Wednesday, December 15, 2010

Eurozone FX Strategizer : Looking for another year on a roller-coaster

The G-10 FX outlook for 2011 won’t differ too much from the one seen this year. As global 
and even more local risk factors will continue to set the tone, FX trading will be mostly 
for big-wave surfers again: implied volatility will thus stay high for most of the year, keeping
currency majors further on a rollercoaster ride.   

The rationale behind this behavior is well known: the overall economic picture is far from 
encouraging, with most economies experiencing only sluggish growth. More protectionist 
polices may be implemented, while major central banks will keep a prudent monetary stance,
delaying any rate hike to late 2011 at best. Despite recent yield spikes, interest differentials 
will not play a crucial role in determining exchange rates, and in this sense the Fed’s 
case is emblematic. With its decision to start QE2 in November, the US central bank has 
completely clarified its intentions on rates until June 2011 and should stay on hold thereafter,
although Bernanke has recently indicated that more QE after next June is “certainly possible”,
if the economic recovery stalls. The greenback will be more sensitive to external factors than
to issues at home also for most of 2011, and  tensions in EU periphery will work as the 
most critical driver for the entire G-10 FX universe. We don’t expect any contagion 
affecting the EU Latin bloc, but nervous sessions should continue until 1Q11 at least, thus
pointing to more sub-1.30 trading for EUR-USD. In turn,  diminishing market woes in
2H11 should favor a euro rebound above 1.35, while prospects of a rate hike by the
ECB in late 2011 may offer relief too. However, as the ECB will increase the refi rate by just 
25bp and will maintain ample liquidity so as not to damage EU peripheral countries, the net 
impact on EUR-USD will not be exaggerated, likely not too much above 1.40. 

EUR crosses will mostly depend as usual on EUR-USD behavior: tensions across the EU 
periphery and prospects that the SNB may hike rates much sooner than the ECB should still
pave the way for a EUR-CHF re-test of 1.28 early in 2011 and limit any pullback later in the 
year not too much above 1.35. EUR-JPY may benefit from a firmer USD-JPY over time, but 
won’t exceed 125; EUR-GBP will reflect again tensions in the EU periphery and prospects
that the BoE will not capitulate to government calls for more asset purchases, and may hike 
the repo rate to 1.25% should favor a gradual slide back close to 0.80. Lastly, EUR-SEK and 
EUR-NOK will keep a structural bearish trend towards 8.95 and 7.80, respectively, although
the tightening process by the Riksbank and the Norges bank will be less intensive next year. 
The two charts below capture the essence of the EUR-USD dynamics that should continue to 
remain of reference for 2011 too: first, the lack of an unique direction that amplified the seesaw dynamics of this pair for most of 2010; second, the role as key driver played by EMU 
woes from the Greek crisis to the latest tensions affecting the EU periphery. 

In any case, with the decision to start QE2 in November, the Fed has basically cleared 
up expectations on rates until June 2011, when this round of quantitative easing 
concludes. During this time, more bad data from the US real economy may hurt the
greenback, as seen after the very disappointing US unemployment report for November, but 
cannot induce a new plunge as the data won’t  immediately affect the US monetary strategy. 
Chairman Bernanke did hint at a possible QE extension after June, if the US economy stalls,
but this scenario still appears far away to impress markets and may become a drag for the 
USD only in 2H11, if at all (actually, we still expect no QE continuation, although a Fed rate
hike won’t occur before 3Q12).  

Accordingly, the main driver for EUR-USD will remain EU peripheral tensions: with the 
ECB signaling its intension to provide ample liquidity further and being ready to buy more EU
peripheral bonds if needed, we expect no serious contagion that may severely derail the
EU Latin bloc. However, this should not reduce the room for new nervous and volatile
sessions at least throughout 1Q11 that may point to more sub-1.30 trading. In any case, 
receding EMU jitters in 2H11, as we assume, should mean a EUR-USD recovery back 
above 1.35. In addition, the expected ECB first rate hike in late 2011 should offer further relief
too, but,  as the move will be limited to just 25bp  to 1.25% and the bank will likely provide 
again further liquidity to limit the negative impact of its move for the EU periphery,  the 
consequent boost for EUR-USD won’t be exaggerated, not too much above 1.40.  
Consequently, we acknowledge that the main risk to our forecast scenario will be likely 
tilted towards a potentially higher EUR-USD towards 1.43-1.46, based on the hope that 
there will be a final break-through in Europe and no EMU break-up.  

EUR-JPY: the yen to lose part of its attractiveness in the long run  
As usual, EUR-USD behavior is expected to have a greater influence on the dynamic of EUR 
crosses. In that sense, a firmer EUR-USD in  the long term may be consistent with a higher
EUR-JPY. However, investors waiting for an impressive rally of this exchange rate may be
steadily disappointed also due to the impact of a still relatively constrained USD-JPY. In a 
sense,  a USD-JPY break below the all-time low at 79.75 hit in April 1995 still looks 
unlikely, due also to fears of renewed BoJ heavy intervention, but the Japanese unit won’t
give back most its recent strength against the greenback, even if the global picture becomes
less cloudy. We do pencil in a quite muted USD-JPY trajectory for 2011, mostly between 
the 82-87 trading band, also taking into account that Beijing will not concede a sharp CNY 
revaluation next year. As a result, while it may stay confined below the 110 area as long as
EMU tensions persist,  the EUR-JPY upside potential next year should remain relatively
contained, not exceeding sharply the 120 area in 1Y time.  

EUR-CHF: upside potential still constrained  
We remain positive on the Swiss franc, as EU periphery woes should support the CHF role 
as a safe-haven unit at times of global uncertainty and as an EMU hedge. Moreover, EURCHF inability to hold gains much above 1.32-1.33 even when EUR-USD was on a recovery 
path suggests that selling this pair on a rally remains favored, at least during 1H11.

Actually, there is a distinct probability that the SNB may be forced to start hiking rates well in 
advance of the ECB to cool down a still healthy domestic housing market  and an excessively 
high money supply (M2 was up 8.4% yoy in October), delivering a first 25bp rate hike as early 
as by 1Q11. This move, together with creeping risks of more EMU tensions as 2011 starts, 
should favor more EUR-CHF trading below 1.30 during 1Q11. At the same time, the room 
for a EUR-CHF rebound in 2H11, when we expect less nervous market conditions, will 
remain limited and should hardly exceed the 1.35 area. In turn, USD-CHF should remain 
under pressure in the 1.00-0.95 band for most of 2011, as a reflection of both EUR-USD 
and USD-CHF dynamics. 

EUR-GBP: moderately on offer again, as EMU woes & a tighter BoE will weigh  
Sterling’s outlook for 2011 appears a bit complicated, as many factors, both at home and
outside the UK, may impact the British pound in regard to direction and extent. Although
recent dynamics suggest that sterling has become more sensitive to external issues (i.e., the
USD behavior across the board and escalating EMU tensions), UK fundamentals cannot be 
fully ignored. Latest economic data offered a relatively mixed picture, but on balance, the UK 
real cycle has showed so far signs of underlying strength that should help contain the impact
of the very tight fiscal policy which Chancellor Osborne confirmed in October in his spending 
review. In turn, this should make it easier for the Bank of England to resist Osborne’s call 
to print more money. Unlike the Fed, the bank may be more reluctant to restart its asset
purchasing program (APP) with UK inflation still stubbornly higher than the BoE target (3.3% 
in November vs. 2%), and there is still room for the UK rate hike cycle to start in 4Q11 and 
continue throughout 2012. In turn,  these prospects should bode well for cable, pointing to a
return back above 1.70 on a one year horizon. On the other hand, as EUR-USD and cable 
should continue to follow a fairly identical trend, the  EUR-GBP dynamic should be 
smoother again. However, with the Irish crisis now patched up, thus reducing risks of
spillover effects for the UK banking sector, sterling may resume its usual role of EMU hedge if
EU tensions continue. Thus, we expect EUR-GBP to progressively slide towards the 0.80 
area in the coming months.  
Nordics: Still firm, although more prudent monetary tightening at home  
Recent SEK and NOK ability to break key support  levels against the euro at 9.10 and 8.00, 
respectively, suggests that  the underlying appreciation path of the two Nordic units is 
intact. Unsurprisingly, retreats over 9.40 and 8.20, as occurred this Autumn, ultimately turned 
into a new opportunity to buy the two Scandies at cheaper levels. Accordingly, we pencil in 
again a further downward correction of both EUR-SEK and EUR-NOK during 2011, but 
the slide should occur at a relatively slower  speed. Actually, the economic outlook for both 
Sweden and Norway is expected to be positive but less exuberant than in the past, and thus 
will imply that the tightening process in the two countries will continue, but not at a very fast
pace.  We expect the Riksbank to raise the repo rate to 2.25% from the current 1.25%, while 
the Norges Bank should hike to 2.75% from  the current 2.00%. Higher short-term interest 
rates should offer support  to the SEK and the NOK, but  the expected EUR-SEK and EURNOK slide should not exceed too much 8.95 and 7.80, respectively.

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