Thursday, May 1, 2008

What does Fed pause mean for currency markets?

The Fed appeared to signal a pause in its easing cycle Wednesday when stating ‘The substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help to promote moderate growth over time and to mitigate risks to economic activity’. Of course the downside risks to growth are still highlighted, as they should, but the Fed’s policy of aggressively cutting rates in recent months has failed to translate into lower borrowing costs for consumers while the credit crunch persisted. Markets won’t be convinced the Fed will remain on hold if economic data deteriorates further, particularly in terms of employment. But for now, the Fed would appear to have adopted a ‘wait and see’ policy and this will have implications for currency markets as we move into the summer and through the remainder of the year. With interest rate differentials a major factor in determining exchange rates, we need to look at currency pairs where the rate differential is likely to narrow or widen in favour of the US dollar over the coming quarters.

The only major currency for which we can say with a degree of certainty that interest rates are going to be cut is sterling. Rates in the UK currently stand at 5.00%, having been cut by 75 basis points since last November. The UK economy is slowing, house prices are falling rapidly, inflation is significantly lower than in the euro area, the credit crisis is taking its toll on UK business and the UK itself has a vast current account deficit, all which point to a need for lower interest rates and a weaker currency. We could see UK interest rates cut by a further 100 basis points this year, something which is going to undermine the country’s currency. Cable is currently riding high close to 1.99, but we could easily see it fall to 1.85 or much lower this year, if interest rate differentials between the UK and the US narrow by a further 100 basis points.

In terms of the yen, the dollar has fallen from a high of Y124 last year to a low of just below Y96 earlier this year. Currently trading around Y104, the dollar has an opportunity to appreciate significantly against the Japanese currency, even if interest rates remain on hold in both jurisdictions over the next 6 months, because the dollar offers a higher yield to investors (2% Vs 0.5%). The key driver for any acceleration in this exchange rate will be a return to broader market stability and a rise in risk tolerance levels. We could see the dollar appreciate back up to Y112 through this year.

The EUR/USD currency pair is something of a conundrum but the net risks to the pair are to the downside. With inflation riding high in the euro area, the ECB will not move to cut rates unless there is a marked slowdown in inflation and a significant deterioration in the euro economy. However, some economies within the euro block are struggling, notably Spain and Italy, while a diversification in the performance of France and Germany is becoming ever more noticeable. This poses a major headache for the ECB and it threatens the euro’s ability to sustain its 2.5 year rally against the dollar, at least in the medium term. Interest rate differentials are unlikely to widen in favour of the euro over the next 12 months and with the heightened risk of a sharp downturn in the performance of the euro economy, the euro is beginning to look like an unattractive proposition against the dollar through the remainder of this year. The next leg in EUR/USD could be to the downside and it could prove to be quite a sharp move, especially if the ECB is forced to cut euro area interest rates later this year. A return to 1.45 is probable, with a chance of a retreat to 1.38, if interest rate differentials look like narrowing significantly. If the US enters a prolonged recession and the Fed move to further cut US interest rates, then of course the euro may benefit, but it is very difficult to see the pair sustaining any rally back above 1.60. The Swiss franc will most likely follow the euro’s fortunes, although it will perform better if Swiss interest rates remain on hold when euro rates are cut.

A broader dollar rally should trigger a fall in commodity prices and in turn in the commodity currencies which appreciated sharply over the past year, notably the Canadian dollar, Norwegian Krone and the Australian dollar. The Australian dollar will be protected to a degree because of its higher yield attraction but the Norwegian Krone in particular could fall significantly, especially if oil prices come off sharply and if there is a general malaise within the wider European economy. The Canadian dollar has not looked comfortable on prices higher than parity against its US counterpart and with growth in Canada coming to a near standstill, Canada needs some respite from its currency, to allow the economy breathe again. The greenback could appreciate sharply against the loonie and a return to at least 1.10 looks very achievable.

The above synopsis does not mean we are going to witness a long-term reversal in the dollar trend, which is downwards, but the fundamentals are stacking up to favour a sustained period of relief and a medium-term retracement for the embattled greenback. It is only a stronger dollar that can deflate the commodity price bubble and relieve the current spate of rising global inflation.

Ted B - May 1

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