Saturday, October 3, 2009

FX Briefing : Doubts about Upswing Scenario


  • Weaker stock markets bring some relief to the dollar
  • US economic data disappoint; employment is cut further
  • Europeans resist appreciation of the euro

This week the dollar showed strength again. The losses of the past weeks were partly corrected as equity markets weakened and a more cautious assessment of the chances for an economic recovery diminished risk appetite. During the week, EUR-USD dropped close to 1.45 and most other European currencies showed similar weakness. After the losses of last Friday to below 90, USD-JPY was more or less stable. At the beginning of the week, the exchange rate dipped briefly to 88.24 triggered by irritating comments from finance minister Hirohisa Fujii. But after the minster added that he did not exclude interventions in the case of extraordinary movements, the US currency recovered to below 90.

The current exchange rate development is influenced by two factors. One is that doubts are growing whether the expected recovery of the global economy justifies the levels that markets have reached. For weeks, stock prices have risen, credit spreads diminished and the dollar has depreciated as risk appetite increased. But the expected moderate recovery - the IMF for instance is forecasting 1.3% growth in industrialized countries for 2010 - is not providing any impetus for markets at the moment. In addition the reporting season for the third quarter is starting next week in the US. Stock markets participants are especially keen to hear how companies are assessing their earnings prospects.

The current economic data are mixed. The manufacturing ISM fell slightly in September to 52.6. This does signal expansion but only a moderate one. Moreover there is uncertainty about the extent of the deterioration in the data as the cashfor- clunkers programme runs out. Domestic vehicle sales have already collapsed in September.

The situation is similar in the housing market. Admittedly, existing home sales have recovered considerably in the past six months. Pending home sales increased by 6.4% in September. But the question is whether this recovery can be sustained in the coming months without government support measures.

The labour market is another critical area. Although the pace of job losses has gone down considerably, there are no signs of a labour market recovery. Surveys such as the ISM and consumer confidence indicate that jobs are still being cut. Initial jobless claims are pointing in the same direction: at 550,000 they remain quite high.

The second factor, which is increasingly gaining influence on the forex markets, is politics. The G20 called for the correction of global imbalances, which are mainly reflected in the current account balances. The statement does not explicitly say much about what this means for exchange rates; only in the appendix it is stated that exchange rates should be market-based and reflect the fundamental situation. But implicitly the statement calls for a dollar depreciation. On Thursday, the IMF's chief economist pointed out at the presentation of the new World Economic Outlook, that it is difficult to see as to how the necessary adjustments could be achieved at the current exchange rates, especially without an appreciation of the individual Asian currencies.

Japan was not named in this context but it is obviously affected. Japan is the prototype of an export-oriented economy with high current account surpluses and above-average output in the export sector. Moreover the new government under Yukio Hatoyama itself is advocating a rebalancing of the economy towards stronger domestic demand. But the finance minster recently hinted that abrupt exchange rate shifts would not be permitted.

European politicians are seeing the danger that the euro and other European currencies will become ensnared in a possible appreciation process. At the Ecofin meeting in Sweden finance minsters and central bank governors put together a paper on the euro exchange rate which is to be discussed at the G7 meeting in Turkey this weekend.

Medium-term outlook for the euro The euro's development over the coming months will depend mainly on whether the nascent recovery turns out to be sustainable. In our opinion there is a significant risk of a setback, which would dash hopes of a recovery. The government can stabilize the economy with the help of public spending programmes but a real upswing is only possible if private demand picks up. The signs for that happening are not good, however. If the reaction pattern that has established itself in the course of the financial and economic crisis holds, this would result in higher risk aversion and pressure on the euro.

The central banks' support does, however, make it unlikely that the liquidity crisis escalates again as it did in winter 2008/09. Moreover, there is support for a depreciation of the dollar from the political side. The US has an obvious interest in improving its international competitiveness and this interest would increase if the hoped-for recovery does not materialize. The G20 basically agree on this. These two factors are likely to limit the downward risk for the euro. Over the next six months we therefore expect a moderate weakening of EUR-USD.


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