FYI | Jul 07 2008
By Chris Shaw
Since the second half of last year Danske Bank has been warning of the potential dual shock of a financial crisis and a global economic slowdown, and in the bank’s view both are now in place given there is nothing to suggest the financial cirsis is over and there are enough cyclical threats to keep the world economy under pressure.
Risk is things get even worse in the bank’s view, especially if the two waves of consumers and banks attempting to repair their balance sheets come together at the very same time. As well there is the issue of higher inflation thanks to rising food and fuel prices, which flows through into lower disposable income at the same time as rates around the world are being pushed higher to deal with the threat of higher inflation.
In the bank’s view inflation is now the greatest single threat to the global economy as while general market opinion is the issue will be resolved without a sharp decline in economic activity there is a substantial risk this won’t in fact be the case. This would leave the world economy having to deal with a period of financial deleveraging at the same time as the level of economic activity is slowing.
One other problem according to Danske Bank chief strategist Teis Knuthsen is central banks have few options in terms of dealing with inflation, with the only real choice the old-fashioned approach of tightening monetary policy to slow down the level of economic activity.
As a result inflation is likely to remain at the forefront of policy in coming months, especially as there remains upside risk to oil prices in the curent environment. This will impact on currency markets, with only those currencies where the associated central bank can follow through with any hawkish rhetoric with respect to interest rates likely to post gains.
This splits the currency market into two camps in the bank’s view as only the European Central Bank, the Norges Bank and Sweden’s Riksbanken are well enough positioned to follow through with their threats to lift rates in coming months. In contrast the Reserve Bank of Australia is likely to hold steady (though Knuthsen sees the risk of one further tightening on the back of recent strong retail sales figures and an improving terms of trade), while the Reserve Bank of New Zealand is considered the most likely to lower its rates given the dramatic slowing in the New Zealand economy of late.
Talk of the US Federal Reserve, the Bank of Japan and the Bank of England lifting rates is likely to prove just that in Danske Bank’s view, meaning any inflationary shocks in coming months on the back of higher oil prices should see their respective currencies underperform against those mentioned in the first group.
As Knuthsen points out, such expectations are in line with its findings on the relationship between oil prices and foreign exchange moves, which show rising oil prices are bullish for the euro against the US dollar and the euro against the yen while being bearish for the US dollar against the Canadian dollar and for the US dollar/NOK pair.
While previously forecasting a euro/US dollar rate of around 1.55 for the northern summer Danske Bank suggests risk is to the upside and given the poor outlook for the US economy in particular it has lifted its three month forecast to 1.60 from 1.55 and for six months to 1.55 from 1.50.
The euro/yen pair recently traded at a record high of just below 170 and with the Japanese economy continuing to struggle the bank sees scope for further highs in coming months. Further gains are also expected for the euro/UK pound pair as Knuthsen sees little chance of the Bank of England actually lifting rates in coming months. As a result Dankse Bank is now forecasting a rate of 0.78 in 12 months time against 0.75 previously.
The Aussie dollar is expected to drift even higher against its Kiwi counterpart as the commodity inflation that had been supported that currency is now fading and as New Zealand’s main export markets are flat while Australia’s continue to rise. This should also support the Aussie against the US dollar and Danske has responded by lifting its three and six-month forecasts to 98c and 95c respectively.