13 January 2012 at 9:03 GMT
With a perfect storm in sight for the beginning of 2012, one would expect we had something dramatic and new to say about the currency outlook relative to our most recent quarterly musings. But with a couple of notable exceptions, our song for this outlook remains mostly the same for the majority of the G10 currencies. In broad strokes, we expect the USD rally to pick up further steam in early 2012 on global uncertainty and continued deleveraging and on the flipside of that development, we expect that the pro-cyclical currencies will generally face an uphill battle. The Euro is likely to continue to weaken against the USD, JPY and GBP as the EU crisis looks to reach a crescendo some time in Q1.
With a perfect storm in sight for the beginning of 2012, one would expect we had something dramatic and new to say about the currency outlook relative to our most recent quarterly musings. But with a couple of notable exceptions, our song for this outlook remains mostly the same for the majority of the G10 currencies. In broad strokes, we expect the USD rally to pick up further steam in early 2012 on global uncertainty and continued deleveraging and on the flipside of that development, we expect that the pro-cyclical currencies will generally face an uphill battle. The Euro is likely to continue to weaken against the USD, JPY and GBP as the EU crisis looks to reach a crescendo some time in Q1.
Euro to continue struggling
The December 8-9 summit outcome once again failed to shore up confidence that the Eurozone is moving toward fiscal and political sustainability. The agreement on a new EU treaty by March will be a critical focus in Q1, though the cracks on political resolve were already beginning to show merely days after the summit. And any refusal of various members of the EU-27 to sign on to the proposed treaty could render their connection to the EU potentially tenuous to say the least.
Meanwhile, for the European Central Bank, we’ll paraphrase Forrest Gump and say that “easy is as easy does”, meaning that, while the ECB stance is far different from that of the Federal Reserve or Bank of England, which are happy to more directly monetise debt, the December 8 ECB announcements did see further ECB easing moves of a kind. The lowering of reserve ratios and the launch of 3-year Long-Term Refinancing Operations (LTRO’s) are a possible back door for sufficient liquidity to ease some of the pressure on the banks and EU peripheral sovereign debt in the short-term, even if this is yet another delaying tactic and does not address the overall longer term problem of insolvency.
Regardless, as we have said in the past regarding the Euro – the situation is “lose-lose”. Scenario One is simply more of the same: as long as the EU dithers on fiscal union and the ECB dithers on true Quantitative Easing, the crisis will be re-aggravated and the EU will tilt quickly to the brink of a hard default and/or EMU exits or wholesale/partial devaluations of debt back into local currencies and the prominent risk of widespread bank nationalisations. Scenario Two is one in which the ECB either overtly or covertly provides sufficiently massive liquidity to keep the system out of a crisis for the near term while the solvency question is once again kicked down the road. This would be de facto QE and bearish for the Euro.
The two scenarios above are not discrete, but more a description of two dynamics that are working at all times, and to them we must add the political dimension, such that the most likely eventual scenario is along the lines of: the ECB provides covert liquidity that keeps the crisis at bay for a time, but the political fragility is what in the end undermines market confidence and we end in a serious reorganisation of the EU, along with said bank nationalisations, partial defaults, etc. – the true Crisis 2.0 we have discussed in this publication and previously. However reality plays out in 2012, the Euro is likely to fade against the USD, GBP, the JPY, and possibly the Scandies as well.
The USD dollar rally to extend further
In our fourth quarter outlook, we suggested that the USD rally would extend in Q4 as global markets faced uncertainty and as we might see a new US corporate profit repatriation scheme in 2012 similar to the one that boosted the USD back in 2005. We were both right and wrong in that outlook. While markets have zigged and zagged, the general rise in global growth uncertainty has increasingly plagued markets and kept the USD well bid, such that it broke to new 11-month highs ahead of year-end. On the other hand, we’ve seen no signs that a new corporate profits repatriation bill is imminent.
The US economy had a rip-roaring Q4 even as the EU sank into a funk and Chinese growth worries mounted. Going forward, those relative strengths are likely to persist, with the US perhaps only relatively resilient, if not particularly strong. Meanwhile, the compelling political rewards to be reaped from a new profit repatriation scheme as we go into election year still offer compelling odds that new legislation comes to pass early in 2012. That and the continued deleveraging in the world economy and shrinking carry as the other central banks have kicked off a new easing cycle, are factors likely to boost the US dollar, an accommodative Fed notwithstanding.
The pound sterling - stronger than in ought to be?
There is nothing at all to like about the pound sterling from an objective standpoint. The currency sports a virtually non-existent yield, the economic outlook is poor, the country’s twin deficits remain massive, and its central bank has an overtly bearish and dovish president willing to offer endless helicopter drops of cash. Even some of the more determined efforts at austerity are failing to shore up budget deficit credibility as much as hoped. And yet, the pound has been recovering slowly in recent months and that demands an explanation. Part of the reason can be found in shrinking carry disadvantage as other central banks began easing in the second half of 2011.
And from a capital flow standpoint, and even from a positioning/sentiment standpoint, we have to wonder whether the currency might actually do relatively well in our favoured scenario over the next quarter or two. After all, as long as the sovereign debt time-bomb is not detonated in the coming several months, the ongoing risks of balance sheet deleveraging and safe haven seeking are possibly sterling positive. (Not only could sterling continue to find a bid as the EU seems to be doing everything in its power to drive investors away, the geopolitical angle is interesting as well, with the still huge UK financial sector’s ties to world financial flows, not the least from oil-producing nations.) It is clear from the EU debate that the UK has no interest in signing on to the new EU treaty proposals, both because of intolerance for the loss of sovereignty, but also because the UK recognises the importance of its financial services sector and wants no part in possible new taxes on financial/currency transactions.
Swiss franc
The Swiss National Bank and Swiss government must be quite happy with themselves after their dramatic efforts to halt an aggravated rise in the Swiss Franc in 2011 took EURCHF from collapse to parity all the way back to 1.20 and higher once the new EURCHF floor was introduced and so-called sight deposits were employed to force massive liquidity into the banking system. In 2012, we should expect more of the same, the question only being one of timing and whether the SNB will act forcefully in the midst of EU turmoil early on in the year and possibly bide its time until Q2 or later. Regardless, the pressure on EURCHF is generally higher as the central bank and government will simply not tolerate damage to the Swiss economy from an overvalued currency. Additional expansions in sight deposits are a given in 2012, but other measures that are already having an effect are Swiss agreements with the UK and Germany on cracking down on tax dodgers and possibly even the application of negative interest rates on foreign deposits. In 2012, the combined forces of the Swiss government and the SNB will show that intervention can work, if it is done “the right way”.
Japanese yen - wild card of the G-10
The Japanese Yen seems interminably associated with the carry trade – always strengthening when risk is off and weakening against higher yielding currencies when the market is risk-seeking. In early 2012, the JPY may just manage to continue its past behaviour, with brakes applied by the Ministry of Finance/Bank of Japan intervention on market attempts to push USDJPY below 75. The question we have asked for so long, however, is what happens when world government interest rates rise? Japan has the world’s heaviest public debt load, a shrinking current account surplus, and a demographic structure that is tilting Japan towards a nation of net spenders rather than net savers, so there is a potentially explosive direction change in store for the JPY from strength to weakness if/when the government can no longer roll its debt at virtually free rates and the population loses faith in its paper. The Japanese Yen will not be a currency for the faint hearted trader once it reaches this inflection point.
The commodity dollars (AUD, CAD, NZD)
We’re throwing the “commodity dollars” of the G10 together here in one paragraph, but their fortunes are likely to diverge considerably in the New Year. The Aussie’s ability to navigate the turmoil of late 2011 with relative aplomb fascinates. Normally, one would expect that the bouts of risk asset selling, commodity prices plunging and Reserve Bank of Australia expectations nose-diving due to the weak domestic economy would have resulted in a far weaker currency. This demands an explanation – and that explanation might just be that the Aussie has been a kind of safe haven for capital flight flows from China, where worries are increasing that a hard, post-bubble landing is in the making. How long such flows might sustain the Aussie is unclear, but the massive erosion of fundamental support for the currency could mean a very significant reality check rather early on in 2012 if a perfect storm is brewing. Relatively speaking, NZD and CAD will likely be stronger than AUD, as they don’t have this premium built in. CAD may be the best performer of the three because of its proximity to the relatively strong US dollar and more resilient US economy, though Canada still faces an extensive deleveraging in its private sector, even as its public sector has remained fiscally very prudent.
The Scandies (NOK AND SEK) – Safe havens by default?
The European investor is desperate for a safe place to park capital. The SNB after all is bent on devaluing the former franc safe haven, and EU banks and EU sovereign debt are in a parlous state and possible bank nationalisations, devaluations and debt haircuts on the agenda. As if that wasn’t enough, EU politicians are also pounding the table on the need for financial and currency transaction taxes. Enter the Scandies and their relatively open, capital friendly economies, with low sovereign debt loads to boot. For those willing to brave the low liquidity of NOK and SEK (one of the main reasons we rejected their potential as safe haven currencies in the past), there may be further appreciation ahead. The liquidity point is still a challenge for strong appreciation, as is the Swedish krona’s normally more pro-cyclical behaviour due to its dependence on exports. But given the external environment, these two currencies are unlikely to replay the sharp weakening they saw in 2008/09 and instead may default to the strong side in early 2012. Another potential source of trouble for Sweden is its housing bubble, which finally appears to be unwinding and could drag on the health of the country’s banking system.
The probability is we will see yet another crisis summit in Q1 and Germany will cave in - maybe agreeing to the issuance of Eurobonds with joint and several liability - causing bund yields to soar. One way or another we will finally see the European Central Bank satisfied that is has wrung enough fiscal quid pro quo out of politicians and, hiding behind its statutory requirement to ‘ensure monetary stability’, coming to the rescue by explicitly buying distressed sovereign bonds. In fact one can argue that they have already implemented this policy via the back door; December’s announcement of unlimited, 3-year liquidity enables banks to borrow from the ECB at 1 percent, (or lower in time probably), and invest in the bonds of their mother country at maybe 6 percent or more. Thus we see the classic mechanism by which banks can rebuild capital, (without equity issuance), and the states can apparently stay liquid. Did someone say Ponzi?
In addition to this overt or covert quantitative easing, we’d expect the main Refinance Rate to hit 0.75 percent in Q1, with a further cut to 0.5 percent later in the year.
See the entire Saxo Bank Q2 2012 Outlook report in PDF version.
See previous Saxo Bank Quarterly Outlooks.
See a video with Saxo Bank's Chief Economist Steen Jakobsen on the Q2 Outlook.