FX Forecast Update: On the Brink of a Global Recession

Here are our latest thoughts on the G10 currency markets:

When we presented our latest FX forecast at the start of July (see FX Forecast Update: To catch a rising tide), we were quite sure that EUR/USD was set to go higher. This prompted us to revise up our short-term forecast for EUR/USD to 1.60. However, we were not prepared to abandon our expectation of the inevitable turn in the enduring ascent of the euro, and so we kept our 1-year forecast of 1.50 intact. Events have moved fast since then, with EUR/USD already hitting a new high of 1.6038 on 15 July and then tumbling below 1.50 in early August. To be sure, it is not only the euro that has lost ground to the dollar, which underlines that the main explanation behind the movements of recent weeks is heightened fears of an economic downturn outside the USA. While the economic woes of the USA should definitely not be underestimated, there now appears to be an increasing risk of a global recession, or at least a G10 recession, which has yet to be accepted as conventional wisdom. Since the problems of the USA have been plastered across the front page for rather a long time, the cyclical impulse to currency markets in the coming months is likely to be beneficial to the dollar.

EUR/USD likely to fall further. There are three sound reasons why EUR/USD could continue to decline in the coming year. First, the euro is decidedly overvalued relative to historical benchmarks. This can continue as long as the economy is expanding, but in a downturn, with several countries on the brink of recession, it can be difficult to maintain. Second, Euroland has experienced a significant outflow of capital in the past several months (see EUR: Where's my 75bn?). From a historical perspective, it is rather unusual that the euro has been able to rise at the same time as net capital flows have been outbound. One likely explanation is that while there has been an outflow overall, there has been a significant inflow from the USA, as European investors have been aggressively selling US securities since last summer. However, we do not believe this will continue. Third, one should not underestimate that the USD typically strengthens between 6 and 12 months into a US slowdown, or that the USD often benefits from a global hard landing. There are, of course, risks in the other direction, including the significant cyclical and structural problems that lie ahead for the USA, just as economic policy targets after the November election are unclear. Overall, though, we believe that EUR/USD could fall further in the coming year, but just as was the case in 2000/2001, the turnaround could be slow in coming. We have reduced our forecasts to 1.45 in 3m, 1.43 in 6m and 1.40 in 12m.

JPY likely to outperform. The yen has been unable to match the pace set by the dollar in the past month, but is nonetheless the second-best performing G10 currency. We expect the yen to perform well in the coming months, driven largely by global factors. Depending on your yardstick, Japan may already be in recession, but - contrary to popular belief - this has historically been of little importance to the yen (see Japanese recessions and the yen). Instead, key drivers at present are US rate expectations, global risk appetite and speculative positioning. We expect US bond yields to head lower in the coming months, volatility to rise further and leveraged JPY shorts to be reduced - all of which argue for a stronger yen. The main risks to our forecast appear two-fold: First, relative US economic strength could propel USD higher across the board and, second, Japanese capital flows, including the trade balance, have deteriorated considerably of late. Nonetheless, with the BoJ likely to remain on hold, EUR/JPY should move lower as expectations of a European recession are likely to rise. We expect USD/JPY to move towards 105 and EUR/JPY to fall below 160.

Fundamental view still bullish on CHF... EUR/CHF has held to a narrow 1.60 - 1.64 range since April. We are still biased for a move lower, targeting 1.56 in the coming year, but the lower end of the range may be difficult to break. Our economics team is no longer looking for a September hike, but relative rates should be moving in favour of the CHF as ECB rate cuts are being increasingly priced. While we expect the Swiss economy to modestly outperform the euro-area, the key arguments in favour of CHF appreciation beyond mere valuation considerations is reduced leverage in currency markets as the liquidity cycle tightens further.

...and still bearish on GBP. We have been bearish on GBP since autumn last year; first as a response to the financial crisis and, second, in reaction to the economic downturn. The Bank of England (BoE) has been burdened by a rapidly deteriorating growth outlook and soaring price pressures, and while high and rising inflation has put the central bank on hold, we expect the BoE to resume its easing cycle when it has been confirmed that inflation rates are falling. Accordingly, we anticipate that the BoE will continue to lower rates in the beginning of 2009, taking the base rate down to 4% by year-end. We expect sterling to be under further pressure for the rest of this year, but more so against the dollar than the euro: due to the rapidly advancing slowdown in the euro-area we have lowered our 3m EUR/GBP forecast from 0.82 to 0.81.

A final hike in Sweden? Near-term focus in Sweden is on the Riksbank rate decision on 3 September. The Board is evenly split, and since the July meeting the hawks have been supported by higher than projected inflation and a further rise in inflation expectations, while the doves will point to a sharp deterioration in almost all growth-related data as well as in commodity prices. Though a close call, we expect the hawks to carry the day and secure a final 25bp hike in September. Further out, we now expect a series of rate cuts in 2009 based on a sharp slowdown in growth, a fall in inflation and further weakness in the labour market. Euroland is facing a similar challenge, and the relative play between the ECB and the Riksbank will be important input to EUR/SEK this autumn. At present, however, the dominant driver for SEK has been risk sentiment and stock market developments. Without further improvements in both, we see limited downside potential in EUR/SEK. On balance, we adjust our forecast for EUR/SEK upwards to 9.45 in 3m and 9.30 in 12m.

NOK'ing around. EUR/NOK has held to a tight 7.95-8.10 range in the past two months, as a lack of commercial interests over the summer and falling oil prices have outweighed the lure of high interest rates and a relatively robust economy. Norges Bank raised rates to 5.75% in June, but we now expect the bank to leave rates on hold for the foreseeable future. Though still looking sounder than the euro-area in general, the decline in global activity is also weighing on the Norwegian economy and output figures for Q2 are likely to be flat. Historically, NOK has performed well in September ahead of the payment of oil taxes, but this effect is likely to have disappeared following a recent restructuring of tax payments. Overall, consistent with our call for a move lower in EUR/USD, we look for EUR/NOK to rise modestly in the near-term to 8.10 in 1m and 8.0 in 3m, but still forecast a return below 8.0 further out.

AUD and NZD tumble. Currency performance down under has been dramatic in the past few weeks, with both AUD and NZD tumbling more than 10% vs. USD. Though we have had a long-term negative view on both currencies - more so on NZD than AUD - spot rates have fallen to or below our 12-month forecasts from July. The fundamental drivers are straightforward: New Zealand is widely seen as being in recession and the Australian economy is also losing momentum. Both currencies are overvalued and both are backed by massive current account deficits. As was the case with GBP late last year, cyclical turning points can then have a substantial impact on exchange rates, particularly when combined with rising risk aversion. In the near-term, a bounce-back is highly likely, as growth concerns are overdone, but the medium-term outlook remains negative. Further, Japanese margin accounts still appear substantially long both NZD and AUD and further losses could trigger aggressive stops.

Danske Bank

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