Monday, January 7, 2008

Market Watch: 2008 Currency Outlook

The US dollar tanked in 2007 as the US dollar index (dollar measured against a basket of currencies) came off by 9%, following an 8% decline in 2006. The steep 2 year move away from the US currency can primarily be explained by a worsening in interest rate differentials between the US and the other major economies, during which time rates were on hold before being cut in the US, while largely rising almost everywhere else. The dollar came off worst against its Canadian counterpart last year (13.45%), followed closely by steep declines against the euro (11.45%) and Australian dollars (11.49%). Declines against the Swiss franc, yen and sterling were more modest, ranging between 4% and 8%. 2007 closed out with the US economy headed into deeper trouble with growth prospects for 2008 dwindling with each new data release. However with 2 year and 3 year US bonds effectively having already priced in a further 1.25% in Fed rate cuts in 2008 and with the global growth picture looking less and less attractive, the dollar’s decline is largely overdone and 2008 could see a significant recovery in the greenback against its major rivals as we see the baton of economic uncertainty passed around to economies in Canada, the UK, Japan and the Eurozone. The flagging greenback has resulted in a major import inflation issue for the US and indeed as we ended 2007 the US had the highest headline inflation rate of any of the major developed countries (4.3%),

The US is now in a period of stagflation already and those whom believe the Fed has a free hand to cut rates at will to stimulate an economy battling against soaring oil and import prices, may need to think again. The Fed’s ability to cut US interest rates this year is dependent on a stronger US dollar, not a weaker one. If the Fed acts outside its primary remit to appease market expectations (by ignoring higher inflation in favour of short-term economic growth and a bounce on Wall Street), the Fed will dig a deeper hole for itself and threaten the longer run stability of the world’s largest economy. An important consideration is that inflation initially began to flag early in 2007 and the core inflation rate continued to ease during the course of the year, but this means that the year on year comparisons in early 2008 will not prove favourable for inflation and with US GDP likely to struggle in the first half of the year, the US economy seems destined for a sustained period of stagflation in the coming months. The Fed will find it difficult to justify an aggressive reduction in interest rates and indeed if it does move aggressively, the FOMC will be taking a major gamble. Lower interest rates will not cure the ills of an economy that has more deep-rooted fundamental issues (such as negative savings rates).

Expectations for aggressive rate cuts may restrain the dollar in the short-term, particularly against the euro and the yen, but looking forward, the more blurred global outlook picture will benefit the dollar and the currency should make some strong gains this year, particularly against the Canadian dollar, and also against sterling with the UK economy likely facing a headwind in 2008. The principal recommendations for the longer run players for this year are to buy USD/CAD and sell GBP/USD, with these pairs having the greatest scope for favourable greenback gains. The euro will begin to lose its invincibility as the year progresses and the wheels may well come off the single currency in the second half of the year as investors begin to place value over rhetoric and actual growth over inflation, so do not be surprised to see EUR/USD end 2008 closer to 1.30, even if we do have a brief period of trading above 1.50 over the opening months of the year.

The euro did exceptionally well in 2007, ending the year significantly higher against both the dollar and sterling, despite the ECB keeping rates on hold for the second half of the year. With both the Fed and the Bank of England now in an easing cycle and the ECB maintaining a hawkish line, the euro looks to have the most to benefit in the coming months when one looks exclusively at interest rate differentials. But when we start to look closer at economic performance, we see that the US economy grew at twice the rate of the euro economy in quarter 3 of 2007 and while the euro economy may have outperformed the US in quarter 4, the outlook for the euro economy this year is at best uncertain. With credit constraints continuing to curtail European markets and marked evidence of slowing economic growth in the 13-nation zone, in normal circumstances we would expect the ECB to cut interest rates, but instead the Bank are threatening to raise rates because of current inflation rates of 3%. While the US Fed are gambling on softening inflation risk, the ECB takes the opposite view and markets have thus far taken the ECB at its word in terms of how it is pricing the euro. The likelihood however is that the euro economy will cool considerably as the year unfolds and markets will start to move ahead of the ECB in terms of lowering rate expectations and the euro should come under intense selling pressure, particularly against the dollar. There is enormous scope on the downside for the euro if events move against it and with so much bad news already priced into the US currency and the US economy likely to outperform the euro economy as we move later into the year, the dollar could end 2008 around much the same price level as it started 2007, i.e. with EUR/USD trading around the 1.30 mark. The euro will remain strong against sterling and likely reach 0.80 in the first half of the year as UK interest rates are lowered, but if the Bank of England front-ends its rate cuts, sterling should battle back stronger in the second half of the year against the euro. We expect to see the euro fall to 145 against the yen as a sustained period of risk aversion sends the yen higher over the first two quarters, before a euro recovery in the latter half of the year.

Sterling is written off by most analysts in 2008, with economic fundamentals having shifted to the soft side and the Bank of England expected to cut rates several times during the course of the year. In recent months the slowing housing sector has begun to have a negative impact on consumer spending while we have also witnessed a marked slowdown in both industrial sectors of the economy (manufacturing and services). UK growth has consistently been above 3% over the past 2 years but could slow to around 1.8% or below this year. The UK economy is very much dependent on the country’s financial sector and with credit restrictions still gripping the economy, the Bank of England will be forced to cut rates just to keep liquidity at palatable levels. The biggest risk to the overall economy in 2008 is likely to come from the housing sector, where negative equity concerns will lead to more difficult credit conditions and more conservative spending by consumers. The housing downturn is not yet a crisis in the UK, like it is in the US, as house supply levels on the UK market have remained remarkably tight. Still, the UK has a significant current account deficit and with incoming Merger and Acquisition funds drying up, sterling may have few friends this year. UK interest rates, at 5.5%, remain high by comparative standards and to stimulate the economy in 2008, we expect the Bank of England to trim rates by as much as 125 basis points. Like in the US, UK interest rates may be falling at a time when inflation is on the rise, but the Bank of England’s primary concern as of now, like that of Fed, appears to be economic growth. Most of the UK rate cuts should come in the first half of the year and this is when sterling will be at its most vulnerable, particularly against the euro and the Swiss franc, where rates are most likely to remain on hold. The euro should hit 80 pence, probably by the second quarter, but we expect the single currency to then come under pressure itself and the pound should be able to curb its losses against the euro in the second half of the year. There is however much more downside potential against the dollar, as we believe the greenback will bounce this year as the economic doubts that plagued the dollar last year spreads more rapidly to Europe, the Far East and the developing countries and we believe this will lead to a major repatriation of funds back into the US dollar. We also expect UK interest rate cuts to exceed those in the US by 50 basis points and see sterling falling to below 1.75 against the dollar, at least, by the final quarter.

Japan remains an export-dependent economy and domestic demand simply is not there to grow the economy at the levels required to see the country through in the event of a sharp slowdown in the global economy. To make matters worse, the recent appreciation in the yen has forced Japanese exporters to become more competitive as exchange rates reach their most unfavourable level in two and a half years. The yen remains the least responsive of all major currencies to domestic economic data and the fate of the currency this year will very much depend on events elsewhere. We see more upside potential for the yen in the coming months as broader global economic concerns keep risk aversion levels near their highs and scares off investors that would normally fund risky assets through the low-yielding yen. A rebalancing of global capital accounts should result in the repatriation of capital funds back into Japan over the coming months and boost the value of the yen. The huge volume of net yen short positions that existed in the market over the past 12 months has now been eroded and the sudden, massive spikes in appreciation that have become synonymous with the yen in recent years will become less of a factor in 2008. We do see the dollar depreciating to below Y100 probably sooner rather than later, but see limited scope for movement below this level as we don’t see Japanese interest rates moving at all this year, while we expect the Fed to emerge from its easing cycle by Quarter 3. While inflation in Japan is currently running at a multi-year high, it is still only a 0.6% annual rate and it is owed exclusively to imported inflation from higher oil and food prices. This inflation will evaporate when offset against a higher yen and once commodity prices ease, as we expect the will. When the US Fed’s easing cycle is over and rate cuts elsewhere also patter out, we believe renewed interest in carry trades will send the yen back into retreat and indeed by December we expect the dollar to be trading higher against the yen than where it started the year. We see potential for a sharp move downwards in EUR/JPY with the single currency coming under real pressure the further into the year we go and the euro should fall to below Y145, most likely during the middle two quarters.

Bob and Ted

To be continued….

No comments: