Q2 FX Outlook: USD rally to get back on track

There were two key drivers for FX in the first quarter, neither of which we anticipated particularly well with our Perfect Storm outlook, even if all of the ingredients for a perfect storm remain very much out there. Those two drivers were a continued upward spiral in risk appetite and a tectonic shift higher in interest rate expectations – or at least a tectonic shift away from expectations for imminent further quantitative easing. These developments kept the USD rally contained for the quarter. Relative to past behaviour vis-à-vis risk appetite, this was actually a very strong performance for the greenback. Elsewhere, developments were mixed – the Euro rebounded from record lows versus the rest of its G-10 peers as the European Central Bank managed to pound peripheral Eurozone sovereign bond yields back lower, while action in the most pro-risk currencies was underwhelming as the favourite pairings of these trades versus the hapless Euro failed to perform. The most marked move was in the Japanese Yen, as the Bank of Japan made dramatic new easing measures in February, just as expectations for further easing elsewhere were rapidly beginning to unwind and as interest rate comparisons all along the yield curve moved against the yen’s favour. The yen therefore revived its status as the carry trade funding currency of choice by quarter-end.

In the coming quarter, the market will transition to our “balancing act” - the after effects of the extreme central bank efforts thus far and resolving the degree to which the recovery story continues to catch fire. Will the US stay on course, Europe improve and China stimulate its way out of its current deceleration, or will the market find cause to fret that the negative cycle will start all over again as stimulus has now been withdrawn and as austerity remains in the pipeline? We expect some of the Q1 developments to continue, particularly the USD resilience which will likely become outright USD gains if the extreme complacency in Q1 yields to the reintroduction of volatility in Q2. Meanwhile, the JPY may eventually shift into a consolidation phase on the same developments, though we will also need the shift higher in interest rates all along the various major yield curves to ease at some point for the JPY to find support. Elsewhere, the pro-risk currencies are likely to come under significant fire, particularly the Australian and New Zealand dollars, which have already shown significant signs of weakness in recent months relative to prevailing market conditions. Emerging markets will also be vulnerable as a weak China could see widespread disdain for EM assets.

Euro – muddling through
Q1 saw the ECB executing another massive 3-year Long-Term Refinancing Operation at the end of February, which stamped out the fear, in the near term at least, that the peripheral Eurozone countries all face imminent sovereign defaults. But the ECB moves have merely bought time in the same old extend-and-pretend fashion. Eventually, the political mess will return in full force sometime after the French election is a fait accompli in early May and the ECB will have to warm up the printing presses again. In Q2, our FX view on the Euro is fairly neutral to bearish broadly speaking - capped to lower versus the USD with a view towards 1.2500 and possibly lower by the end of the quarter, but perhaps stronger than the commodity currencies.

USD - rally to get back on track
The USD’s marginal weakness in Q1 versus the rest of the major currencies as a basket was actually a stellar performance relative to the intermarket conditions - as bonds sold off and central bank easing expectations eased while risk appetite soared. Going forward, Q2 may see some further normalisation in rates, but we suspect this will quickly lose momentum and that the complacency that was the hallmark of Q1 will yield to more volatility. The move higher in bond yields in Q1, the withdrawal of central bank stimulus and prospects of automatic government austerity measures kicking into gear in early 2013 will put the brakes on higher risk asset prices and will likely see the USD thriving in Q2. The Federal Reserve will likely be geared up for QE3 in Q3, but only because forward expectations have been adjusted considerably lower, and by that time, the USD would have a far higher starting point from which to consolidate.

JPY - Volatility fireworks to fade?
The yen was punished for enormous losses in the first quarter, almost across the board, on the combination of healthy risk appetite and higher interest rates all along the major global government yield curves. At the same time, the BoJ announced a major new effort aimed at restoring positive inflation to Japan in mid-February just before other major central banks were stepping off the printing press accelerator. The weak JPY move may continue in early Q2, but if the seasonal pattern of the last couple of years repeats itself and the higher interest rate expectations prove unfounded, the JPY is more likely to consolidate and carve out a new range rather than continues to heavily sell off. For the longer term, the worsening terms of trade and non-existent bond yields will eventually help and a determined push from the BoJ is likely to see the desired weaker outcome for the yen.

GBP - Middle of the pack
Sterling will continue to “rally by default” with downside risk possibilities stemming from signs of deteriorating public finances and lack of credibility on the fiscal front and the possibility that the ratings agencies follow up on their negative outlooks with actual downgrades at some point in the two quarters ahead. On the other hand, sterling has been doing quite well recently considering the renewed stability in the Eurozone sovereign debt markets and positive risk appetite. Going forward, sterling may perform slightly ahead of the middle of the pack if global complacency is replaced with more volatility. In the likes of GBPUSD, this could mean it eases lower, but in crosses like GBPAUD or GBPNZD, it could mean a strong rally.

CHF - Hard to have a view short-term
Rather than pulling the EURCHF floor higher, the Swiss National Bank took the opportunity at its quarterly policy meeting in March to tighten rules on personal financial transactions after the embarrassing exit of Hildebrand. This spoiled an opportunity for the SNB to move again at a time when the Euro was stabilising. It is tough to forecast now when the SNB will move again, but it is rapidly getting cheaper to make a guess as 3-month volatility in EURCHF had collapsed to close to multi-year lows south of 3.5 percent by late March after trading above 8 percent as recently as December. The SNB will move again, and we stick to the forecast that the EURCHF will trade higher within the next year - the question is merely one of timing.

AUD, NZD and CAD
Our least favourite currencies for Q2 are the Aussie and the Kiwi. Given the market conditions (wild appreciation in major equity markets) their performance in Q1 was actually extremely weak, rather than merely slightly weak. The chief concerns are valuation and the questions surrounding China’s attempt to transform its economy. If Chinese resource demand falls or even if demand remains relatively steady and prices fall, Australia’s economy could be set for a rough patch as the extractive industries are the only ones really contributing to overall growth and Australia’s post-bubble housing market is now in full retreat. A tax on mining profits is also in the works. With the highest yield of any major currency, the Reserve Bank of Australia has the most room for accommodation of any currency, and thus the most potential to fall as a result of compressing rate spreads. The outlook is theoretically better in New Zealand, but the kiwi also suffers from overvaluation and won’t be particularly prized due to its thin liquidity if volatility returns in Q2. Of the three commodity dollars, the Canadian dollar is likely to fare far best due to its exposure to the relatively strong US dollar and economy and as it is less exposed to China risks. Energy remains an important wildcard for Canada in either direction. Clearly holding the CAD back is the prospect of the domestic housing bubble beginning to unwind, which could scotch the recent rise in Bank of Canada rate expectations, which rose sharply in Q1.

NOK and SEK
The Norges Bank was none too happy with EURNOK moving below 7.50 and decided to ease rates at its March meeting as rate expectations elsewhere were in many cases steady or on the rise. This saw a spike weaker in NOK across the board. Still, while the potential for Norges Bank rhetorical and rate intervention remains a threat, the downside potential for NOK appears limited in this market as it has a spotless sovereign balance sheet and may continue to serve as a relative safe haven. Given the Norges Bank activism, a strategy of fading weakness may be the preferred one. SEK tends to be more pro-cyclical than NOK and has yet to be tested as a safe haven currency, though it will likely prove safer than it has in past situations because of the solid condition of the sovereign balance sheet. Two vulnerabilities would be a weaker than expected European economy/disruptive political event in the Eurozone and Sweden’s massive housing bubble, which is showing incipient signs of an unwind. Still, much as with NOK, fading excess SEK weakness may be the strategy of choice in Q2.

See the entire Saxo Bank Q2 2012 Outlook report in PDF version.

See previous Saxo Bank Quarterly Outlooks.