FYI | Dec 11 2007
By Chris Shaw
According to Danske Bank, the gains by the euro against the US dollar in recent months have been well supported by fundamentals, as the signs were global growth remained solid even as the US economy was slowing.
As a result the euro last week hit an all time high of more than 147 against the greenback, but at the same time as this has happened the bank notes conditions in currency markets are now not as supportive for the European Union currency given some weakness in global equity markets, falling freight rates (which suggests weakening economic conditions) and an increase in volatility.
The bank also points out technical indicators suggest the euro is due for a pullback with 143 seen as a realistic target from a technical viewpoint, but despite all this Danske sees reasons why further gains in the currency are likely.
Firstly, relative interest rates remain supportive for the euro, particularly as the US Federal Reserve is tipped to announce a rate cut later today (US time). Secondly, the bank also expects the oil price will rise further and push through US$100 per barrel in coming months, which is a negative for the US dollar and so supportive for the euro on the crosses.
Also supportive is the fact the emerging economic powers in the world, collectively known as the BRIC economies (for Brazil, Russia, India and China) continue to accumulate huge levels of foreign exchange reserves.
For some time there have been rumblings among these countries of the need for greater diversification of these holdings, with the euro a logical beneficiary of such a move given it is the second most important currency in global trade behind the US dollar.
The bank as a result has not changed its forecasts, which call for the euro to hit 148 against the US dollar sometime in the next three months and 150 at some point in the next six months.
The bank’s analysis of the direction of currencies given differing global growth rates also supports its view of further euro strength, as it has conducted a study into how different currencies move in response to changes in the OECD Composite Leading Indicator (CLI).
Using the CLI as a proxy for global growth the bank’s study found the various currencies can be divided into two groups – the offensive, where the currency appreciates when global growth as measured by the CLI is strong, and the defensive, which deliver negative returns when global growth is strong.
The study shows exchange rates appear more sensitive to growth when global production is below potential, while the level of global inflation also plays a role. Using the former as the primary measure shows the Australian, Canadian and New Zealand dollars are offensive currencies while the euro and the Swiss franc are defensive currencies.
Adding in inflationary measures sees similar results, as periods of high inflation contribute to stronger performance in the Australian and Canadian dollars and British pounds, while the Kiwi dollar does better in a low inflation environment. Regardless of the inflationary environment the bank’s study shows the euro, the Swiss franc and the Japanese yen are defensive currencies.
Applying this to the current environment, where the signs from the CLI are global growth is slowing, the bank suggests the euro, yen and the Swiss franc should gain, supporting its forecast of further gains in the euro/US dollar rate, while the Aussie and Canadian dollars and the British pound may face additional pressure in coming months.
