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FX forecast update: To catch a rising tide

Fri, Jul 4 2008, 13:34 GMT
by Teis Knuthsen, Kasper Kirkegaard, John Hydeskov

Danske Bank A/S


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Here are our latest thoughts on the G10 currency markets:

• Difficult waters to navigate. The best performing currency during the past month has been CZK (up by 4% vs EUR), followed by HUF (2%) and PLN (0.8%). The worst have been ISK, PHP and NZD (down 5-6%). The performance split between ISK and HUF, which can be seen as both belonging to a group of high-yielding currencies backed by fragile fundamentals, clearly illustrates how difficult currency markets have been to navigate in the past month. Overall, European currencies, led by CEE, have performed best, Asian currencies have as a block underperformed, and EUR/NZD (up 5.3%) represents the extreme in terms of G10 performance. Shift in relative rates have been a key driver, at least among major currencies: Outright declines in NZD and JPY rates help explain un-derperformance of these currencies relative to countries such as Norway, the United Kingdom and Euroland, where rates have risen the most. However, the pattern is not entirely consistent, as the 3% rise in GBP/CAD during the past month despite a near identical +40 basis point rise in two-year swap rates illustrates. Carry performance has been essentially flat whether it is measured against G10 currencies or a global universe.

• Inflation is now the main threat. If the relative movements have been difficult to pin down, there is little confusion in our view when it comes to the absolute outlook. Since last autumn, we have warned about the dual shock of financial crisis and economic slowdown. There is still nothing to in-dicate that the financial crisis is over, and cyclical threats to overextended consumers on both sides of the Atlantic should be enough to temper economic optimism. If the two waves of bank and consumer balance sheet repair collide, which now appears to be happening, the consequences could become ugly. On top of this, we have to deal with rapidly rising inflation. Higher inflation caused by rising energy and food prices equals a decline in disposable income, just as monetary tightening coming in the wake of inflation can be expected to tighten the liquidity cycle further. But the real issue is whether we are witnessing a secular shift from a low-inflation era to a period where price pressures are becoming more entrenched. The jury is still out on that, but inflation should now be seen as the predominant risk to both the economic outlook as well as to financial markets. Conventional wisdom largely seems to be that the global inflation problem will be resolved without a sharp decline in economic activity. We are not so sure. We continue to believe that we are headed for a period of financial deleveraging against a backdrop of slower activity. There is a distinct possibility that oil prices, and thereby inflation, could rise further in the coming months. There is also an obvious risk to the economic outlook presented by the latest collapse in global consumer confidence. And third, pushed up against the wall, there is very little that central banks can do other than to slay the inflation beast in the old-fashioned way. This is particularly so in Asia-excluding Japan, where underlying inflation is rising sharply.

Published on  Fri, Jul 4 2008, 13:37 GMT

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