as well as six and 12 months after the start. We also show the performance of the dollar during the past three months.

As with easing cycles, there is no standard recession when it comes to the dollar, but a number of patterns that stand out are:

• The dollar has been stronger one calendar year after the start to the recession period in all three occurrences.
• The only exception is against USD/JPY during the 1990 recession.
• Six months past the start of the recession the dollar was weaker with no exceptions.
• During the past three months, the dollar has fallen across the board. Of the three recessions highlighted here, the only period with a similar performance is the 1990 recession.

So, what have we got? Our call for a weaker dollar in the coming months (see our FX forecast update, of 7 January 2008) is consistent with past performance during recessions. Our prediction of a reversal of the dollar bear trend between 6 and 12 months from now against most currencies also seems to fit the picture pretty well. Our forecasts are biased for a stronger yen, even a year from now (USD/JPY at 105), is consistent with the outcome of the 1990 recession, as is the dollar's performance during the past three months. Interestingly, our study of past easing cycles also picks 1989 as the one that mostly resembles what we see today. As mentioned, that period was characterised by a massive rise in debt exposure and the Savings and Loan crisis.

AUD: Possible short-term relief - but destined long-term weakness

The outlook for AUD in 2008

This article is a summary of our research paper FX Strategy: AUD: What goes up..., 21 January, 2008. In this paper we take a closer look at the Australian economy with an emphasis on the outlook for AUD in 2008.

The Australian economy is generally in good shape and is expected to maintain high growth in the short term. We therefore expect relative growth and interest rates to remain favourable throughout the year. This should bring short-term relief to AUD, but does not remove the fact that AUD is overvalued - particularly against USD. We therefore expect AUD to begin a correction this year and see the global slowdown and increased risk aversion as potential triggers.

We are therefore forecasting a gradual depreciation of AUD and expect AUD/USD to reach 88, 84, and 80 in 3, 6, and 12 months' time, respectively, compared to a forward of 87, 86, and 84.5.

The economic outlook

The Australian economy is growing rapidly, and is currently in its 16th year of ongoing expansion. Growth has even accelerated in recent years and the economy continues to grow at above-trend growth rates. Despite the lengthy expansion there are still no signs of any imminent slowdown. One can question the sustainability of some of the recent years' growth drivers though, and in particular, private consumption and gross fixed capital formation is expected to slow slightly. Meanwhile, net exports will continue to subtract from overall growth. On top of this comes an expected slowdown of the global economy, which inevitably will have an effect on domestic growth - even though Australia will likely be less affected than other economies. This is a result of Australia's large trade with Asia, which has led the overall growth of Australia's main trading partners to exceed that of the total OECD area. We are therefore expecting overall growth to stay at trend in 2008.

Australia's lengthy expansion is beginning to weigh on overall capacity utilisation though, and price pressures have been building. Inflation data released today shows that underlying inflation surged in Q4 and now stands at 3.6% - well above the RBA's official target zone.

The RBA was highly data reactive in 2007 and chose to raise rates at meetings following the release of inflation reports. This happened last in November, where the policy rate was increased by 25bp to 6.75%. There is no doubt that today's inflation surprise would usually prompt an interest rate hike by the RBA. However, things are not as usual and there is currently great uncertainty about the global economy. Equity markets have lost value in January, and also in Australia, which could restrict growth in private consumption and investments - a rate hike so soon after a great policy reaction by the Fed is thus uncertain. Risks are that the RBA will stay on a wait-and-see mode for now. However, we still believe that inflationary pressures are so strong, that the RBA will take the policy rate to 7% on 5 February. So far the credit crisis has not had a great affect on the Australian economy, although we acknowledge that the recent fallout in equity markets could change this.

Near-term strength and long-term weakness

AUD has rallied since 2001 and despite a minor correction during autumn last year, AUD has entered 2008 as highly overvalued - not least against USD. If we can learn one thing from exchange rate economics, however, it is that corrections back to long-run fair values take a long time.

Nonetheless, some of the main drivers behind the past years' appreciation of AUD are turning around and will weigh on AUD in 2008. The three single most important drivers of AUD have been: (i) accelerating commodity prices, (ii) low risk aversion, and (iii) a booming global economy. These pillars are all beginning to shake.

Commodity prices have historically been very important in explaining movements in AUD, and the past years' commodity bull market is likely to explain most of the rally in AUD. The bull market has ended for now, however, and we are expecting world commodity prices to even fall slightly in H1 before rising again in H2. The positive stimulus from the terms of trade is therefore fading in Australia.

Recent years' low global risk aversion has also supported AUD, as investors have entered very large positions in carry trades. However, with risk aversion rising, carry trades are unwinding and AUD is losing value. One symptom of this is the current very high correlation with equity markets, illustrated not least last Monday as AUD followed the equity markets in red numbers. With a continued high, and a rising level of risk aversion, AUD is also under pressure from this driver.

On top of this, we are expecting global growth to be slowing, something which historically has implied a depreciation of AUD. In fact, AUD is the G10 currency most correlated with the global business cycle. Considering all these events it can perhaps seem odd that AUD has not lost significantly so far. However, there are also factors providing shortterm relief to AUD, as relative interest rates have become increasingly favourable since November last year.

If anything else, one thing is clear, the next months will be interesting for AUD. The market has lately priced out most of the expected tightening from the RBA, however, we still expect the RBA to hike rates at its 5 February meeting. This would leave Australia as one of the few economies with a mainly positive newsflow and a reserve bank in a tightening cycle. It could be some time therefore, until we see a correction of AUD. However, current events on the financial markets, not least on the equity markets, will be determinant as AUD remains sensitive to global sentiment.

Trading Points

Danske Bank http://www.danskebank.com/danskeresearch

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