FX Forecast Update: No Country for Old Men

Here are our latest thoughts on the G10 currency markets:

Ain't no sunshine. Though financial markets saw patches of sunshine in February, the environment remains unusually hostile. Stock markets have generally traded sideways, but financials' lack of performance has been noteworthy. Equally, bond markets corrected in the first part of the month but interest rates have fallen sharply during the past week. Credit markets have been outright gloomy and IPOs have been pulled from markets in record volumes. Despite central bank attempts to add liquidity, TED spreads (the difference between t-bills and interbank rates) have risen as well. The outlook for housing markets has yet to improve and commercial real estate may be the next shoe to drop. To add insult to injury, headline inflation has risen sharply in most countries. However, there has also been some good news. Commodity prices have risen, as has the Baltic Freight index. Within equity markets, materials, energy and industrials have outperformed, normally a sign of global economic strength. Furthermore, a substantial easing of fiscal policy lies ahead in the US. To be sure, whether you believe the glass is half full or half empty, the environment is challenging. Our call remains that markets will be guided by the dual shock of an economic slowdown and a financial crisis and we continue to recommend a cautious investment stance.

Commodity currencies gain. In the world of FX markets, currencies such as ZAR (down 9% vs. EUR), TRY (down 8%) and ISK (down 4%) have unperformed sharply during the past month. Within the G10 space, USD and GBP have performed the worst (down circa 2.5% vs EUR). Asian curren-cies have also underperformed, disproving the thesis that rising inflationary pressures would speed up currency appreciation in the region. The best performing currencies have again been CHF, CZK and JPY (up by 1.5 - 2.5%), followed by commodity sensitive currencies such as NOK, BRL and AUD. The split in performance between G10 carry and EM carry is striking, highlighting that com-modity exposure and domestic demand is currently more relevant than the allure of high interest rates.

Dollar downturn still not over. Last month we wrote "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". We still consider it premature to turn bullish on the dollar. The economic downturn appears to be deepening to a point where the risk of a recession is close to even. Housing market indicators have deteriorated, the labour market has softened and consumer confidence has plummeted. Despite aggressive rate cuts, lending rates remain elevated, highlight-ing a potential weakness in the monetary transmission mechanism caused by the credit crisis. While global banks have been able to recapitalise their balance sheets, local banks are likely to struggle to attract global investor interest, and the result, as Fed Governor Bernanke pointed out in last week's testimony, could well be several bank failures. We continue to expect the Fed to cut rates to 2% by June. A crucial issue for financial markets is the forthcoming fiscal package. Tax cuts worth USD 100bn are due in 2008, with another USD 10bn due in 2009, equivalent to a sub-stantial 1.1% of disposable income. The IRS is likely to begin sending out checks in late May at a rate of 9m per week, suggesting that the economic impact will be concentrated in Q2 and Q3. Even assuming cautious response by consumers to the lift in income, spending will inevitably increase. However, come Q4 the good days could be over. The likely result is an uneven pattern for the US economy for the coming year that may be the cause of financial volatility but provide little direc-tional guidance. Overall, we expect further dollar weakness until credible signs of a turn in the economy emerge.

New high in EUR/USD. The euro area has yet to slow significantly. Inflation has risen and data has generally been solid enough to allow the ECB to cling to a hawkish stance with some credibility. We do not doubt, however, that the euro area will slow this year and that the ECB will move to cut rates. We still pencil in a rate cut by June, the same time as we expect the Fed to signal a pause. Our 1.52 target for EUR/USD has now been reached and a new lifetime high of 1.5240 has been set. We ex-pect the dollar to weaken further in the coming months and are setting a new 3-month target of 1.55. We are biased for a turn further out, but have lifted our 12-month target to 1.45 from 1.40.

USD/JPY still expected to fall to 100. The yen weakened in the first part of February, but as we suspected it was a temporary decline. We remain confident in our call for a further rally and con-tinue to target a move in USD/JPY to 100. Ultimately, we also believe in a pronounced drop in EUR/JPY. The economy is shifting to a lower level of activity and while it is not our current forecast, a recession is a risk. As the fiscal year-end approaches, the focus may turn to possible hedging of equity portfolios as the clear underperformance of the Nikkei during the past year suggests that global equity investors may be short JPY relative to benchmarks. Furthermore, the turn of the fiscal year may also reveal further losses from subprime-related debt at Japanese banks. Should this re-sult in a decline in equity prices, the yen could benefit. We do not consider intervention an imminent threat.

GBP to fall further... We expect the GBP to remain under pressure in the coming months as the troubled housing market and the decline in PMI figures bear witness to a slowing British economy. Although the BoE has stated that it has less scope to respond to slowing demand due to elevated inflation expectations, we still expect rates to fall to 4.50% by the end of the year, with the first move likely in May. Risk reversals still point towards further sterling depreciation while relative rates and equity prices favour some appreciation. We think the truth lies in between and remains biased towards sterling weakness.

...and EUR/CHF to trend lower. We warned a month ago about the risk of a rise in EUR/CHF based mainly on the expectation of a correction in oversold equity markets. With that correction likely to be out of the way, the path of least resistance is again for EUR/CHF to trend lower. We believe that global financial deleveraging will see at least a partial reversal of the multi-year decline in CHF from 2005-2007 and target a decline in EUR/CHF to 1.55 in the coming months.

Surprise, surprise. Ignoring signs of weaker growth at home and abroad, the Swedish Riksbank sprung a surprise rate hike in February and gave no indication that an easing cycle was approach-ing. The ensuing shift in relative rates gave some support to SEK, but a rise in risk aversion soon had the better of the currency. The Riksbank's hawkish stance and an earlier start to the euro-area easing cycle could give some support, but global issues as well as market expectations of Swedish rate cuts could just as easily push EUR/SEK higher. The result could well be continued range trad-ing for EUR/SEK within the well-known 9.20 - 9.50 band.

Solid support for NOK. Our bullish stance has stood the test of time well and in February NOK was the best-performing G10 currency after JPY and CHF. We continue to highlight Norway's enviable cyclical position, with the prospect of further rate hikes this spring, as well as its exposure to rally-ing oil prices. Our 3-month target of NOK 7.80 from last month came close to being met towards the end of the month and we have lowered our target to NOK 7.75. The main risk factors are a sharp drop in oil prices or a similar rise in risk aversion.

AUD/USD at parity? AUD and NZD were among the top-performing G10 currencies during the past month. Both currencies have gained support from accelerating commodity prices, from strong domestic data and from reduced risk aversion during the better part of February. Both currencies have historically depreciated during periods of slowing global growth and rising uncertainty and the ability to resist that pattern in 2008 so far is significant. While we have argued that AUD and NZD could see short-term support, we also believe that both could end the year lower. We maintain this view, but stress that the support for both currencies could persist for some time and that a cyclical turn has moved further away. This is particularly the case for AUD, where two more rate hikes this spring should prolong the uptrend and secure outperformance relative to NZD. The CAD has also gained support from rising commodity prices and is likely to outperform a falling USD in the coming months. However, with Bank of Canada in the midst of an easing cycle, CAD looks set to underper-form the rest of the dollar block for now.

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

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