Key points
- Dollar negative factors to dominate over the next 12 months and push EUR/USD towards 1.50
- Still some value in the Scandi currencies as the market underestimate the risk of further monetary tightening
- USD/JPY to stay close to intervention levels as no support from US rates
The cyclical outlook has changed significantly over the summer and with it also the central bank outlook. The Fed now predicts near zero percent interest rates until at least mid-2013 and we expect it to be right in this prediction. Also, in the eurozone further hikes have been cancelled, as economic data has deteriorated and pressure on the European bond market has intensified – with a temporary drop in EUR/CHF towards parity as the most visible implication.
Notwithstanding weaker-than-expected growth, the medium-term outlook has turned increasingly dollar bearish, in our view. Zero rates for longer, a large current account deficit, lower domestic growth, high fiscal adjustment needs and increased political risks are not positive for a currency. We forecast the dollar depreciation trend will continue for longer than previously expected and that the dollar will not least depreciate against currencies backed by central banks where potential for further rate hikes remains, e.g. the Scandinavian currencies, the commodity currencies and the high growth emerging market currencies.
Event risks remain high, though, and policy responses are likely to remain an important market driver. If the European debt crisis has taught us anything, it is that markets will have to move very close to the edge for politicians to react. This means that the path towards a long-term solution is likely to continue to be characterised by recurring periods of market stress – and in turn recurring downwards corrections in EUR/USD. A significant worsening of the European debt crisis remains the most important risk to our forecasts.
Main forecast changes
The Fed’s prediction of zero rates until mid-2013 has increased the depreciation pressure on the dollar and we have opted to lower our dollar forecast significantly. We now forecast EUR/USD will reach 1.50 in 12 months – a significant revision to our old 1.36 forecast, which was based on the prediction of a first Fed rate hike during 2012. However, we have lowered our three-month forecast to 1.42, to reflect the expectation of continued weak macro data over the coming months.
Lower rates for longer in the US also imply that the long-expected depreciation of the yen, which was expected to go hand in hand with higher US rates, is likely to be postponed even further. We now forecast USD/JPY at 79 on a 12-month horizon.
Neither the SEK nor the NOK has been able to perform over the summer. This underlines that the Scandinavian currencies are not safe haven in the traditional sense. The weaker SEK and NOK have gone hand in hand with lower global risk appetite, a significant repricing of monetary policy expectations in both Norway and Sweden and the weaker cyclical outlook in both countries and globally.
However, in our view the repricing of monetary policy expectations in both countries has gone too far. In our main scenario, neither Norges Bank nor the Riksbank will cut rates over the next 12 months. On the contrary, we forecast that both central banks will restart their hiking campaigns if the dust settles in financial markets. Hence, in our view, risk is skewed to the upside for money market rates in both Norway and Sweden going forward and not to the downside as the market price today.
Even though the Scandinavian currencies are clearly not safe-haven currencies, we still believe that the market will tend to reward the currencies that will not be burdened by a counter-cyclical fiscal policy. However, this said, the experience over the summer underlines that even strong fundamentals are not enough for smaller business cycle sensitive currencies when risk aversion dominates and volatility spikes. To reflect the weaker cyclical outlook and lower risk appetite we have revised our EUR/SEK forecast slightly higher and now expect the cross to fall to 8.90 on a six-month horizon. We expect EUR/NOK to fall towards 7.70 in the same period.
The CHF90bn liquidity increase by the SNB and market expectations of further policy measures (e.g. a temporary EUR-CHF peg) have weighed on the Swiss franc. Hence, the EUR/CHF outlook will largely depend on what further policy measures are taken. We expect either a temporary peg or SNB intervention, which should stabilise the franc but not weaken it significantly. Risks are still to the downside in EUR/CHF. We forecast EUR/CHF at 1.15 at the entire forecast horizon.
Global recovery or recession?
The cyclical outlook has deteriorated rapidly over the summer to the point where economic indicators suggest a non-negligible risk of recession. This is a big blow to the consensus analysis, which, until recently, assumed a reacceleration in global growth during H2 11 as the three negative shocks from earlier this year faded (higher oil prices, Japan earthquake and Asian monetary tightening). However, leading indicators have not recovered but have instead continued declining – in sharp contrast to the forecast rebound in economic activity.
Our economists still expect a recovery in activity data later this year and forecast that the global and US economy will avoid a recession. However, this is not the same as saying that the market will not price a risk of recession. With leading indicators expected to decline further (Danske Bank forecast the ISM at index 45), recession fears are likely to stay elevated and potentially even rise further.
Market expectations have already been scaled back
While economic data is expected to deteriorate further, it is important to note that growth expectations have already been scaled back significantly. Back in February, the consensus expectation for 2011 US growth was 3.2% (as surveyed by Bloomberg). This has now been reduced to just 1.8%, as shown in Chart 2. This means that it will be much more difficult for the market to continue being disappointed going forward. In other words, the greater part of adjustments in market expectations is likely to be behind us – and, hence, perhaps also the greater part of the price adjustment in risk assets.
As Chart 2 shows, economic data has in fact delivered fewer disappointments lately, with the US economic data surprise index slowly moving higher again. This is a pattern often seen on the market; first economic data begins to deteriorate, triggering an adjustment in market expectations and a correction in market prices, but then, as expectations are eventually adjusted to the new growth outlook, economic data stops disappointing, which in itself is a positive shock to market sentiment and potentially even enough to trigger a rebound in market prices. Table 1 shows that during the past two growth scares in 2008 and 2010 the economic surprise index bottomed out more or less simultaneously with the equity market.
With indications of a trough in the US economic surprise index and with market growth expectations having been reduced significantly, we could perhaps already be near a bottom in risk assets. In this respect, it is interesting to note the tentative signs of a peak in FX option market volatility, which previously led a recovery in market sentiment (see Table 1). This is not to say that we feel confident in calling a recovery in risk sentiment but rather that it is likely to require new negative shocks to the market to trigger another 13% drop in stock prices, as the negative phase of reduced growth expectations has already come far.
Dollar implications – medium-term outlook turns more bearish…
Going into 2011 there were plenty of reasons to sell the dollar. Now, as we approach 2012, this list has become even longer.
- Large current account and BBoP deficit.
- Zero interest rates for longer – the Fed predicts until at least mid-2013.
- Weak cyclical outlook – below trend growth and high unemployment.
- Large fiscal adjustment needs and risks – another US credit downgrade is likely.
- Potential for accelerated reserve diversification out of the dollar.
- High political risks – as illustrated by the recent debt ceiling negotiations.
In fact, the only medium-term dollar positive factor currently is valuation, with the dollar trading around 14% undervalued according to simple REER (PPP) analysis. With most structural factors pointing towards dollar weakness we expect the dollar to re-embark on a medium-term depreciation trend and, hence, to become even more undervalued. More specifically, we expect the DXY dollar index to depreciate by more than 2% in 12M and for the dollar to remain the world’s favoured funding currency.
The currencies most likely to gain against the dollar are those: (i) backed by economies with little fiscal adjustment need and (ii) backed by central banks where the money market can price expected hikes again, when global macro data recovers. These include the AUD (almost 140bp cuts priced in 12M), the NZD (only 50bp hikes priced in 12M), the CAD (one 25bp cut fully priced), the NOK (one 25bp cut fully priced) and the SEK (close to two 25bp cuts fully priced). We forecast all of these currencies will appreciate by at least 4% against the dollar in 12M and for AUD/USD to reach 1.10 again.
Given the current market conditions, only two scenarios could reverse the medium-term dollar depreciation trend in our view: (i) a recession or (ii) a more severe European debt crisis. This is similar to the situation of the past 10 years, where also only a recession (the 2008 financial crisis) was able to cause more than a short-lived reversal of the underlying dollar downtrend – see Chart 3.
…but short term dollar support could still materialise
Structural dollar weakness does not rule out temporary dollar support, however. As we have argued, deteriorating macro data could cause recession fears to rise even further. In this scenario, we would expect safe-haven and deleveraging flows temporarily to take the dollar higher, especially if a further decline in global PMIs coincides with increased pressure on European bond markets.
How high a probability should we attach to this scenario? This is a difficult question, as the market is currently very sentiment driven. However, it is certainly a risk scenario that needs to be considered. Not least because market positioning still leaves potential for dollar strength. According to the latest IMM report, non-commercial investors (a good proxy for overall speculative positioning) have unwound only half of their aggregate short dollar positions, which still leaves net short positions at USD15bn.
We have factored in the potential for higher recession fears to our forecasts, by leaving the bigger dollar depreciation on the 6-12M horizon. We have factored in the potential for higher recession fears to our forecasts, by leaving the bigger dollar depreciation on the 6-12M horizon. In 3M we forecast EUR/USD at 1.42, GBP/USD at 1.60, USD/CAD at 1.00 and AUD/USD at 1.03.
EUR/USD to move higher during 2012
The dominating driver on the currency market this year has been relative monetary policy. This is not least visible in EUR/USD where a wider interest rate spread has taken the spot from 1.30 to 1.40. However, with the ECB now likely to be on hold, relative monetary policy will become less of a euro supportive factor. In the short term relative rates are clearly a downside risk to EUR/USD (see Chart 4) – as a potential ECB cut cannot fully be ruled out.
While we do not expect either the Fed or the ECB to change the policy rate during the next 12 months, we still see potential for European money market rates to rise more than US money market rates. With the US money market curve more or less tied to the zero rate floor for the coming year, most of the volatility in relative rates should be expected to come from European rates.
Event risks remain plenty
If the European debt crisis has taught us anything, it is that markets will have to move very close to the edge for politicians to react. This is perhaps not that surprising, as politicians do not want to introduce too much ‘moral hazard’ to the system and as politicians have to cater to their domestic voter base in order to stay in the job. However, this also means that the path towards a long-term solution to the European debt crisis is likely to continue to be characterised by recurring periods of market stress. This in turn means recurring periods of rising market volatility and probably also downward corrections in EUR/USD – and depending on the SNB policy response, also in EUR/CHF. A significant worsening of the European debt crisis remains the most important risk to our forecasts.
Event risks are also present for the dollar, however. We see a high probability of yet another US credit downgrade, see Research: Further downgrade of US debt likely in 2012. To what degree this, and the higher political risks in the US, will accelerate reserve diversification out of the dollar remains to be seen.
