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FX forecast update: Better safe than sorry

Wed, Oct 15 2008, 15:28 GMT
by Kasper Kirkegaard, Stefan Mellin, John Hydeskov

Danske Bank A/S

Here are our latest thoughts on the G10 currency markets:

• Panic! The financial crisis unfolded beyond our wildest imagination over the past month. The VIX index, a measure of expected volatility in equity markets, rose to a record-high of 77; the US Ted spread, the difference between secured and unsecured lending, sky-rocketed to 4.6 percentage points and the credit default swap spreads widened substantially. Most financial institutions - some more than others - found it hard to get short-term funding and perceived counterparty risk rose considerably. Global financial markets were balancing on the brink of a systemic meltdown and had "ceased to function" as Britain's Prime Minister, Gordon Brown, put it. Clearly, something had to be done.

• Three out of three ain't bad. From economic theory (see for example Kindleberger: Manias, Panics and Crashes) we know that three things are typically observed in the final phase of a financial crisis (the discredit phase). Firstly, prices usually fall to clear the market. That has indeed happened: from 19 September to 10 October, global equities lost one-third of their value. Secondly, trading is usually cut off. Stock exchanges have been closed in Russia (-61% year-to-date), Indonesia (-44%) and Iceland (-89%). Finally, lenders of last resort step in and cut policy interest rates and ensure liquidity. Central banks in the US, UK, Euroland, Canada, Sweden and Switzerland announced a coordinated 50bp rate cut, see Coordinated rate cuts, and after a genuine dollar shortage and several additional liquidity injections, the Fed, ECB, BoE and SNB joined forces and provided unlimited dollar liquidity (full allotment) at fixed interest rates. In our view, financial markets are still dizzy and trying to get a hold on things. We remain in the discredit phase, and we believe it remains premature to consider the financial crisis over, as no obvious indicators to this have been observed. Accordingly, our well-known theme of financial deleveraging remains central to our approach to currency markets.

• Rescue packages. Since the last edition of FX forecast update, governments across the world have discussed and agreed on rescue packages, all designed to curb the financial crisis (effect on the real economy. How should we think of the packages in relation to FX? Firstly, the packages will eventually unfreeze conditions in money markets. Spreads should therefore eventually narrow and market participants should expect fewer difficulties with getting transactions through. Secondly, it is still hard to compare the packages to get the relative picture right and draw strong conclusions on specific currency crosses. Thirdly, even though the rescue packages don't eliminate risk aversion completely, they reduce the systemic risk substantially. Safe-haven currencies that have appreciated due to a scale-down of risk-taking are accordingly put more at risk, ceteris paribus. There is however other factors benefitting these, see Why defensive currencies are still your friends.

• Download full FX Strategy with charts

Published on  Wed, Oct 15 2008, 15:38 GMT