FYI | Jun 26 2008
By Chris Shaw
If the latest economic outlook is one of rising inflation around the world can be taken as given Danske Bank suggests the trends of the past decade or so in foreign exchange markets are now likely to unwind, with implications across most of the major global currencies.
As the bank’s chief strategist Teis Knuthsen points out, the group’s strategy with respect to forex markets was based on the credit crisis creating a temporary setback for the financial sector, which would have been followed by a short-lived economic slowdown.
That was the theory but reality has proven to be a little different as Knuthsen notes there has yet been no evidence the financial crisis has finished, as evidenced in his view by the continued poor performance of banks and brokers since the crisis began.
At the same time consumers appear to be overextended given current cyclical threats, with extremely negative implications if both banks and households are forced to attempt to repair their balance sheets at the same time. Throw inflation into the mix and there is a fall in disposable incomes, further reducing the level of economic activity and so making any recovery in the global economy in 2009 less likely.
Assuming this is the reality of the present situation Knuthsen notes such an environment has historically been a period where the Swiss franc, the Japanese yen and the euro have outperformed the Australian and Canadian dollars and the British pound.
As well, he points out policy makers in the Asian region have also sharpened their focus on inflation of late and are using traditional monetary policy measures in attempts to bring it under control. This is likely to weaken the economic fundamentals of these countries in his view, at the same time increasing the risk premiums associated with their respective currencies.
As a result expectations of currency appreciation in the region may not be met as few currencies in the region at present seem to be able to follow the Chinese yuan higher and none of them have been able to match the strength in the euro.
Knuthsen also suggests with US growth struggling and its currency falling as a result it may no longer be the case that a number of countries simply peg (unofficially) their currency to the US dollar, but adjusting such pegs at this point in the cycle is likely to change what for several years has been a relatively stable forex system.
The focus on inflation means tightening is back on the agenda as nine of the G10 central banks are tipped to move rates higher as their next move, with the Reserve Bank of New Zealand the only exception. To play this outlook Knuthsen suggests traders sell the US dollar/Yen and to sell the British pound against better performing currencies such as the euro or the Aussie dollar, as the US and UK have the most mis-priced monetary policies at present.
In the US for example real interest rates are now negative and the market expects a normalisation of rates in the shorter rather than longer-term. Knuthsen suggests such a view is incorrect because the world is still in a financial crisis and this implies downside risk to economic growth and, more importantly, the current rise in inflation rates is unlikely to continue as rising energy prices will lower demand, which will curb inflation over the medium-term.
Following the recent surge in oil prices Danske Bank has also looked for correlations between the oil price and foreign exchange markets in an attempt to identify any forex crosses that are misaligned thanks to the movement in the oil price.
Its analysis suggests the greenback is at present not correctly priced against the Canadian dollar as it should have fallen on the back of higher oil prices but has been largely steady, meaning there is downside risk from any make-up movement. Similarly there appears to be upside risk for the euro/US Dollar and euro/Japanese yen pairs as movements to date have not been enough given the size of the recent rally in oil prices.
