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FX Strategy

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FX forecast update

Mon, Jan 7 2008, 15:31 GMT
by Teis Knuthsen

Danske Bank A/S

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• • Our opinions on currency markets have not changed materially over the turn of the year. We continue to expect that USD weakness has further to run, we are increasingly confident in our call for a stronger yen and we still believe that the overall economic and financial environment argues for higher volatility and lower risk-seeking relative to the previous years. What is new is that we now expect the global economic slowdown to advance to a stage where European central banks beyond the Bank of England (BoE) will begin to cut rates in the second half of the year. Our macro team has now pencilled in two rate cuts from both the ECB and the Swedish Riksbank and one from the SNB. In terms of EUR/USD, this makes us more comfortable with our call for a reversal in the year-long uptrend toward the middle of the year.

• • Dollar downturn not over... The global economic cycle is likely to slow sharply in the coming months, led by the US. We do not currently forecast a US recession, but the risk of such an outcome can not be easily dismissed. We expect the American economy to slow to a standstill in Q1 and while we continue to forecast a recovery toward trend growth in the second half of the year, we are observant of the fact that a housing-induced slowdown may take a long time to unwind. Despite inflationary pressures, we think the Fed will waste little time in cutting rates further and we now expect the central bank to ease at each of its next four meetings, taking the Fed funds rate down to 3.25%. While money markets currently imply rates below that level, interest rates across the curve are likely to fall further in the coming months. Until the economic outlook improves, the dollar bear trend should remain in place.

• • ...but euro peak approaching. The euro area has performed well in recent years and the strength of the labour market is testimony to an economic cycle that has yet to slow signifi-cantly. If not for the financial unrest in the second half of 2007, the ECB would probably have raised rates in both September and December. ECB President Trichet retains a hawkish stance, but we believe the rate cycle has peaked and that a substantial deterioration of the in-dustrial cycle will persuade the bank to cut rates twice this year; inflationary pressures not-withstanding. While the timing of this call is uncertain, the call for rate cuts may be loudest just at the time when the US cycle is beginning to improve. As the European tide goes out, the euro should begin to descend from its overvalued level. We have previously included a rever-sal of EUR/USD in our forecasts, but are now bringing the peak forward just as we lower our 12-month forecast from 1.45 to 1.40. In the coming months, we continue to expect a rise to 1.52, and quite likely beyond.

• • Our call for a rise in the value of the yen rests on three arguments: First, the Japanese yen is the only G10 currency that is undervalued relative to USD and it is substantially mispriced relative to EUR. As BoJ stays put while other central banks ease, relative rates will continue to benefit the yen. Second, the turn in the global liquidity cycle should continue to be a blessing as rising volatility and reduced risk-taking cuts down the appeal of carry trades. Third, we believe that Asian currencies in general, but CNY in particular, will rise on a trend basis this year. We are not changing our forecast for a drop in USD/JPY to 100 in the coming months, but we have lowered our forecast for EUR/JPY to 150 within six months.

• • We believe the trend rise in EUR/CHF during 2006–07 is over and we do not expect the Octo-ber high just below 1.69 to be surpassed. A drop in global stock markets – which is now being anticipated by our equity strategy team – will benefit in particularly CHF and JPY. Further, EUR/CHF is exceptionally overvalued relative to its history and we do not consider it likely that the factors that created the mispricing in the first place will be repeated in 2008. The Swiss economy continues to perform well, but also here a slowdown is in the offing and we expect the SNB to cut rates toward the end of the year.

• • The sell-off in GBP has been exceptionally sharp in recent weeks, and even more than we out-lined in our December forecast update. Last month, we wrote that “the pound has been strug-gling since summer on a hostile cocktail of a domestic bank run and a turn in the monetary policy cycle. [...] We continue to forecast a weaker pound in the coming months, based on the perhaps simple view that GBP is an overvalued, high-yielding currency backed by a substantial current account deficit and with a rate cycle that is turning lower. [….] Eventually we expect a rise in EUR/GBP above the previous high of 0.7247 from 2003.” We continue to believe that the risks are biased towards further depreciation. The British economy is more exposed to both a housing slowdown as well as financial unrest than its European peers and we expect the BoE to cut rates aggressively in the coming months. So far, the rise in EUR/GBP has gone hand in hand with a shift in relative rates and until markets begin to price in ECB rate cuts, the path of least resistance is for a further rise. We now target a rise to 0.7550 in the coming month before a more two-way market is established.

• • NOK has started the year on a strong note and we continue to predict a further rise. While even the Norwegian economy appears to be turning lower, strong domestic growth, solid household consumption and a buoyant labour market suggest that Norges Bank will continue to lean toward rate hikes. Further, the rally in oil prices provides – as always – a good base for NOK and EUR/NOK looks overvalued on our short-term models.

• • We are less bullish on SEK but do see a chance for a further drop in EUR/SEK toward 9.30. We expect the Swedish economy to slow in line with the euro area and now expect the Riks-bank to cut rates twice in the second half of the year. SEK may benefit from previously an-nounced privatisation flows, but elevated – or rising – global risk aversion and a general slow-ing in activity will provide headwinds to the Swedish currency.

• • Local rate cycles as well as buoyant commodity prices have supported AUD and NZD in re-cent months. However, the outlook is not particularly bright. Negative carry should weigh on both currencies relative to JPY, CHF and EUR in the fist half of the year, while a deteriorating local business cycle could see them fall sharply in the second half. A final hike from the RBA during the spring is possible, and we may underestimate the impact of Asian growth, but both currencies have in the past been highly vulnerable to a global slowdown.

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Published on  Mon, Jan 7 2008, 15:35 GMT