FX Forecast Update: It.s a L-U-V Thing

Here are our latest thoughts on the G10 currency markets:

Financial markets witnessed dramatic movements in January. Sharp declines in equity markets and interest rates are testimonies to a lowering of expectations for the economic cycle to a point where a US recession is close to being priced in. The underperformance of emerging markets suggests that investors are now abandoning the idea that large parts of the world economy can decouple from the US economic downturn. Finally, the widening of credit risk premiums to new highs is a clear indication that financial markets are still suffering from the credit crisis that began last summer. All told, markets are still responding to the dual shock of an economic slowdown and a financial crisis. Major currencies have moved less aggressively, but are nonetheless shifting along predictable fault lines. The weakest G10 currency during the past month has been the US dollar, down 1.25% against the EUR, followed by NOK. The strongest have been JPY and CHF, up by 3.3% and 2.5% respectively. Several emerging market currencies have fallen sharply, most notably ZAR and ISK.

It.s a L-U-V thing. Recent market changes have been broadly consistent with our overall framework (please see FX forecast update, 7 January 2008), and we continue to believe that the combination of an economic deceleration and a persistent financial crisis will be important signposts also in the coming weeks. What.s making the analysis somewhat more complicated now is the magnitude of policy actions already on the table. Investor expectations have been reduced significantly at the same time as central banks, led by the Federal Reserve, have taken actions to ease financial tensions and stimulate business and consumer spending. Further, at least in the US, policy makers have promised to ease fiscal policies. Conventional wisdom remains biased towards a turn in the US as well as in the global business cycle around the middle of the year (a V-scenario). If that.s indeed the case, current attempts to reflate ailing economies may soon prove to be excessive and result not just in asset price rallies but also in a rise in inflation expectations. Such a scenario could see a return to positive carry in currency markets and a decline in the JPY. However, we consider it premature to shift from recession to recovery trades, partly because we expect the US economy to continue to deteriorate in the coming months. We do not expect a US recession, but consider the likelihood too high (40%) to be of much comfort. Outside the US, the slowdown is less advanced but weakness appears to be spreading towards Europe and Asia. In our central scenario, global economic conditions may begin to improve in the second half of the year, but a recovery could well be postponed to 2009 (a U-scenario). While the probability is not as high as for the two other scenarios, it seems prudent also to consider a continued downturn without a near-term recovery (the L-scenario).

The financial crisis has not yet ended. The credit crisis still shows few signs of letting up. Writedowns among the major banks have now cleared the USD 100bn mark and new losses continue to be revealed. A full year since subprime bonds first attracted major headlines, downgrades remain the order of the day. Investor concerns are now turning to the financial guaranty insurance industry, the so-called monolines, whose USD 3.3trn industry could be the next leg to unravel (please see Monoline bond insurers . what now? 24 January, 2008). Unsurprisingly, credit is being restricted, as can be seen from senior loan officer surveys in the US, the UK and the euro-area. A certain decline in lending is natural considering that economic activity is on the vane. However, a tightening of lending standards also raises the threshold for economic ventures that again work to slow overall activity. Thus, the persistency of the credit crisis is now having real economic implications as well.

Dollar downturn not over. We have yet to change our bearish view on the USD, based partly on the economic downturn, partly on the financial crisis and partly on a shift in the management of sovereign assets away from the US (please see Will the USD decline become disorderly?, 14 November 2007). Our US economists now expect the Federal Reserve to cut raises to 2% by summer, implying a further decline in interest rates, absolute as well as relative. As long as global economic fears are focussed on the US, a dollar recovery seems unlikely. Further, the US is now offering the third lowest interest rates among the G10 group, after Japan and Switzerland. A dollar recovery from the middle of the year would be consistent with evidence from previous downturns, though lessons from the 1990 recession suggest that the combination of an economic slowdown and a debt-related financial crisis makes a comeback for the currency harder to initiate (please see USD, recessions and Fed easing cycles, 23 January 2008).

JPY still likely to rise against USD and EUR. There.s no hiding from the fact that also the Japanese economy is slowing. BOJ rate hikes are off the table for now and calls for monetary stimulus may grow louder as governor Fukui.s term comes to an end in March. However, our call for a rise in the yen is mainly based on global arguments, where high volatility and reduced leverage point to a further appreciation. We continue to expect USD/JPY to fall to 100 during spring, just as we look for a trend decline in EUR/JPY. That said, February could see a correction as equity markets recover from oversold levels and volatility drops temporarily.

Euro-area headwinds becoming harder to ignore. We are becoming increasingly confident in our call for a slowdown in the euro-area and we continue to expect the ECB to cut rates twice this year. However, residual economic strength and worryingly high inflation suggest that the ECB can retain a hawkish stance with some credibility in the coming months. As long as this is the case, we consider it premature to look for an end to the multi-year increase in the euro. Nonetheless, the turn in the monetary policy cycle is likely to coincide with a relatively sharp decline in the euro. Hence, just as we continue to expect a final rise in EUR/USD above 1.50 this spring, we also continue to expect a move to 1.40 a year from now.

GBP/CHF continues to shift lower. We remain bearish on the outlook for the GBP and continue to forecast an aggressive easing by the Bank of England in the coming months, driven by a persistent slowing of the British economy. The RICS indicator of housing activity has fallen to the lowest level since 1992, mortgage approvals have plummeted and we expect house prices to turn negative this year. Consumer and business confidence are fading as well. We have raised our forecast for EUR/GBP to 0.78 in six months time after our 0.76 target was reached in January. In contrast, we retain a positive view on CHF. The Swiss franc has gained in line with our expectations, and though a correction in oversold equity markets may shift EUR/CHF higher in the early part of February, we continue to forecast a trend decline in the coming months. The substantial external surplus of Switzerland suggests that the currency will tend to increase as the amount of CHF funding for use in leveraged carry trades is reduced.

Heavy financial weather hurts NOK and SEK. The Norwegian equity market was hit hard in January and together with signs of position squaring, the resultant rise in EUR/NOK above 8.00 was not entirely surprising. But buoyant wage growth, high underlying inflation and rising rents make us believe that Norges Bank will move to raise rates again during spring, highlighting NOK.s enviable combination of cyclical support and positive carry. We see EUR/NOK at 7.80 in three months. The SEK has also suffered from subdued risk appetite during the last month. We maintain our bias for a slightly stronger SEK in the short term but acknowledge that both the global deceleration and the credit crisis go against this view, as does the expected start to a central bank easing cycle. The SEK will likely be supported by the selling of stateowned companies in 2008, but so far the planned sale of Vin&Sprit, a liquor company, has been delayed due to adverse market conditions.

Staying alive. Both AUD and NZD have performed better than one might have expected considering the widespread pressure on financial markets in January. However, solid domestic demand, particularly in Australia, is continuing to lend support to the currencies down under. We expect the RBA to raise Australian policy rates again in February and issue a hawkish statement at the same time. Both AUD and NZD are vulnerable to a global slowdown, both are significantly overvalued and both are exposed to high current account deficits. However, a more significant decline in both currencies will probably await a turn in the monetary policy cycle. In Canada, we expect the BOC to conduct monetary policy less aggressively than south of the border and though a moderation in economic activity is to be expected, it is likely to be more gradual than in the US. This should keep USD/CAD around parity for now.

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

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