FX Forecast Update: Fat Lady Has Yet to Sing

Here are our latest thoughts on the G10 currency markets:

Ain't over till the fat lady sings. Back in November we proposed a scenario outlining a disorderly decline in the dollar, setting targets for EUR/USD and USD/JPY at 1.55 and 100, respectively. Both targets have been surpassed during the past months. However, it seems unjust to label the dollar decline disorderly or irrational in light of the key developments during 2008 so far. In fact, dollar weakness seems rational considering the relative weakness of the US economy and the threat the ongoing financial crisis presents to the US financial system. That said, measured against our short-term models the latest rise in EUR/USD does seem somewhat excessive, just as valuation models now put EUR/USD at more than two standard deviations away from fair value, the first such occurrence since 1992 and only the second time since the break-up of the Breton-Woods fixed exchange-rate regime in 1971. Valuation considerations notwithstanding, we consider it appropriate to again consider the likelihood of a disorderly decline in the dollar from present levels.

US recession in another word. We now expect the US economy to contract in the first half of 2008. The recently adopted fiscal package should secure a decent bounce-back in Q3 before underlying weaknesses gain the upper hand again in Q4. In other words, without the fiscal stimulus, the US would fall into recession this year. Our forecast also entails the ISM falling below 45, a further rise in unemployment and no imminent stabilisation of the housing market. As a response we now expect the Fed to cut rates to 1.5% by June. The view described here puts us on the weak side of current market pricing. Though we foresee a modest recovery in 2009, we worry that the combination of high inflation, falling house prices, rising unemployment as well as more restrictive lending practices will result in prolonged economic weakness and, unlike the last recession in 2001, one cannot assume that consumption will respond eagerly to an easing of monetary policy.

Recouple or decouple? A crucial issue for currency markets is to what extent the world economy can continue to decouple from US weakness. It is hard to believe that a US recession will have no negative repercussions elsewhere, particularly seeing that the effects of the financial crisis are visible in most places. A recoupling with a US slowdown, much like what was being priced in financial markets at the beginning of the year, will be beneficial for the USD and detrimental to commodity- based currencies. A more pronounced slowing in the euro area is also likely to result in a decline in EUR. So far, however, the dataflow has continued to support the idea of economic decoupling. Last week, both the German Ifo and the Belgium business confidence indicators posted a third consecutive monthly gain. In Japan, the trade surplus is diminishing thanks to a serious terms-of-trade shock from rising energy prices, but real exports are still growing healthily. Though exchangetraded commodities may be subject to speculative gains, non-exchange traded commodities such as iron ore are also rising sharply, giving support to the idea of residual global momentum. In the near term, we expect the decoupling hypothesis to hold, resulting in further USD weakness and continued support to commodity based currencies.

Is the financial crisis over? An equally important theme is the ongoing financial crisis. The past month has seen a number of positive developments, including the Fed's attempts to improve the supply of liquidity to US banks, as well as brokers, and the plan to increase the leverage of US agencies. However, bad news continues to weigh more heavily on our scale. Not only did we witness the collapse of a number of well-known financial institutions, we have also seen rising tensions in the money and credit markets. Though many asset classes now look cheap, fear may win over greed also in the coming months and we suspect that liquidity will continue to command a premium. The financial crisis in itself will lend support to former funding currencies with significant current account surpluses including CHF and JPY, and weigh on leveraged currencies such as ISK, TRY, ZAR, HUF and RON just to name a few. However, the arbitrary nature of the news flow should not be underestimated, and increased pressure on European institutions, for example, will weigh on EUR/USD.

Policy response uncertain, but intervention unlikely. Policy makers are warning about excessive market movements and the dollar is certainly weak enough for us to consider the risk of some form of currency intervention as substantial. However, we continue to view the near-term risk of intervention as limited: First, it is important to recognise that movements in G10 currencies are not disorderly and that FX volatility is mostly caused by tensions in other parts of global capital markets rather than vice versa. This alone suggests that policy initiatives should be directed elsewhere. Second, the current setup for G3 monetary policy does not lend support to intervention presently, considering that the Fed is attempting to promote growth and the ECB is combating inflation. And finally, from a valuation perspective, G3 intervention should target EUR/JPY, but attempts to buoy the yen further are likely to be met with fierce resistance in Tokyo. The G7 meets again on 12-13 April. We do not expect concrete measures to be taken at that meeting.

EUR/USD forecast raised to 1.60. After reaching our 1.55 target in March, we have opted to lift the 3m target to 1.60 and the 12m target to 1.50 from 1.45. Our scenario does not include a disorderly dollar decline and our risk scenario includes not just a weaker dollar but also a more prolonged period of dollar weakness. However, we continue to expect the economic outlook for the euro area to deteriorate in 2008 to a point where the ECB will want to cut rates. The current upswing in Europe is based on exports and investments and both must be expected to slow this year. Headline inflation is also likely to have peaked already. Technically, there is nothing sacred about the 1.60 level, where the current uptrend currently targets the 1.62 area as a turning point.

USD/JPY forecast lowered to 96. We have also lowered our 6m forecast for USD/JPY to 96 after the 100 target was passed. The economic performance of Japan is being questioned, with the need for rate cuts now being discussed, particularly in light of an expected drop in core inflation this year. However, the decline in confidence surveys has not been matched by a similar decline in realactivity data and we do not forecast a recession for Japan this year. The most recent rally in the yen has seen a further unwinding of domestic JPY shorts. The risk is not only that remaining speculative shorts will be squeezed out, but also that the poor performance of assets markets in general will persuade Japanese investors to keep funds at home, thus improving the net flow of funds for JPY. Implied volatility has risen sharply recently and a calmer period may result in a weaker yen temporarily. However, considering our view on global markets in general, we expect JPY to continue to perform well.

EUR/GBP forecast raised to 0.82. We have argued since late 2007, that the dependency upon the financial sector eventually would become a drag on the UK economy and it now finally looks like the BoE is ready to join the battle on liquidity. After stubbornly maintaining a hawkish stance on the back of inflation above target, the Governor last week signalled that the BoE is poised to take revolutionary action to find a "resolution" to the problems faced by British banks unable to sell or refinance mortgage-backed debt. Our general perception is that the financial turmoil will resume and GBP will continue to suffer. Since the UK economic cycle is deteriorating and price pressures are expected to ease over the summer, the BoE's task will be easier; rates will be cut substantially, leading to another round of sterling weakness. We maintain our mid-March forecast of EUR/GBP at 0.80, 0.82 and 0.78 at 3, 6 and 12M, respectively.

Support remains for CHF. In last month's forecast update we argued that the path of least resistance was for EUR/CHF to trend lower once again, following a correction in the financial markets during February. CHF did strengthen in early March and EUR/CHF even traded shortly below 1.54 (our old 12-month forecast) following the take-over of Bear Stearns, before adjusting higher in the past two weeks. We continue to see the case for CHF strength and have therefore lowered our 3, 6, and 12-month forecasts for EUR/CHF. Although there are mounting signs of slowing growth, we still expect the Alp economy to outperform the euro zone in 2008. Less aggressive monetary easing from the SNB compared to the ECB in H2, continued global deleveraging, and elevated risk aversion should see the franc appreciating further.

NOK and SEK: Strong potential but risk aversion remains key. Once again the Scandinavian currencies, especially NOK, have proven highly responsive to risk sentiment. NOK was taken hostage when the financial unrest unfolded, helped by a decline in oil prices. April will probably offer widening of the policy spread between Norway and the euro area, as NB is expected to hike the policy rate by 25bp to 5.5%. However, the peak can probably lie further north, which has also been pointed out by NB, as price pressures are sustained. We remain positive on the Norwegian economy and Norwegian monetary policy and see still see good value in buying NOK on dips. However, before the financial distress disappears, we find it hard to expect EUR/NOK much below 7.75. Price pressures are still evident in Sweden and the Riksbank will not rest until its illustrative inflation barometer tilts from the red, dangerous zone to the grey, comfortable zone. As the effects from higher mortgage costs, energy and food prices abate, this will eventually happen and the hawkish stance can give way to a sensible one, leading to lower Swedish rates. Risk aversion remains key for SEK and we need to see less financial distress before we expect any strong SEK appreciation. After a month of pronounced range trading with EUR, we keep our existing forecast of SEK weakness in the near term but slightly stronger in the longer run.

Mounting weakness in the $-block. March brought indications of slowing growth in both Australia and New Zealand, as several confidence indicators reached multi-year lows. However, growth is only to moderate to (or just below) trend-level in 2008. March also marked a cyclical turn in Australian monetary policy. At the Board meeting of 31 March, the RBA kept its policy rate unchanged at 7.25% and indicated a shift from a tightening bias to a more neutral stance. With a peak in monetary policy and tentative signs of moderating growth, two of the main pillars under both AUD and NZD are beginning to look slightly unsteady. However, the terms of trade is still expected to bring support in 2008, which should cause some resilience in especially AUD in the short run. However, we continue to expect both AUD/USD and NZD/USD to trend lower in H2, as global deleveraging continues. We have lowered our 3-month forecast on AUD/USD and NZD/USD slightly. We continue to expect CAD to perform relatively well against its southern neighbour and have therefore kept our targets for CAD strength. The BoC is expected to lower rates more than the Fed but the loonie can gain from high oil prices and a relatively better economic outlook.

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

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