FX Forecast Update: To Catch a Rising Tide

Here are our latest thoughts on the G10 currency markets:

Difficult waters to navigate. The best performing currency during the past month has been CZK (up by 4% vs EUR), followed by HUF (2%) and PLN (0.8%). The worst have been ISK, PHP and NZD (down 5-6%). The performance split between ISK and HUF, which can be seen as both belonging to a group of high-yielding currencies backed by fragile fundamentals, clearly illustrates how difficult currency markets have been to navigate in the past month. Overall, European currencies, led by CEE, have performed best, Asian currencies have as a block underperformed, and EUR/NZD (up 5.3%) represents the extreme in terms of G10 performance. Shift in relative rates have been a key driver, at least among major currencies: Outright declines in NZD and JPY rates help explain un-derperformance of these currencies relative to countries such as Norway, the United Kingdom and Euroland, where rates have risen the most. However, the pattern is not entirely consistent, as the 3% rise in GBP/CAD during the past month despite a near identical +40 basis point rise in two-year swap rates illustrates. Carry performance has been essentially flat whether it is measured against G10 currencies or a global universe.

Inflation is now the main threat. If the relative movements have been difficult to pin down, there is little confusion in our view when it comes to the absolute outlook. Since last autumn, we have warned about the dual shock of financial crisis and economic slowdown. There is still nothing to in-dicate that the financial crisis is over, and cyclical threats to overextended consumers on both sides of the Atlantic should be enough to temper economic optimism. If the two waves of bank and consumer balance sheet repair collide, which now appears to be happening, the consequences could become ugly. On top of this, we have to deal with rapidly rising inflation. Higher inflation caused by rising energy and food prices equals a decline in disposable income, just as monetary tightening coming in the wake of inflation can be expected to tighten the liquidity cycle further. But the real issue is whether we are witnessing a secular shift from a low-inflation era to a period where price pressures are becoming more entrenched. The jury is still out on that, but inflation should now be seen as the predominant risk to both the economic outlook as well as to financial markets. Conventional wisdom largely seems to be that the global inflation problem will be resolved without a sharp decline in economic activity. We are not so sure. We continue to believe that we are headed for a period of financial deleveraging against a backdrop of slower activity. There is a distinct possibility that oil prices, and thereby inflation, could rise further in the coming months. There is also an obvious risk to the economic outlook presented by the latest collapse in global consumer confidence. And third, pushed up against the wall, there is very little that central banks can do other than to slay the inflation beast in the old-fashioned way. This is particularly so in Asia-excluding Japan, where underlying inflation is rising sharply.

Central bank credibility moving to the forefront. With oil prices continuing to set new highs we recommend staying with the theme of rising inflation over the summer. Central bank.s willingness to follow through on hawkish rhetoric is then likely to be key to currency performance in the near-term, just as the issue of credibility once again moves to the forefront. Among G10 countries only ECB, Norges Bank and Riksbanken are likely to do well on threats to tighten policy further this year. We expect the RBA to leave rates unchanged, but a terminal rate hike cannot be ruled out com-pletely considering the latest rise in retail sales and the substantial term-of-trade improvement. In contrast, we do not see forecasts of US, UK or Japanese rate hikes as credible and we still expect RBNZ to cut rates. This suggests that inflation shocks should continue to benefit the first group of currencies over the latter, a pattern that is consistent also with our findings on the relationship be-tween FX and oil: By and large, rising oil prices are bullish for EUR/USD and EUR/JPY and bearish for USD/CAD and USD/NOK (see also FX Crossroads: Focus on inflation and FX, 25 June 2008).

EUR/USD has been mostly range-bound between 1.52 and 1.58 since falling from a peak of 1.6019 on 22 April. The development has been consistent with our call for the pair to trade around 1.55 during the summer (see Struggling between greed and fear, 5 May 2008). However, we see risks as being biased to the upside. This follows mainly from our interpretation of the two central banks. reaction functions, as well as from rising energy prices. Further out, the fundamental back-drop to both countries appears exceptionally uncertain. There can be little doubt that the euro-area is witnessing a sharp decline in economic activity. As before, we believe a turn in the policy cycle will leave an overvalued euro at risk of a considerable decline. But we also believe that markets are too optimistic about the outlook for the US. Neither the financial crisis nor the housing recession seem likely to be resolved any time soon, and judged by the collapse in both car sales and con-sumer confidence, once the effects of the fiscal package peters out a more negative picture is likely to be revealed. Hence, we are opting to revise our forecasts higher to 1.60 for 3M (from 1.55), 1.55 for 6M (from 1.50), leaving the 12M forecast unchanged at 1.50.

JPY without primary drivers. Consistent with both higher energy prices and the movement of rela-tive rates, EUR/JPY reached a new high in June at 169.45. The move has been well in excess of our expectations, but the logic is difficult to dispute, and new highs could yet be seen. Little domestic support is coming to the yen currently. The risk of an economic recession in Japan should not be ignored, monetary policy is tied down by low (core) inflation, and politics is in a mess. At the same time Japanese margin traders have raised their yen shorts to the greatest level since August last year, just as traditional flow-of-fund yardsticks show considerable capital outflows. This leaves a rapid increase in market volatility as the best bet for a stronger yen. We expect volatility to trend higher over the summer and are biased for a further drop in the USD/JPY exchange rate, but the risk is for EUR/JPY to clear 1.70 near-term.

Short-term risk on EUR/CHF forecast remains on the upside. During the past month the Swiss franc strengthened temporarily against the euro, as equity markets headed south. This strengthen-ing of the franc was furthermore catalysed by statements from the Russian central bank about a potential rise the reserve share held in CHF. Meanwhile, however, relative interest rates have be-come an increasing drag on the CHF and are at present a significant upside risk on EUR/CHF. The interest rate spread to the eurozone has widened to a 5-year high and could rise even further if the SNB does not follow the ECB.s lead and hike rates at the September meeting. We believe that this divergence in monetary policy will become increasingly important in the months to come. However, we do still expect the CHF to strengthen in the medium- to long-term, as support remains in place from economic fundamentals and as the CHF remains cheap by long-term valuation standards.

UK slowdown closer. By far the greatest surprise over the month was the upside surprise in retail sales. Exceptionally warm weather sparked sales of seasonal food and clothing, retail sales sky-rocketed unexpectedly and GBP appreciated sharply. But wait a second; did all gloomy prospects disappear due to just a single positive reading? Of course not! This week, Marks & Spencer, one of the most iconic and widely recognised chain stores in the UK and the largest clothing retailer in the country, said sales dropped the most since 2005 and fired the director in charge of food after the company.s worst quarter in at least a decade. Higher prices are definitely starting to squeeze the UK consumer. Another problem child is the housing market, reeling from the worst slump in 30 years. Also this week, Taylor Wimpey, the UK.s largest housebuilder, failed to raise funds and home loan approvals are more than halved compared with a year ago. So something is rotten in the UK. We have called out for higher levels in EUR/GBP during 2008. So far, the pair has risen eight per-cent but more is still to come. UK PMI.s are plummeting the most in the G10; equities underper-form on a relative basis, writedowns are still being reported and risk aversion is on the rise. While risk is that ECB decide to rate further lie on the upside, the hawkishness of the BoE is purely specu-lative. Accordingly, we continue to believe that the next BoE step is downwards. With higher rate spread at the longer term, we raise our 12M EUR/GBP forecast from 0.75 to 0.78.

NO(K) support from oil. Norges Bank decided to raise the deposit rate by 25bp to 5.75% and lift the deposit rate path by 25bp, leaving the door open for another rate hike. Norway is still perform-ing well with unemployment at a record-low, but signs of weakness, particularly in the housing mar-ket, are starting to arise. Manufacturing PMI unexpectedly fell to a level indicating economic con-traction and credit constraints are beginning to pose to downside risks to the economy. In the view of Norges Bank, the NOK is currently weak. We share that view and keep our bias for EUR/NOK go-ing lower in the medium to longer term. In the shorter term, however, we have become more reluc-tant to call out for a stronger NOK. The historical close relationship to oil is currently off the table and the rising risk aversion disfavours a small and rather illiquid currency, such as the NOK. De-mand from commercial clients tends to abate in the summer period and speculative investors will probably try to take advantage of the situation and buy EUR/NOK. We revise our 3M EUR/NOK forecast up from 7.80 to 7.90 but keep our bias for NOK strength further out.

Swedish überhawks. In late June, TeliaSonera turned the bid from France Telecom down and Va-sakronan was sold to a domestic buyer, AP-fastigheter. Both privatisations were expected to gen-erate SEK demand, which is now off the table. Adding declining global economic activity declining, rising risk aversion and thin summer markets, we are left with an unhealthy cocktail for SEK. Res-cue comes from the increasing price pressures. The Riksbank came up to expectations and raised the repo rate by 25bp to 4.50%. Furthermore, it raised the repo rate path by as much as 60bp. We believe they will put action behind words and raise the repo rate to 5% before year-end. Forecasts for inflation were revised up while GDP forecasts were revised down. This fits well into our view, al-though we still believe the Riksbank underestimates downside risks to growth. However, deteriorat-ing growth prospects are only of minor importance near-term as the inflation scares dominate Riksbanken.s actions. Relative rates benefit SEK and only a sharp decline in oil prices has the power to prevent Riksbanken from further hikes. Accordingly, we have kept our bias for SEK strength at the three to 12 month horizon but acknowledge that we might experience spikes in EUR/SEK over summer due to low liquidity.

Further divergence down under. During past months we have seen a divergence between the per-formance of the AUD and NZD, which was further emphasised in June. As a result AUD/NZD reached a new seven-year high breaking above 1.26 . and we expect the pair to drift even higher. While the latest surge in commodity prices is dampening the depreciative effect on the NZD, from a deteriorating growth outlook and an expected turn in the monetary policy cycle, the support from commodity inflation is fading. In fact prices on New Zealand.s main exports have been broadly flat recently, while Australia is still experiencing an unprecedented boost to its terms of trade. The AUD is also still receiving support from high interest rates, augmenting its use as an inflation hedge. We would not recommend going short on the AUD in the current environment, even at a break of historical highs, and given the heightened risk of further increases in commodity prices we have chosen to raise our 3M and 6M AUD/USD forecast to 0.98 and 0.95 respectively. Mean-while, we are still expecting a large depreciation of the NZD over the coming year . and especially against the euro in the short term. USD/CAD continues to trade in an approximate +/- 2.5 % range around parity, although the fact that the BoC stayed on hold in early June, while the market was looking for further rate cuts, has helped keep the pair at the upper end of the range. We expect USD/CAD to stay range bound around parity and are targeting a move below parity in the short term, given the support to the CAD from the surge in oil prices.

Danske Bank

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