FX Forecast Update: Extending the Tunnel

Here are our latest thoughts on the G10 currency markets:

Lights not on yet. The financial crisis is moving into its second year and there are no comforting signs that the hurricane is fading. Over the past year banks have announced writedowns and credit losses of USD510bn, while capital raised runs at USD360bn. This USD150bn gap is taken off the balance sheet and the way banks are run means that credit available is being reduced by more than that. On top of this, it seems that it is becoming increasingly difficult for the financial sector to refinance itself, and the outstanding refunding pipeline through to year-end is likely to make things more, not less, difficult. To make things worse, investors around the world are looking at financial losses on almost all asset classes, including stocks, riskier bonds, properties and carry trades in currency markets. Because many assets are leveraged, price declines force margin calls, and without additional funding the result is not only asset liquidation but also debt liquidation. This point in the financial cycle is often referred to as a Minsky moment. The cycle turns when capital raised exceeds capital lost, or when a new group of investors move in to take advantage of rock-bottom prices. In 2007 that investor group was sovereign wealth funds. This year, we seem to have to rely increasingly on central banks and finance ministries as stopgap investors to prevent a financial meltdown. In short, our well-known theme of financial deleveraging still remains central to our approach to currency markets.

On the brink of global recession. Economic data have been poor recently, particularly in Europe and Asia, accentuating fears of a global hard landing. Since the US grew the fastest of the G7 economies in Q2, the global slowdown seems increasingly to feed on the combination of a food/energy price shock and a credit crunch, rather than just a slowing of exports to the US. We believe that the outlook for economic activity is negative in the coming months. In Europe, a Q3 contraction will send the euro-area into recession. Several other countries are either in or on the brink of one, including the UK, New Zealand and Japan. In the US, the effects of the fiscal package are now fading and the next couple of months should see growth stalling again. Our economics team expects the global economy to remain on the brink of a recession for the next six to nine months, but also looks for lower inflation and a stabilisation of housing activity to help a recovery on the way in H2 09. From the perspective of currency markets, an economic slowdown reinforces the signals toward deleveraging from the liquidity cycle mentioned above.

What a rally! The performance of the dollar in recent weeks has been nothing short of spectacular. The annualised monthly rise in the dollar-index (DXY) has surpassed 100% for the first time since 1992 and, though not unprecedented, the rally so far is the fourth largest since 1980. With that in mind it is little wonder that most observers of currency markets are grappling with the question: what's next? We believe that though a correction may seem long overdue, the medium-term (three to nine months) outlook remains constructive for the dollar. On a global level, a sharp universal slowdown combined with a credit crunch presents an overall framework that is supportive of the dollar. However, a number of constructive local factors have only recently appeared. First, the fear of a US recession has been replaced by hopes that come 2009 the worst could be over. Further, recent policy initiatives - particularly with regard to fiscal policy - have shown that US authorities are taking a highly active stance to prevent a financial and economic meltdown. Second, the rest of the world is experiencing - some for the first time - the shockwave that hit the US about a year ago. In Europe, a slowdown is well under way, and a recession - at least a technical one - is forthcoming. Policymakers have yet to lend much support (the most recent move of the ECB was to tighten banks' access to liquidity). Down under, New Zealand is in recession and Australia is slowing fast. Third, the latest decline in commodity prices (with the largest-ever drop in absolute oil prices during the past month) is also offering support to the dollar, not least by eroding part of the fundamentals for commodity-based currencies, such as AUD, NZD and BRL. And finally, in terms of valuation, the EUR, AUD and NZD have been heavily overvalued. One should not make light of the challenges ahead for the US economy, but for now at least, challenges elsewhere seem greater.

Too far, too fast? Arguments in favour of a meaningful correction are not difficult to find: 1) The rally in the dollar appears overextended by most technical yardsticks, as well as relative to movements in interest rate markets; 2) Speculative investors are now long in US dollars; 3) The US economic surprise index has risen sharply in recent months, in absolute terms as well as relative to the euro-area, suggesting that negative surprises could be forthcoming. Such a correction could well take the euro/dollar rate back above 1.45. Importantly, however, we would treat such a move as a correction rather than a journey toward new lows for the dollar. To turn negative on the dollar, a number of arguments would need to fall into place. These include hard evidence of a US recession, uncertain political signals in the run-up to the November elections, or a surprisingly fast recovery of financial risk-seeking globally.

EUR/USD target reached. Last month we argued that the euro/dollar rate would continue its descent driven by a combination of both financial and economic arguments (see On the brink of a global recession). Our 12-month target of 1.4 has now been surpassed, at least temporarily, but we continue to believe that the combination of a euro-area recession (our economics team now looks for the ECB to cut rates twice in 2009), valuation considerations, plus the fact that the US has taken more aggressive steps to deal with the implications of the financial crisis should drive the euro/dollar rate lower. With that in mind, we are cutting our 12-month forecast to 1.35. Our 2010 forecast of 1.30 remain unchanged.

Keeping up with the yen. We have been both pleased and disappointed by the performance of the yen over the past month. Disappointed because we believed the dollar/yen rate would have fallen to our 105 target faster than turned out to be the case, but pleased because the yen has still managed to outperform a roaring US dollar. Considering our outlook for global markets in general, we expect the yen to perform well overall. However, there is reason to note that despite everything it seems difficult for USD/JPY to set new lows and we are still some way above the 97 low that was printed prior to the Bear Stearns rescue package this spring. From an economic perspective, Japan is close to a recession and the political situation is in a state of flux after PM Fukuda's resignation. Neither has much bearing on the yen, but an easing of fiscal policies under LDP front runner Taro Aso could have some influence going into 2009. A wide range of 100-110 is likely to capture most of the trading in USD/JPY in the coming months, and for now we favour the downside.

We still like the CHF. During the first days of September EUR/CHF finally broke out of its post-April 1.60-1.64 range and traded below 1.60 on the back of renewed tension in the financial markets. This fitted well with our call for a fall in EUR/CHF. Our economics team is now pencilling in two 25bp rate cuts from the ECB in H1 09, but only one 25bp rate cut from the SNB, which should imply further support to the CHF from movements in relative interest rates. Overall, however, the key argument in favour of further CHF appreciation on the 12-month horizon remains continued financial deleveraging. We maintain our forecast of EUR/CHF to reach 1.60 in 3M, 1.58 in 6M, and 1.56 in 12M.

GBP to remain under pressure. Since our last forecast update, EUR/GBP rose to an all-time high of 0.8187 before falling back below 0.80. British data has generally been weak with the retail sector and housing market under particular pressure. From June to September the OECD has revised its projection of UK average quarterly growth over 2008 down from 1.2% y/y to 0.1% y/y - the lowest among G7 economies. The Bank of England is still burdened by a rapidly deteriorating growth outlook and soaring price pressures, but we continue to expect substantial monetary easing when the peak in inflation is truly passed. We expect EUR/GBP to bounce back above 0.80 and keep our 3-12M forecasts unchanged.

No immediate support to SEK. We argued in the last FX Forecast Update that global forces - risk aversion, a broad-based US dollar rebound and stock market developments - coupled with poor domestic macro readings were likely to send the SEK lower. And lower it went, albeit faster than we had anticipated as our medium-term targets for EUR/SEK and USD/SEK have already been breached. So what's next? We still believe that the Swedish krona needs firm support from stock markets and risk appetite in order to see any meaningful appreciation. Subpar growth, falling inflation and rate cuts to come are not of much help either for the Swedish krona. The first cut is likely to come in Q1, although that is more or less priced in by now. Basically we see the Swedish krona continuing to trade on a weak note and see a non-negligible risk that EUR/SEK takes another leg higher. However, barring any extreme events any such move is likely to be relatively short-lived. We see the euro/Swedish krona rate trading around 9.60 and 9.50 in one to three months time and have raised our six-month and 12-month forecasts slightly to 9.45 and 9.40, respectively.

NOK interesting on the more distant horizon. A dollar appreciation and a decline in oil prices are both grim for the Norwegian krone, due to the negative correlation with these. Since both events have occurred, EUR/NOK has risen above 8.1 - our one-month forecast. If the dollar continues its rally and the risk of global recession drives oil prices substantially lower, we believe the euro Norwegian krone rate could rise to mid-2006 levels (8.30-40). A stabilisation of the euro/dollar rate and a rise in oil prices could, however, in combination with more focus on fundamentals, push the euro/Norwegian krone rate below 8.00, where it arguably belongs. A vigilant Norges Bank observant of high underlying inflation should also support such a move. The Norwegian economy is still set to outperform all other G10 countries next year and with a boom in oil investments, surpassing all previous years, we believe the Norwegian krone is set to be one of the best-performing currencies.

Further AUD and NZD weakness on the cards. We have long argued that the trio of an external deficit and a cyclical turn in both the economic cycle and monetary policy cycle constitutes a lethal cocktail for any overvalued currency. When coupled with a global financial crisis and considerable dollar buying, the result has been a 17% drop in AUD/USD and a 19% drop in NZD/USD from the 2008 high. Despite the recent correction, however, both AUD and NZD remain expensive by long-term valuation measures. Going forward we still see the global economic and financial climate as hostile to the AUD and NZD and do not foresee any support from relative interest rates, or any significant support from relative growth and global commodity prices. We have therefore opted to lower our forecast profile, such that we now look for AUD/USD to reach 0.76, and NZD/USD to reach 0.63 in 12 months. Compared with the US, Canada has had fewer positive data surprises lately. Nevertheless, the Canadian dollar has managed to keep pace with the US dollar. Markets still price that the BoC will lower rates by 50bp within 12 months and as we attach little probability to that, due to a quite decent Canadian outlook, we leave our USD/CAD forecast flat.

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

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