FX Forecast Update: Struggling between Greed and Fear

Here are our latest thoughts on the G10 currency markets:

Risk returns. The three best-performing currencies during the past month have been ZAR, BRL and COP (up by 4-5% vs EUR), followed by AUD, ISK and TRY. The worst-performing currencies belong to groups of either low-yielders such as CHF, JPY and CZK (down 1-3% vs EUR), or Asian currencies such as KRW, INR, PHP and IDR. The performance mirrors the development in other parts of the financial market since late March, where risky assets have generally outperformed. Within the G10 space, the exception is NZD (down 0.6%), which has suffered on the back of a re-pricing of the economic outlook. Year-to-date risk aversion still stands out as the overriding theme, with ISK down 27%, ZAR down 18%, TRY 16% and with CHF as the strongest G10 currency (+2%).

EUR/USD 1.60 target reached. Relative to our expectations a month ago, April has been a mixed blessing. We reached our 1.60 target for EUR/USD mid-month, only to see it fall back to 1.55. We had reached our USD/JPY target at 100 in late March, but the subsequent drop in the yen went beyond what we had expected. The same applies to the Swiss franc. While the rally in CHF since October has gone beyond our positive bias, the weakening in April has also been more pronounced than we expected. EUR/GBP rose swiftly in the first part of April, reaching a new high just shy of 0.81, mid-way between our three and six-month forecast, only to correct lower again in the second part of the month. From a starting point of 8.06, EUR/NOK did not quite reach our one-month target of 7.85, but the low at 7.89 came close. EUR/SEK also came close to our 9.45 target (9.429 high), but has since backed down to 9.34. Within the dollar-block, performance has been as widely expected, with AUD outperforming, CAD holding steady and NZD struggling with a deteriorating cyclical outlook. Going into May, we favour NOK, CHF, JPY, SEK and AUD (in that order) over NZD and GBP, with expected returns in EUR/USD and USD/CAD almost flat.

Has the game changed? Conventional wisdom now seems to suggest that the magnitude of policy initiatives aimed at solving the financial crisis during the past eight months is enough to warrant a return to risky assets. Many single out the Bear Sterns rescue package and the subsequent opening of the Fed's discount window to US brokers in March as game-changing events. We think that perhaps a more likely explanation is that speculative positions have been unwound at the same time as long-only investors have started to accumulate distressed assets. US bond markets, for instance, have seen speculative bets in both 2s and 10s being turned from net longs to net shorts since mid-March. Conversations with a number of our institutional (long-only) clients also suggest a gradual increase in their holdings of stocks and credit bonds. Quite likely, the worst of the financial crisis may be behind us in the sense that financial stress has peaked. Going forward, therefore, it is the economic slowdown and the negative implications from the financial crisis that will be the most important factors. Despite the rally in the stock and credit markets, the tail-risk of a deep and protracted distortion of the financial industry, with significant negative repercussions on the global economy, has not receded much. As a result, we believe that the money markets underestimate the amount of policy easing yet to come and, as such, see significant value in the front-end of most yield curves.

Volatility set to rise in May, carry to underperform. Implied FX volatility has risen in four distinct waves since August 2007. Each wave has seen a correction lower while keeping the trend towards higher volatility intact. Since mid-March, USD/JPY implied 1m volatility has fallen from 16.3% to 11.25%. We do not expect volatility to fall much from here and expect it to trend higher due to financial deleveraging and the ongoing global economic slowdown. Consistent with the decline in volatility, G10 carry has performed well in the past month, up by approximately 75% annualised. In recent history, such levels have often marked the peak and have been followed by a period of carry underperformance. If we are right in expecting a turn in volatility as well as in carry performance, JPY and CHF looks likely to gain on high yielders such as AUD, GBP and NZD. Strictly speaking, USD is a funding currency in G10 terms, but higher volatility should see USD/JPY move lower.

Welcome to the European slowdown... We have long held the view that a European slowdown was inevitable. A considerable tightening of monetary conditions, rising food and energy prices, softening housing markets and a slower pace of global economic growth are in combination likely to take a considerable toll on the euro area. The surprising resilience of the German Ifo survey, as well as the ‘take-no-prisoners' attitude from the ECB has helped to conserve the view of a European decoupling. But the barrage of bad news delivered during the past two weeks is making this stance difficult to uphold. The latest rally in the euro has taken it to new highs in terms valuation, both in real effective terms, as well as against USD and JPY. As the business cycle turns, the barrier to new gains will be set increasingly higher.

...but too early to bid farewell to US recession risk. Despite rising market optimism, good news from the US has been in scant supply. The housing market remains in a free fall, consumer confidence has plummeted and the labour market has deteriorated. We think the coming months will witness a further deterioration in key indicators, with the leading ISM likely to head below 45. Consistent with this, we expect the Fed to deliver at least one more rate cut before the summer. Current pricing suggest only a 16% chance of a cut to 1.75% and more than a 40% chance of a rate hike to 2.25% in September. We think this distribution greatly underestimates the need for additional easing. The fiscal stimulus package will begin to impact on consumption patterns from late May onwards. Although the net impact is being moderated by rising food and energy prices, as well as by persistently high mortgage rates, there can be little doubt that both Q2 and Q3 will enjoy a windfall gain. As the effect fades, it may well expose an economy still struggling to stay on its feet.

Whither EUR/USD? In our latest forecast we expected EUR/USD to reach 1.60 within threemonths, only to fall to 1.50 in 12 months. We expected a turning point to arrive around mid-year, partly thanks to a noticeable slowing of the euro area against a back-drop of a considerable euro overvaluation, but also partly reflecting the historical evidence of dollar-turns six months into an economic contraction. It is difficult for us not to argue that the European slowdown is now unfolding, leading to an almost inevitable break with the multi-year upturn in the euro. At the same time, there is an obvious time gap between our forecasts of a final Fed cut in June and the first ECB cut in September. The straw on the camel's back may, in terms of the business cycle impact, not break until the ECB caves in for good, causing considerable uncertainty about the near-term outlook. Technically, a break of the 1.53-1.5350 area could see a swift drop to 1.48 and only a break here will tell us for sure that the upturn has ended. On the other side, only a break above the 1.61-1.6150 area will argue persistently in favour of further EUR gains. To reflect this uncertainty we are cutting our three-month forecast to 1.55 and our six-month forecast to 1.50.

JPY to rise.... The fall of the yen in the past weeks is consistent with a shift in relative rates in favour of the US, the fall in volatility and the rise in the equity markets. These three factors easily dominate the positive impact from rising energy prices. Our short-term model based on these factors has seen the fair value estimate on USD/JPY rise from 95 in March to 105, not far from present levels. Our bullish call on the yen is thus heavily dependent on a reversal of the current market climate. In favour of the yen is also a more constructive economic outlook than currently found in either the US or Euroland, in the sense that we expect the Bank of Japan to leave rates on hold for the foreseeable future. However, it would be foolish to ignore a shift in trade as well as capital flows that are now again net outbound from Japan. Overall, we expect the yen to gain on both USD and EUR in the months ahead.

...together with CHF. One of the main questions regarding CHF is whether the current historical high correlation to equity markets will persist. We believe it will not. There is no fundamental reason to expect a high correlation in the long term and extrapolating the current relationship too far into the future when making forecasts therefore appears a dangerous strategy. Nonetheless, it should not be ignored in the short term and even a gradual normalisation of the correlation would weigh on CHF if equity markets continue to rally. The improvement on the equity markets is, however, not the only explanation of the recent rise in EUR/CHF, as the interest rate spread to Euroland has widened. We consider the recent sell-off in the front end of the curve as relatively more excessive in Euroland and expect a narrowing of the interest rate spread going forward. We furthermore continue to see both the economic and inflationary outlook as favouring CHF. Netting out the factors, we therefore continue to see the case for a lower EUR/CHF.

GBP under pressure. It took a lot of doing, but the MPC members managed to get into step and lowered the base rate to 5% in April, thereby continuing the easing cycle that began in December 2007. Falling house prices are now a reality and the economy is set to underperform in H2 08 and possibly also in H1 09. Inflation is set to rise above letter-writing territory (3%) creating a dilemma for the BoE and making it extremely difficult to cut rates aggressively, which might be needed if avoiding the British economy is a concern for the Bank. We expect more bad data out of the UK in the coming months and a BoE focus on medium-term inflation, which is set to drop to comfortable levels. Accordingly, GBP will remain under pressure over summer but can perform well against EUR when the ECB reacts to the inevitable European slowdown, that is on the 6-12M horizon.

Strength for Scandies. The surge in oil prices and a relatively hawkish central bank have so far failed to support NOK significantly and the missing rally of the Norwegian currency remains a puzzle (see FX Crossroads 28 April 2008). Inflation is still on the rise; unemployment is still heading lower despite the extraordinarily low level and the overall growth of the Norwegian economy is still sound. However, as a whole, the market is extremely short EUR/NOK and this might limits NOK performance in the near term. We still expect strong performance in the medium term and have kept our forecast for NOK strength going forward. SEK: The Riksbank has remained stubbornly hawkish despite the global economic slowdown set to hit Sweden harder due to the openness of the Swedish economy. The outlook of lower policy rates in Sweden is postponed to 2009 due to elevated price pressures, set to create a positive policy rate spread vs the euro area for the first time since spring 2004. Also, M&A flows are set to support SEK throughout the year and we have therefore lowered our EUR/SEK profile slightly.

Expect further divergence down under. Our view on the dollar-block currencies has proven robust during the past month, and our fundamental call remains broadly unchanged. AUD continues to see support, as commodity price inflation edges higher and yet another CPI surprise has induced the market to price out expected rate cuts from the RBA. We expect AUD to remain resilient in the short term and have opted to raise our three-month forecast of AUD/USD to 0.93. Meanwhile, the growth outlook in New Zealand has deteriorated further, causing the market to price in a more aggressive monetary easing. This discrepancy in economic and monetary outlook has taken AUD/NZD above 1.20 and we are forecasting a move toward 1.24 during the summer. We have not changed our forecast on USD/CAD and are still expecting the cross to trade around parity in the short term.

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

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