FX Outlook: Critical Challenges for the Major Currencies

The rest of this year should see large swings in currencies, with each of the three super-major currencies facing huge challenges in the coming quarter. Namely, in the US: how will the Federal Reserve deal with the anticipation of the phase-out of QE2 and will it provide hints of QE3+? In Europe: will Europe maintain its resolve to bailout the PIGS (Portugal, Ireland, Greece and Spain) and will the PIGS show signs of rejecting the bailout in favour of a clean slate? And in Japan: how will Japan fiscally cope with the devastation from the terrible earthquake and tsunami of March 11? Elsewhere, the most important question is whether the Chinese regime will be able to engineer a soft landing for its overheated economy that has been over-reliant on relentless fixed asset investment and a property bubble. The stakes are very high around the world on these themes, and the dip to multi-year lows in FX volatility in early March was by no means a reliable barometer of the market environment in coming quarters, more likely serving as a period of calm before the storm. The remainder of 2011 should provide plenty of fireworks, judging from the themes that are in play.

2011 Outlook revisited

The world looks very different than it did when we began putting pen to paper on our outlook for this year. Two devastating earthquakes have altered the landscape for New Zealand and especially Japan, both in terms of the terrible loss of life and property, and due to the enormous fiscal and financial challenges these tragedies present. At the same time, revolutions in the Middle East/North Africa have rocked not only world politics, but also energy and all other markets with their implications.

Revisiting our outlook for the year, one of our main points was our belief that equity prices, and therefore risk appetite, would have a hard time rising simultaneously with bond yields and commodity prices as they did in late 2010. Eventually, we felt, either the rise in bond yields or the rise in key input prices (especially considering the notable output gap) would serve as a damper on risk – particularly in emerging markets due to their higher per capita exposure to commodity prices. Indeed, the further rise in commodities early this year saw many emerging market currencies taking a beating and their equity markets underperforming. Elsewhere, spiking food prices clearly provided at least some of the spark for the revolutions in North Africa and on the Arabian peninsula.

In Q2, the trajectory of commodity prices will remain a critical factor – especially food and energy prices, of course. But even aside from commodity prices, we expect that most of the G-10 currencies could become more volatile as the themes pushing and pulling on the market are no longer so clearly aligned along the axis of risk appetite (though risk appetite is still a large general theme) as they were during the 2008-09 crisis and in its aftermath. Here we refresh our outlook for all of the G-10 currencies for the coming quarter and beyond – an exercise that is particularly challenging as we are writing this in the nervous days just after the catastrophic Japanese earthquake and tsunami.

USD: QE to infinity?

We asked in our yearly outlook whether the USD might find itself in a win-win situation this year, as risk appetite might correct lower later in the year (the USD has been negatively correlated with risk for years now) and on relative outperformance of the U.S. economy stemming from some of the stimuli put in place by the Fed and Obama administration. Instead, we have largely seen a lose-lose situation. The greenback has more or less fizzled slowly to start the year – first as risk appetite was strong and other central banks were engaging in increasingly hawkish rhetoric while the U.S. Fed remained clearly committed to completing the QE2 (Quantitative Easing) programme. Then, when risk appetite finally faltered, it was due to unrest in the Middle East and spiking oil prices, with negative implications for the U.S. based on its reliance on crude imports and to the risk to the USD from reserve diversification from massive profits in the various petro-currencies etc. Throughout, the animating anti-greenback theme has been the complete lack of Fed credibility on monetary policy response to the inflation threat and its maintenance of an easy money policy.

Going forward then, the only hopes for the greenback come from two directions: first, relative economic weakness elsewhere in the world that forces a reassessment of the policy response of the other central banks relative to the Fed and second, an end to QE2 with no move toward QE3 and beyond. Markets are very forward looking and although QE2 is scheduled to end at the end of Q2, odds are clearly already being taken on QE3 and beyond. And why not? The new Congress, which we expected to present a tougher face to the Bernanke Fed, has done virtually nothing to stop the money printing or even show signs that it really wants to. If the economy weakens again, the Fed is ever-ready to wheel out the printing press once again, it seems. One interesting scenario is the idea that the Fed might let QE2 expire for a time in order to test the real strength of the economy and markets and “sweat” the politicians a bit before moving ahead with QE3. We’ve been predicting a USD comeback for quite some time now, particularly in the event of a faltering global growth picture and the Fed finally being forced to stop its printing ways. If no one stands up to Bernanke’s machinations, however, the USD will have a tough time making the expected comeback (which we only expected as a significant rally within a secular period of decline in the first place). A third dark horse that lies outside of the above assumptions includes a new Homeland Improvement Act, à la 2005, which boosted the USD as U.S. corporations repatriated billions in profits.

EUR: Turbo-deflation

The Euro has seen a big comeback since the beginning of the year as the PIGS sovereign debt crisis has so far been relatively contained, even as the situation in Greece, Ireland and Portugal is tenuous at best and still points toward eventual debt restructuring in those countries. Meanwhile, the ECB has been rattling its sabre on the need to raise rates to fight the threat of inflation from commodity prices. A strongly flattening yield curve on ECB hike threats, vicious austerity at the Eurozone periphery and a possible slowdown in export markets as China clamps down on growth all point to deflationary effects on the economy and even turbo-deflation.

The Eurozone politicians in March were able to agree in principle on an update and expansion of the existing European Financial Stability Fund (EFSF) bailout mechanism, though not all of the details have emerged and the EU summit on March 25 is a further test of how strong the European political resolve remains as the voters are clearly getting restless. For how long can European politicians fail to represent their populations, most of whom are dead set against further bailouts (the Germans, who are footing most of the bill) or the Euro itself (the most peripheral countries that can’t devalue their way out of the crisis and face endless years of austerity)? So the Euro may enjoy a bit of a resurgence for a while in Q2 if the politicians can put enough fingers in the dike for now and the ECB ploughs ahead with its first rate hike, but the entire dike will continue to erode as it has for the last several years as long as bailouts remain in place and the longer term viability of the Eurozone project is still very much in question. Euro tailwinds may continue into Q2, but we haven’t seen the final test of the European banking system and sovereign debt issue.

JPY: Does the sovereign debt load ever matter?

The earthquake/tsunami disaster of March 11 was an awful blow to an already weak Japanese economy. The country posted an outright decline in GDP in Q4 and is certain not to grow at all in Q1 after the tsunami. The initial response to the March 11 catastrophe was a stronger JPY as the market counted on a similar pattern to the 1995 Kobe quake, when the JPY spiked to its strongest level ever just below 80 on anticipation and the reality of repatriated funds going towards paying for the damage. This kind of strength could continue as the market tries to replay the reaction in markets to the 1995 quake. If rates stay low and flows are sustained for a time, this could indeed result in a further spike in the JPY to the strong side for a time to new record lows in USDJPY well below 80.

But the Japanese economy and fiscal wherewithal of 2011 is not the same this time around as it was then, as the domestic Japanese saver is more or less tapped out, and the outstanding question is how the government will finance the payment of disaster relief in the long run. The inevitable answer is that the Bank of Japan will have to print the money, and eventually, if the greenback is getting hammered for money printing and the expansion of the Fed’s balance sheet, the JPY will have to pay the piper on the same account. Eventually, this could mean a sharply weaker JPY as Japan is the country farthest along in the “Keynesian endgame” as hedge fund manager Kyle Bass calls it. That eventuality may lie beyond the end of Q2, but the disaster has brought the date with the consequences of public insolvency significantly forward. Keep in mind that the Japanese financial year ends March 31.

GBP

The pound has outperformed the USD during Q1 as the Bank of England’s (BOE) Monetary Policy Committee (MPC) is taking increasing note of persistently higher inflation levels and the need to signal a move on interest rates (though one wonders whether the bank’s doves will possibly use the situation in Japan as an excuse to wait as long as possible on a policy move). Still, a growing minority of three hawks on the MPC has already voted for a rate hike at a recent meeting. So important for the pound’s outlook in Q2 is whether BoE chairman King and his more dovish cohort may be finally dragged into hiking rates. Even if they are still very reluctant to do so with the economy faced with the challenge of so much public sector austerity taking hold this year after Q4 saw an ugly decline in GDP, though that was to some degree driven by extremely poor weather in December and an exaggerated trade deficit at the tail end of the year, partially attributable to new tax law in 2011.

We suspect that the GBP will continue to echo the USD in terms of the intermarket factors that are supportive for the currency. The BoE is likely to be very slow with any interest rate move, though perhaps faster than the Fed – so when CB rate expectations heat up, the pound will outperform and when they are cooling, the pound may underperform. The pound will do well in a scenario in which the market begins to sell off riskier assets and moves in expectation of weaker global growth going forward. Important for the longer term health of the pound will be the country’s trade picture, as it has alarmingly failed to show any consistent improvement in terms of trade despite the sharp weakening in the pound since the onset of the financial crisis. The degree to which austerity measures will affect growth from here on in are another focus.

CHF: To remain the anti-euro?

The Swiss franc has historically been a safe haven currency of note, but that behaviour has been less consistent over the last 15 months or more of the Eurozone sovereign debt. During that time, the franc has only served as a safe haven vis-à-vis the Euro, tending to the strong side as a safe haven when the PIGS crisis becomes the focus and easing back once the ECB started feeling comfortable enough to start rattling its sabre on fighting inflation. Note that the Euro comeback for the first two months of this year also saw a flailing Swiss currency during the same time period. Otherwise, the currency’s behaviour has been erratic, generally looking less-good when the focus is on rising potential for central bank tightening and looking better when interest rate spreads collapse (on falling rates since Swiss yields are so low). Going forward, it appears the CHF will continue to trade off the Euro and interest rate expectations. On the latter subject, if higher rates and rate expectations ever bring a sovereign debt angle to the fore in the macro environment, the franc may also be able to thrive well, since its sovereign debt picture is matched by few other major currencies.

The other dollars – AUD, NZD and CAD

The Aussie, Kiwi, and Loonie are often thrown into the same boat together as commodity currencies, but that isn’t a fair thing to do, considering the degree to which their fortunes have varied of late. The Aussie has finally taken a bit of a back seat to the rest of the G-10 in Q1 of this year after a torrid performance in 2010. Rate expectations from the Reserve Bank of Australia (RBA) are virtually nil as dovish comments have crept into the RBA’s rhetoric and it is clear that the Australian economy is actually quite weak outside of its overgrown mining sector. The pivotal question for Australia for the remainder of 2011 is the trajectory of the Chinese economy, which is showing signs of stress and is in for a landing of one kind or another. If the Chinese landing becomes a hard one and worse, if that country is racked with a banking crisis, AUD would likely see the most downside of any of the G-10 currencies as it is the most purely commodity-driven currency among the G-10.

The Canadian dollar has had a bit of a back and forth start to the year, but has tended a bit higher with the rise in energy prices as the Middle East crisis went into full swing. Unfortunately, while the country has been a paragon of relative strength due to its robust financial institutions and relatively strong growth, considering the relatively weak economy of its massive neighbour to the south, there are structural challenges going forward: reliance on extractive industries, the world’s most leveraged consumer and the risk of a new decline in its terms of trade. We prefer CAD to some of the most pro-cyclical currencies, particularly the Aussie, but it may begin to face headwinds later in the year as the highest fliers may get their wings clipped.

After a strong rally attempt to start the year after an exceptionally weak finish to 2010, New Zealand was struck with a devastating earthquake that will cost a significant percentage of GDP (in the 10%+ neighbourhood). The damage was sufficiently worrisome for the Reserve Bank of New Zealand (RBNZ) to actually cut rates 50 basis points just when other central banks were making the most noise about hiking rates. The RBNZ may not cut much more, but New Zealand will be in rebuilding mode for some time and will likely tend to the weak side for the next couple of quarters.

The Scandies – headed in opposite directions?

The Swedish krona continued its rallying ways in early 2011, even gaining on top of a strong Euro as EURSEK plummeted to its lowest level since the year 2000 (as low as 8.70). SEK is a generally pro-cyclical currency and its trajectory is largely similar to that of major European equity markets. With a more challenging environment going forward for risk and for the European economy more broadly speaking, the SEK may take an extensive breather here as it may have achieved the lion’s share of its pro-cyclical potential.

The Norwegian krone could fare far better than its cousin to the east. It was generally a laggard during the post 2009 upswing in risk appetite and recovering markets, but has performed better of late on the rise in crude oil prices and after the Norges Bank finally stirred on the inflation threat. From a valuation perspective it looks more reasonable as well, and if sovereign debt issues crop up again, Norway has few equals in the robustness of its national balance sheet.

Trade themes

For the coming quarter, we would propose that if the market moves in accordance with our bias and outlook, the following trading themes may emerge: Long EURAUD, Short AUDNZD, Long NOKSEK and Short GBPUSD. We leave the JPY out this time around as the situation in Japan is so fluid at the moment.

Moves in rate expectations have been critical for the relative movement in the major currencies in the first quarter of the year. Note how expectations ratcheted higher in the first part of this year until the New Zealand and Japan earthquakes deflated expectations (and even the actual rate in the case of the RBNZ). Going forward, will central banks continue to ease off the pedal on growth fears from Asia? Or will crude oil and other critical commodities spike higher again on all of the money printing and cause some central banks to continue to hike rates to fight inflation?

Our measures of risk have seen two dips in the first quarter of this year, the first on MENA revolutions and the second after the March 11 catastrophe in Japan. The USD has tended to respond to risk aversion with strength in the past, but recent market behaviour has suggested that the relationship is no guarantee. Will risk appetite (as indicated by our Carry Trade Index and its “fast” version shown in the chart) continue to head south and will the USD follow its lead? The USD carry trade (the sample in the chart below is the USD’s performance versus seven higher yielding currencies) has been one of the most salient themes among the major currencies over the last three years.