FYI | Jul 24 2008
By Chris Shaw
Given the global threat inflation presents as economies around the globe deal with higher energy and food prices in particular it seems reasonable for the market to be pricing in interest rate hikes. Currency specialists at Standard Chartered believe this makes sense for the US in particular as these inflationary pressures need to be kept in check.
Currently the market is factoring in as much as 1.0% in rate hikes in the US over the next 12 months, even though there is a chance none of that will happen, notes Standard Chartered. The specialists believe this especially applies for the shorter-term given unemployment in the US is moving higher and the banking sector outlook remains weak at best.
In the group’s view the US dollar remains in a long-term bear trend, which means lower highs and lower lows for quite some time to come as the currency appears to be following a similar pattern to previous cycles when it fell on the expectation of rate cuts but then reversed course once market expectations for rates started to move higher.
The group’s view is the weakness in the US economy means these rate hikes are not coming soon. Even if the group’s expectation of further cuts to rates in the next 12 months is not met, the worst case is likely for the US Federal Reserve sitting on its hands and doing nothing. The currency specialists believe this will aultimately cause market expectations to be revised and the US dollar to fall further.
This doesn’t preclude a correction within the longer term trend though and the group expects exactly that in the first half of next year. The reason is while inflationary pressures are taking precedence at present, when these pressures start fading the focus of central banks around the world will turn to stimulating economic growth and here currently only the US is taking any action.
This implies central banks elsewhere in the world will be forced to play catch-up, which is a very bullish scenario for the greenback given relative interest rates would be supportive for the currency at the expense of those in Europe and Asia.
Some other factors support the group’s view of a possible US dollar rally next year, one being signs of continued economic weakness in parts of the European Union such as the Irish and Spanish housing markets. As well, data such as retail sales and industrial production are trending lower in the region and this appears unlikely to change quickly.
The other, and possibly more significant factor in favour of a rally in the US dollar, is the currency appears significantly undervalued at present against currencies such as the euro, British pound, Swiss franc and New Zealand dollar even allowing for the state of the respective economies. For example, Standard Chartered suggests long-term fair value for the US dollar against the euro is in the order of 1.15-1.20 compared to its current level of near 1.60.
Under its scenario of a US dollar rally in the first half next year the group is forecasting the US dollar/euro rate will be at 1.48 by the end of the March quarter and at 1.40 by the middle of next year, before again weakening to 1.55 by the end of 2010.
With respect to the Chinese currency the group sees further increases, but as with the recent trend more of the movement is likely to be on a trade-weighted basis than simply against the US dollar. With growth slowing in the region there is also scope for a change to a less tight economic policy in 2009, so Standard Chartered is now factoring in a bump higher against the US dollar that is currently not priced into the market before a resumption of the yuan’s existing uptrend.
The growth concerns impacting on the broader economy are evident in Asia as well and the group expects this will become evident in the next year or so as central bankers policies shifts to stimulating growth as inflationary pressures ease. This suggests weaker rather than stronger currencies against the US dollar in particular, with the Singapore dollar, Malaysian ringgit and Taiwan dollar the most likely to come under pressure in its view.
Once this corrective bounce in the US dollar plays out next year the group sees relative interest rates again driving the market, which would signal the re-starting of the long-term US dollar downtrend.
