The FX Market- by Leaps and Bonds

Volatility at top speed

The first quarter of the year in the FX market was characterised by an all-pervading high volatility. None of the established currencies escaped. With no exception, they were forced to give in to massive price swings.

The financial turmoil from last year continues unabated in the new year. Risk appetite has again and again been replaced by a panic risk aversion which has driven exchange rates from one extreme to the other.

How and when this turmoil ends are questions which haunt actors in the FX market constantly. Unexpected economic indicators - positive and negative - as well as random rumours may from one minute to the other result in euphoria or depressive trends among market participants in the FX market. The high volatility can therefore be expected to last until the uncertainty regarding the final outcome of the current crisis is settled.

Growth in trouble

To make matters worse, it became evident during the first quarter that the financial crisis is deeper than originally assumed. The American economy has thus not been able to weather the current financial storm without a significant slowdown in growth. We therefore now expect that the American economy cannot avoid a mild recession phase in 2008.

Whether such a recession will affect growth in the rest of the world is the major unknown factor which divides the FX market in particular. The mercurial sentiment among the actors in the FX market is thus no longer only due to the financial crisis but also due to a real fear of an economic slowdown.

Funding currencies under pressure

The high volatility and the widespread uncertainty were poisonous to the traditional funding currencies such as CHF and JPY in the first quarter. Both currencies fluctuated by no less than 7% in the first three months, straining investors' patience.

As long as risk aversion continues to rise and fall along with the major changes in sentiment in the financial markets, such swings will continue to haunt investors.

In view of the recent years' sharp downtrend in both CHF and not least JPY, we assess that not only the rising/falling risk appetite is to blame for a large part of the swings. Already before the financial crisis broke out, we called for 'a normalisation' of the extremely weak currencies which no longer reflected the fundamentals in Japan or Switzerland but an unlimited appetite for risk due to the currencies' attractive low-yielding status.

The scenario in the first quarter was thus a vehement 'eye opener' for many investors which were forced to take risk into account due to the high volatility. Risk has almost been forgotten because since 2003 the financial winds have been mild in the form of well-defined trends based on the allpervading liquidity. Unfortunately, the liquidity vanished like morning dew in the last six months of 2007, and this will probably be the case for some time yet.

We therefore still not recommend the low yen as a funding currency since we still expect a return to much higher levels for the yen before the end of 2008.

With respect to CHF which may appear attractive at the current levels compared with the levels from 2007, we recommend investors to tread carefully. We recommend a maximum of 25% funding in CHF. We highly recommend our funding portfolio consisting of 25% CHF, 25% SGD, 25% CAD and 25% SEK.

The time is not right to put all your eggs in one basket. The final outcome of the current financial/economic morass is simply too uncertain.

Weak - weaker - dollar

The US dollar was no exception either since it was also affected by the high volatility. Unfortunately, we have to admit that since the turn of the year there has almost only been one direction. The dollar has weakened by another 9% against EUR, which is why we have seen a new record for EUR/USD at 159.05.

In other words, all odds have been against the dollar since the start of the year, which is why the theory of Europe's decoupling from the ailing US has had golden times. A theory which the ECB has used all means to nourish through stubbornly sticking to its monetary policy. Since January, the Fed has cut interest rates by 2% while again and again the ECB maintained a hard rhetoric against the development of inflation quite unaffected by slowing European growth.

Since nothing is different this time, we deliberately trust history which shows that in the last six months of the year the ECB will be forced to turn to lower interest rates to save what can be saved of the already ailing growth rate. As long as the ECB does not loosen the tight rhetoric and the money market's pressure on the ECB does not increase from the current levels, all we can do is to be patient. However, initially we expect a sharp correction of the fundamentally weak dollar. Following the recent decline in the dollar rate, the dollar is now undervalued by no less than 36% against EUR according to the theory of purchasing power parity. For the long term, this situation is unsustainable.

We maintain our view that the dollar is about to gain foothold before it sets the course for the clouds in 2008. The USD downtrend is coming to an end in our view.

Sterling on the ropes

Unlike, the historically high euro, the sterling was forced to bite the dust without a helping hand from the decoupling theory. If anyone, the sterling has learnt the hard way from the FX market in the form of sharp price falls.

The majority of the financial actors look at the British economy as a European exponent of the many financial and economic troubles of the US. In view of the heavy exposure to the financial crisis via London's City and not least the inflated housing market which is losing momentum, the UK is very vulnerable at the moment.

The price fall of sterling has accelerated over the past weeks, and the currency is close to the magic 80 in EUR/GBP. We maintain that we will see an encounter with 83 in EUR/GBP in the coming months. In view of the speed with which the sterling has weakened lately, we expect the weakening to slow down and stretch over a longer period than previously seen.

Commodity currencies - living on borrowed time

True to tradition when risk aversion rises and falls, AUD, NZD and in part CAD led a turbulent life in the first quarter of the year.

Both AUD and NZD fluctuated by 12% while CAD fluctuated by 7%. Investors have had difficulties letting go of notably AUD and NZD. As the highest yielding established currencies, international investors quickly flock to the two currencies when the financial markets calm down just a little bit.

Moreover, both currencies benefit from the market's general confidence in the continued outperfomance of the commodity asset class. The commodity complex is still seen as a safe haven in the financial markets, which contributes to supporting AUD and NZD that are in fact both suffering from budding poor fundamentals.

We do not agree with the theory of 'safe havens' during the current circumstances. We still expect a correction in the commodity complex as a whole, which together with the expected dollar strengthening will be highly destabilising factors for all three currencies.

In our view, AUD, NZD and CAD are therefore living on borrowed time and may be facing a very volatile period. Also, our long-term models for all three currencies signal that a change of the uptrend which has lasted several years may be near. We therefore do not recommend investors to be tempted by the intriguingly high interest rates of AUD and NZD. 'Gold' may be bought too dear!

SEK & NOK - still waters running deep

In comparison with the other established currencies, SEK and NOK have weathered the storm and kept their heads high. SEK fluctuated by 'only' 3% while NOK fluctuated by 5% in the first quarter of the year. The downtrend in SEK has struggled to manifest in earnest against EUR while the expected trend change in EUR/NOK from down to up is long in coming.

In the coming quarter, we do not expect the two Scandinavian currencies to make much noise. The current restrictive monetary policy pursued by both countries has been and will be supportive of both currencies. Not until the day when the priority given to growth forces the two central banks to change their course will the two currencies rise markedly.

However, it is important to point out that these two currencies will be hit immediately when risk aversion picks up. Due to the size of the two currencies, the volatility will rise markedly since market participants will attempt to abandon these two 'side currencies' to reduce their total FX exposure.

On the other hand, they will be the first to rise when things calm down again and investors begin to chase high attractive interest rates.

We therefore do not have major price expectations of neither SEK nor NOK in the coming quarter. However, we maintain that the direction is down for both currencies.

Jyske Markets - FX Research
http://www.jyskebank.dk/finansnyt

The analysis is based on information which Jyske Bank finds reliable, but Jyske Bank does not assume any responsibility for the correctness of the material nor for transactions made on the basis of the information or the estimates of the analysis. The estimates and recommendation of the analysis may be changed without notice. The analysis is for personal use of Jyske Bank's customers and may not be copied.