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USD: End of rally on the horizon

Fri, Dec 26 2008, 11:30 GMT
by Erste Bank Bond Research Team

Erste Bank der oesterreichischen Sparkassen AG

Yen remains strong

US dollar

In the past weeks, the USD plunged steeply. After the upper limit of the trading range, which had held up for round seven weeks, was broken through, the EURUSD exchange rate moved fast towards the mark of 1.4. This movement was additionally encouraged by the bigger-than-expected interest rate cut of the US central bank and by the statements of ECB President Trichet that the ECB might possibly refrain from cutting interest rates in January.

The obviously rather thin pre-holiday trading and the general nervousness before the close of the year pushed the euro to up to 1.47 US dollars. Then, a strong countermovement set in that brought the EURUSD exchange rate to the current mark of 1.4. What is the outlook now? The US central bank did not only lower the key lending rate to nearly zero, but also confirmed plans to buy securities. It left all doors open with respect to how much. This means that the supply of US dollars available will increase massively next year. Because the central bank will convert money tied up into liquidity and finance very probably the new debt of the government, at least in part, by buying government bonds. This is a scenario for a weaker US dollar. The extent to which mainly government bonds will be bought is decisive for the USD exchange rate. If this happens to an extent that would keep the price of bonds high and thus yields low, then these bonds would not be attractive to foreign investors. The consequence would be a substantial weakening of the USD. Our scenario up to now has been of an only slightly weakening of the USD currency due to a rise in yields. At present, it seems as if the US Fed would like to prevent the latter. This has significantly increased the downside risk for the USD. The USD will probably only fall when the interest rate cuts by the ECB are over in March. However, the risk exists of markets reacting earlier and therefore we recommend avoiding any investments in USD.

Swiss franc

The Swiss Franc has ended its weakening trend for now and strengthened again versus the Euro.
After having – as anticipated - lowered the target range for the 3M-Libor to 0-1%, SNB President Roth suggested that further steps were not to be ruled out. Thus we think that a further lowering to 0-0.5% seems likely as soon as the Libor has reached the mid-point of the actual target range. Nevertheless, the Franc should not react to such a step any more. In contrast, a bigger than expected rate cut in the Eurozone could still provoke a strengthening of the Swiss currency.
The UBS’ rescue package has been realized partly by now, and should calm down the situation. Still, a serious deterioration of the Swiss economy has become apparent in the November-data, and even the SNB expects a growth rate of -0.5 to -1% for 2009. This is in favour of weak Franc levels as soon as macroeconomic factors have an impact on the exchange rate again.
On the whole, we think that the financial crisis has the strongest influence on the Swiss Franc for the moment, and that renewed turmoil could lead to a further strengthening.

Japanese Yen

The Yen has rebounded from a several years high vs. the Dollar during the last days. If this proves to be sustainable is highly uncertain.
The BoJ has followed the Fed in lowering interest rates (to 0.1%) and further cuts can only be of symbolic nature.
The deposit facility has been maintained, and next to more purchases of JGB’s the Bank also agreed to purchase CP’s.
As the interest rate differential should remain constant over some time, it should not influence the exchange rate much longer (only until investment positions are adapted). In Japan, the worldwide slump became manifest in the November Export’s contraction of -27% vs. the previous year’s level. The stronger Yen also contributed. Without any doubt, the Yen is not driven by macroeconomic factors currently but by the uncertainty on capital markets, implying that the strength of the yen might prevail for some time.
Against the Euro, the Yen weakened for the first time since long, but this was mainly due to the sharp gains of the Euro against the Dollar.

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Published on  Fri, Dec 26 2008, 11:42 GMT