Outlook for 2007

Key Points

• Global liquidity growth only modestly impaired by higher interest rates - global investor risk appetite still high.
• This suggests upside bias for global interest rates.
• US mid-cycle slowdown unlikely to last - good chance of further Fed rate hike in 2007.
• ECB rates heading for 4.25%, although BoJ may struggle to raise rates at all until Q3.
• Upward pressure will persist on EUR-USD, but USD is likely to show resilience.
• Few authorities will have an interest in significant EUR-USD gains.
• JPY at risk of further weakness in H107 on lack of yield support.
• GBP to retain reasonable support, but structural question marks could see underperformance against the EUR.
• CAD at risk initially due to cyclical doubts, but solid fiscal/BoP fundamentals should eventually support.
• AUD and NZD to retain good high-yield arguments, but NZD could eventually be vulnerable to current account issues.
• Both SEK and NOK should outperform EUR.
• CHF to remain soft against EUR.
• USD-CNY decline could accelerate slightly in 2007.
• Emerging currencies will retain good support for most of 2007, although the establishment of higher global interest rates may cause volatility in H2.
• Forecast table on Page 10.

Global market conditions

Given the strength in global asset markets and various measures of global liquidity it seems reasonable to assume that global monetary conditions are not tight enough. For this reason, it is assumed that rates in most countries will have further to rise in 2007. The chart on the right shows y/y growth in USD securities held in custody at the Fed for official institutions (one could also use total global FX reserves as a global liquidity measure). While the growth in this number is off the peaks seen a couple of years ago, it remains strong. Also note the relationship with US real interest rates.

When US real rates are low it says two things - 1) USDs are cheap to borrow and 2) that the rate of return in the US economy (and on real US assets) is low. The logical conclusion is to borrow USDs and invest them outside the US and this is precisely what happened from 2002-2004, in addition to the flows that were exiting the US via the current account deficit due to the consumer being supported by low real interest rates. Indeed, this is why central bank reserves grew so much during the period and why they are a decent measure of global liquidity as central banks were on the ‘other side' of the private sector flow out of USD. It also shows that Fed, by keeping ultralow rates, had a primary role in the expansion of global liquidity. The rise in US real rates since early 2005 has helped to slow liquidity growth and as one can see from the evidence on FDI and equity balances in the US balance of payments, the outflows on these categories have also been sharply cut back this year compared to 2003 and 2004 (the inflow seen in 2005 should probably be ignored as it was purely driven by the Homeland Investment Act and involved movements out of existing USD holdings). However, liquidity is still growing at a fair pace (15% y/y), which is of no great surprise when one considers that real US rates remain well below the peaks seen in the past.

If global rates continue to rise this could present some challenges for bond markets, although support should remain broadly intact as long as inflation expectations stay under control, which seems likely. Higher risk markets like equities and emerging currencies look like performing reasonably well, although one can envisage some similarities to 2006, where the market is subject to moments of concern related to fears of a hard landing, albeit at a higher level of interest rates.

Fed policy debate delicately balanced

In spite of the above, recent data weakness in the US has raised doubts over whether the FOMC will proceed with any further tightening in 2007. However, from a domestic point of view real US interest rates remain historically low, at least in terms of their being restrictive enough to generate a true peak for the economic cycle, so further tightening would not surprise. The big uncertainty is how far the current mid-cycle type slowdown extends, although it will have to be fairly marked to warrant a rate cut. Our core view is that activity strengthens at some point over the next two quarters and that the Fed hikes again in Q3.

The housing market will be a key factor going forward given the implications for consumer and manufacturing sectors. There have been tentative signs of housing market stabilisation towards the end of 2006 with mortgage applications looking better and this needs to persist to clear the high stock of unsold homes. Only then will the downward pressure on residential construction subside. Home sales have yet to show any sign of recovery, although it is too soon for the pick-up in mortgages to have had any noticeable impact on the sales data that has been published.

So far the impact of the housing market has been fairly limited, although it is reasonable to assume that consumer spending would have been stronger (due to lower fuel prices) if the housing market had held its ground. Still, consumer sentiment has been fairly upbeat, with most measures close to the year's highs. Key now is whether the tentative evidence of housing recovery turns to reality soon enough to spur some additional strength in spending and this will be significant for FOMC policy.

The weakening in the construction industry, at least from a residential perspective, will inevitably have knock-on effects to equipment made in the manufacturing sector and this could be a reason why the ISM has been weaker in recent months. Whether the move below 50 in manufacturing ISM is sustained will be significant and the state of the housing market will influence how conditions develop in manufacturing. Overall, pronounced manufacturing weakness looks unlikely and a recovery should develop in the months ahead.

On the inflation side, core PCE price pressures should ultimately subside, but they are likely to remain elevated enough for the Fed to retain a cautious attitude to policy. Indeed, with a whole host of commodity prices showing strength there is upside risk to this view. It is the combination of this, a recovery in economic activity, historically low real rates and buoyant asset markets that is likely to prompt the Fed to tighten further.

ECB rates heading for 4.25%

Eurozone economic activity has shown little response to the tightening in monetary policy seen over the past year. Part of the reason for this is that the ECB has not really been tightening at all, but merely taking away the easy monetary conditions previously in place. Indeed, in the statement made after the latest hike to 3.5% the ECB said that policy remained accommodative.

The combination of strong economic activity, easy monetary policy and strong liquidity growth remains an uncomfortable one for the ECB and unless there is a dramatic change of fortune in the data they are likely to pursue a restrictive policy in 2007. This should mean rates reaching 4.25%. The ECB is likely to announce 25bp rate hikes in February and April and then it is unclear whether they will proceed to 4.25% in June or wait and see for a few months. The latter scenario is perhaps more plausible. It seems unlikely that 4% rates will be enough to satisfy ECB concerns and another move could be thrown in for good measure in September.

One potential complication to this scenario is the impact of the German VAT hike from 16% to 19% scheduled for January 1. This is a significant rise and somewhat perversely perhaps a reason why activity in Germany is currently so upbeat i.e. spending brought forward to avoid the hike. The consequence of this should be lower spending in Q1, although business expectations suggest that such weakness will be limited or transient. The big question is whether businesses have such foresight or have merely been transfixed by the short-term uplift in spending. Time will tell, but there has been a robustness to the German economy over the past year or so that has been absent since reunification, so there is room for optimism. The latest IFO reading for example reached its highest level since records for a unified Germany began in 1990. A big factor has been the changes to labour market practices pushed through by the private sector over the past couple of years. This has introduced a degree of flexibility hitherto unknown for German employers.

There has been a lot of criticism aimed at the government for continuing with the VAT rise given that the economic recovery has provided a significant boost to tax revenues. However, while one can understand this line of attack, the move should put the German public finances on a more solid footing and this could actually boost national confidence in Germany given that the country has been under a fiscal cloud since the birth of the EUR.

EUR-USD

The profiles for respective monetary policies set out above would appear to be quantitatively more supportive for the EUR than the USD when gauged against current market expectations. However, US rates will remain comfortably ahead of those in the Eurozone and there will be additional qualitative value for the USD if the current concept of a peak in US rates is overturned. Overall, it looks fairly even, although there will inevitably be periods when the news flow will favour one currency over the other.

A 1.20-1.40 range is likely to confine activity on EUR-USD, with the EUR likely to retain an upside bias within these parameters owing to the usual structural arguments (US balance of payments and CB reserve diversification). However, while these are significant factors, they can be overplayed at times.

The current account deficit has been stabilising over the past four quarters and while the deficit still has to be financed, it is a starting point for possible improvement in coming years, especially with the US fiscal deficit also now heading lower. The distribution of demand between countries is also becoming more conducive to some deficit stabilisation (although the deficit with China will remain under upside pressure). There are also growing signs of renewed interest in US asset markets from private investors, even though this remains well below the very high standards set in 1999 and 2000.

Reserve diversification will be a recurring USD negative over coming years, but it is likely to be pursued tentatively by central banks. Indeed, this whole procedure is one reason among many why most authorities will have very little interest in seeing a major short-term weakening in the USD against currencies such as GBP and the EUR, as this would undermine existing official holdings.

Also, compared to Asian currencies there is less justification for it on the basis of existing trade imbalances, as the Eurozone deficit with the US is less than 12% of the total US deficit and is currently stabilising. Indeed, one could argue that the growth in the deficit in prior years owes more to the differential between domestic demand in the US and the Eurozone rather than the exchange rate and this is now being rectified given the resurgence in the Eurozone. In GBP's case, the UK is responsible for just 1.2% of the US trade deficit (see below for more on GBP).

Challenging times for the BoJ

The BoJ is naturally keen to raise interest rates back to more normal levels, in part because of the need to avoid excessive capital expenditure and excess capacity. One can understand their concerns as such a development in the 1986-1991 period created many of the problems experienced by Japan over the past 15 years. Indeed, even now the level of non-residential capex (for Q3 2007 in current price terms) is still 16.3% below the extraordinary peak of Q1 1991.

However, after so many years of living with ultra-low interest rates the Japanese public will need to be convinced about the need for higher rates. With consumer spending and CPI remaining weak it is an argument that the BoJ does not seem to be winning at the present time. Of course, the more lacklustre the economy is the greater the pressure on the new government and this in turn is likely to mean government pressure on the BoJ, especially the closer we get to the Upper House elections in July.

It is looking increasingly likely that the window of opportunity for a rate hike is closing and may not open again until Q3. For this reason we have BoJ rates left unchanged until Q3 with a further hike in Q4. Clearly, if consumer spending suddenly recovers and core CPI inflation moves above 0.5% it would make it easier for the BoJ to pursue a rate hike in the months ahead and this would be also be more tolerable from a government point of view.

However, the risks are not all one way. November CPI data to be released on December 26 is likely to see key y/y rates being boosted by 0.1% due to last November's mobile tariff cut by NTT DoCoMo falling out of the y/y rate. However, this is still likely to see the true core CPI y/y rate (excluding both food and energy) staying well below zero (it is currently -0.4% y/y) and as long as this is the case it is not inconceivable that other key CPI measures gravitate to this core rate. This would be the worst of all worlds - the return of deflation. This is not a core assumption, but it is a tangible risk of similar magnitude to those that lie on the upside for BoJ rates.

More JPY weakness favoured initially

Against a backdrop of continuing low interest rates the JPY will remain vulnerable to attack and a significant move above 120 looks likely on USD-JPY during Q1. The 158-160 area is likely to be seen on EUR-JPY. Support will eventually come from rate hikes in the 2nd half of the year and the fact that the JPY is overdue an adjustment against other Asian currencies. Indeed, if there is a sense that the pressure on the Japanese economy is relenting, the rest of the G7 will feel more able to push the case for a stronger JPY as one factor driving a rise in other Asian currencies, notably the CNY. It would also address concerns in the Eurozone about EUR-JPY.

UK MPC still in tightening mode

The UK MPC is currently of the mind that with economic activity being fairly robust it is free to concentrate on taking no chances with CPI, hence the rate hikes pursued in the second half of this year. Until there is a sign of a weakening in activity, particularly consumer spending, this approach will be maintained and there is a risk of another hike in H1 2007 (most likely February). Current evidence on the consumer is fairly mixed, with most retailers reporting sluggish sales unless heavy discounting is employed.

For the MPC's part they have slightly differing views on inflation risks, although there appears to be universal agreement about wage settlements being key over the next few months. We assume that wages remain fairly well behaved and will not provide a platform for further tightening in 2007. The housing market is an oddity, with the south-east and especially central London the current main performers. This is related to financial market bonus expectations and global liquidity in general finding its way into London. Thus far the spillover to the rest of the country has been limited, so the impact on the consumer and policy is not the same as it was in the boom of a few years ago.

Question marks over GBP fundamentals

The cyclical backdrop should remain reasonably solid in the UK, although one risk for GBP will come from any renewed market focus on some of the structural question marks being raised about UK fundamentals. These not only relate to the current account deficit, which has been advancing, but also the growing role of the pubic sector. Whereas most of the developed world has been intent on rolling back the state, the UK has been moving significantly in the opposite direction and the Chancellor responsible for this development is about to take over as prime minister. This is clearly a threat to the competitive advantage previously enjoyed by the UK and could affect the UK's status as a favoured destination for foreign direct investment. The fact that labour market flexibility remains high is a big saving grace in this regard, but Eurozone countries are slowly catching up. Long-term question marks over UK fundamentals will remain in place. Overall, GBP is likely to underperform against the EUR and a sustained break above 2.00 against the USD might once again prove to be elusive.

CHF

EUR-CHF has made a more decisive move above 1.60 in recent weeks and while the SNB has been reiterating the view that there is no reason for excessive CHF weakness, they appear to be slightly more relaxed about it than they were a few months ago. The reason for this is probably the CHF advances against the USD, as the SNB look at a real trade-weighted index of the CHF when judging its overall performance and the impact it is likely to have on the economy and prices. As SNB chairman Roth noted at the SNB's recent annual press conference, the real TWI is merely back to where it was in 2000. Looking at the chart (see next page), this is definitely true, but such levels are also close to the lows of the past decade. The November average for the real TWI was 95.6 and this compares to the low of 93.7 seen in March 2000. However, after recent movements in USD-CHF and EUR-CHF, this index is likely to have fallen by almost 1% since November, so it is not far off the 2000 low.

Does this mean that the SNB are going soft on the CHF and will tolerate a move below this area? One reason for such speculation is the big downgrade to their CPI forecast for 2007 (+0.4% from +1.1% previously) and some softening in certain aspects of the Swiss data in recent months e.g. the KOF indicator. However, economic activity overall looks reasonably good and is likely to remain so over the coming year, meaning steady SNB tightening of least 75bps. Overall, their tolerance of CHF weakness is likely to be fairly limited. At a push it is likely to be confined to 1.65 on EUR-CHF or more likely, 1.62 given that this is equivalent to the highs seen in 1999. On the basis of recent global asset market performance, safehaven arguments have not entered into the equation for some time, although they are likely to resurface intermittently during 2007, especially in the second half of the year if global markets show any periodic retracements. This certainly provides scope for pullbacks in EUR-CHF at various times during the year.

CAD

The CAD has been suffering a little over the past few months following lacklustre economic numbers, with retail sales and manufacturing data having weakened noticeably. Also, while commodity prices in general remain strong, oil and natural gas prices have been soft and these are the areas to which the Canadian economy is exposed. The softer economic backdrop is likely to mean more USD-CAD strength in the next few months (1.17-1.18) until the economy starts to improve, which it should eventually do. Flat BoC rates are assumed for 2007.

Canada also has a reasonably healthy set of fundamentals when it comes to the public finances and balance of payments and this should also support the CAD. Some affordable fiscal easing is likely over the next couple of years that will and this should benefit domestic demand. Still, even this positive attribute is not receiving good press at the present time, as the government seems to be undecided about how best to proceed. It is trying to juggle several pre-election promises. The biggest risk to the CAD will come from a pronounced downturn in oil and natural gas prices. Any move above 1.20 would also open up technical dangers to the upside.

AUD

The AUD is likely to be well underpinned by RBA rate hike expectations, with at least one more hike due in 2007, although in the absence of additional rises most of the positives may already be in the price. The main upside risk for the AUD will come from any flows that are triggered by the existing high level of interest rates, especially when compared to what will be a fairly miserable looking JPY. However, the AUD will need to show signs of breaking above the 0.80-0.82 area to create additional upside momentum and while this is certainly a risk, it is not part of our core scenario. The commodity story is likely to remain intact through the period and should remain a supporting factor for the AUD.

NZD

The turnaround in NZD sentiment since the beginning of 2006 has been fairly dramatic. It was around this time last year that sentiment regarding the NZ economy started to falter significantly and by the end of March, the March 2007 3-mth bill future had moved to an equivalent rate of 6.24% compared to the cash rate at the time of 7.25% (which remains in place). For a high-yielding currency that had been enjoying large inflows from Uridashi issuance it was a dramatic turn of events and left the NZD vulnerable to net redemption outflows from Uridashi rather than net inflows. However, the weakness in the economic numbers was never built upon and stability in the middle of the year has turned into genuine strength in recent months, allowing rate hike expectations to be rebuilt. The same March 2007 3-mth bill future now stands at 7.78%.

An RBNZ rate hike does look likely in January after the release of Q4 CPI data and the market is taking the view that having done one they will probably hike again. However, this is not set in stone so there is some slight room for disappointment. Still, with rates at such high levels, especially when compared to Japan, there is likely to be decent flow into NZD. Uridashi issuance has already been picking up and this is significant as redemptions from Uridashi issuance in previous years (it is typically 2-yr maturity) will still be coming on stream through 2007. Official attitudes to the NZD have also softened slightly over the past couple of months. Finance minister Cullen has become less vocal, while the RBNZ acknowledged in December that while the exchange rate was challenging for manufacturers, primary exporters had been afforded some protection by strength in key commodity prices.

More NZD strength looks likely for a time in Q1 and this could see an extension to 0.72 but it is unlikely to be sustained. Current account issues will remain a stumbling block for the NZD and will likely return as a negative factor, especially if growth slows.

SEK

The SEK has been showing independent strength since October and looks poised to benefit further during 2007. Cyclical factors have been supportive for some time, although the recent faster pace of rate hikes has upped this as a positive. Further steady tightening looks likely in H1 2007 (possible 25bp rate hikes at each of the four meetings during this period) with SEK40bn in income tax cuts set for January also likely to support the consumer.

The other major factor in 2006 was the change of government in September. The new centre-right government was been voted in on a clear mandate of labour market reform, deregulation and state asset sales. SEK150bn worth of assets have been earmarked for privatisation and while no time scale has been set for this programme, it is likely to promote an environment that is supportive for the SEK in terms of capital inflows (M&A possibilities as well as foreign buying of state equity sales). The Swedish government has stated that it will not seek to protect Swedish companies from foreign ownership. There seems to be something of a sweet spot building for the SEK and sub-9.00 levels on EUR-SEK should be extended in the short-term and through 2007.

NOK

The NOK was a casualty of the initial pullback in oil prices in August/September, even though the vast bulk of oil earnings are recycled back into foreign asset markets. The more plausible argument for NOK slippage during times of oil price weakness is related to equity outflows. For example, the Aug- Sep move in EUR-NOK also coincided with weakness in Statoil's share price. However, the situation has stabilised since then and the momentum of the EUR-NOK upmove has also run out of steam. While a risk premium related to oil will remain attached to the NOK, further major weakness in the oil price looks unlikely, with OPEC now keen on ensuring stability.

A move back below 8.00 on EUR-NOK remains favoured. In the absence of oil-related volatility the NOK is also well supported from an interest rate perspective. Mainland GDP growth remains strong and further rate hikes look likely during the course of the year. The current official rate is 3.5%, although this could reach 4.75% or 5% by the end of 2007.

Emerging Currencies

The year has ended on a slightly sour note with the experiences seen in Thailand, although there is no doubt that high levels of global liquidity and investor risk appetite remain constructive for these markets. Indeed, these are the two key issues that will dominate through 2007 - a) whether liquidity conditions and investor risk appetites change in anyway and b) how countries respond to any further undesirable strength in their currencies.

As noted in the section above on global markets, liquidity remains in abundance and this is unlikely to change until interest rates move to much higher levels. In essence though, this is not the way that liquidity support will start to subside. It is more likely to develop initially through a change in investor expectations about the rate of return (relating to investor risk appetite and the impact of higher interest rates on growth expectations). As noted above, there will inevitably be intermittent fears about a hard landing, especially in the 2nd half of the year, which could see periodic sharp outflows from these markets. However, this is unlikely to cause lasting destruction.

The other point relates to how countries deal with currency strength. Clearly, for Asian countries in particular such concerns would be less of an issue if the CNY and the JPY were a lot stronger. It is the fear of losing competitiveness to China and Japan in third markets that lies behind the concerns of other Asian countries and this is perfectly understandable. The situation regarding the JPY looks set to get even worse during H1 2007, with low Japanese interest rates likely to push USDJPY higher, which brings us to the CNY.

China is under intense pressure to allow things to develop at a faster rate and the more diplomatic approach adopted since Paulson has taken over has now become slightly more aggressive on a different front. While Paulson has acknowledged Chinese concerns about the need to make financial reforms before allowing more flexibility in the currency, the recent delegation of high ranking US officials to China suggests that the US is now keen to offer help to facilitate such reforms. China's response to this latest development was decidedly frosty, probably because they once again feel uncomfortable with US interference and the fact that they do not want to be seen to be responding to US pressure, even though this is pressure of a more constructive kind. Diplomacy won the day once again though, with both countries pledging to take actions to resolve current account imbalances.

However, it is clearly the case that China has more readily embraced CNY strength since the middle of the year, in part because of the slightly different approach of Paulson, but also because China has become more comfortable with economic performance vis-à-vis the exchange rate. The 2005 move to loosen the CNY was something of a leap in the dark as far as China was concerned, but the transition for the economy has been an incredibly smooth one. The current trend in USD-CNY (i.e. since August) is to move around four big figures every month, which is much faster than the one big figure per month pace seen in the first year of the new CNY regime. If the recent pace is maintained it would suggest something close to 7.35 by end-2007, so 7.25 is pencilled in on the basis that the risk is for an even faster pace.

This will provide some small comfort to other Asian countries, although with the JPY likely to remain weak in H1 2007 the benefits will not be felt until the 2nd half of the year. Asian crosses against the JPY will once again be stretched in Q1 if our JPY forecast is correct and while this will offer some support to USD-Asia crosses, it will be small compensation. This brings us back to the question about what Asian countries can do in response to such events and the answer is very little. Occasional intervention is likely to be seen, although major changes in interest rates are not an optimal solution given domestic circumstances. Capital controls are an absolute last resort and simply not an option for countries like Korea and Taiwan. They will just have to take it on the chin and wait for both USD-CNY depreciation and better times in Japan. As noted above in the JPY section there should be broad G7 pressure for a stronger JPY once the Japanese economy picks up again, as we expect in the second half of the year.

In LatAm, the BRL has become very stable but will retain an upside bias on the background of solid growth, high-yield and much improved public finances. The lasting positive of the past couple of years has been the restructuring of Brazilian debt, which has significantly reduced debt-service risk. More progress is now awaited on pursuing spending efficiencies as this will lead to more ratings upgrades.

Emerging Europe has also seen an improvement in sentiment in recent months, especially in Hungary, where the government is now facing up to fiscal realities. Risks of slippage in discipline clearly remain but there is cause for some mild optimism.

PDF Version Here

Mellon Foreign Exchange
http://fx.mellon.com

Note: Although obtained from sources believed by us to be reliable, Mellon Financial Corporation and its affiliates cannot guarantee the accuracy or completeness of the information upon which this report is based. This report does not purport to disclose the risks or benefits of entering into particular transactions and should not be construed as advice in any specific instance. The views in this report constitute our judgement as of this date and are subject to change without notice.