Q3 FX Outlook: Back to the strong USD future

Much of Q2 saw the USD rally moving forward with conviction, but the quarter ended with a question mark, as the market pushed back the USD and bid up risk appetite as it tried to find hope in the morass of EU summitry and on expectations of another round of global central bank stimulus in the pipeline. In Q3, Europe will have many questions that may remain unanswered and this could keep the Euro on the defensive, while the USD is likely to thrive together with the Scandies. The JPY outlook is highly dependent on the direction in global rates as usual, and the commodity currencies may be the dogs of the G-10 if hopes of the arrival of a brave new punch bowl are outweighed by weak growth worries. 

USD – turning the battleship
The USD got a promising start in Q2, as it posted an 18-month high on a trade-weighted basis. However, as has been the case in the past, most of its upside was all about thriving due to its status as a safe haven – in other words thriving because something else was hurting. The main USD positive drivers this year have been the EU debt crisis and more recently the strong correction in commodity prices and negative economic growth expectations – particularly as these have spread to emerging markets. As we enter Q3, the USD strength has faded more than a bit – particularly against the traditionally pro-cyclical currencies and the new safe haven currencies like the Swedish krona. But we don’t expect the USD will remain on its back foot for long – there are still tremendous macro risks in the near term for 2012 that can feed into additional USD strength. As well, the US economy looks set to outperform many of its global peers and is better positioned on the other side of the weak spot in global growth for a recovery due to: demographics, a mostly deleveraged financial system, cheaper real estate, labour flexibility and other possible policy choices (including prospects for a new Homeland Improvement Act (HIA) like legislation aimed at bringing well north of USD 600 bn in retained foreign corporate profits home) as well as a changing energy balance.

EUR – denial or change?
The EU debt crisis will roll on in Q3 as we either head toward “denial or change”, as is the main theme of this quarterly outlook. For the EU, denial could look like this: a nod towards a somewhat deeper union, if that can somehow be conjured from the differing interests of the core versus the periphery, but without any real move to restructure EU bank/sovereign debt. The only way this could be made possible is via a massive further expansion in the ECB’s balance sheet, which is not under discussion yet as the EU pretends that the unfunded or at best under-funded ESM is the right tool – should it be approved by all EU stakeholders. This would be both medium and long term Euro bearish. If, on the other hand, the EU quickly transitions to the “mandate for change” phase of the crisis and looks to be heading toward a real restructuring of the EU and its debt by year end, the downside for the Euro will be found far more quickly in an environment of scary volatility in the near to medium term – but it would position Europe and the Euro better in the longer term.

Chart: EUR vs. the rest of the G-10
The chart shows the Euro vs. an evenly weighted basket of the rest of the G-10 currencies, indexed to 2500 trading days before present. The currency has never been weaker in its existence and its path from here will be determined by the equation of denial (more sustained weakness) vs. change (more volatility but a quicker recovery).

Baseline forecasts
The forecasts below are made in the interest of framing our preferred higher odds scenario – namely that the EU still has a considerable period of uncertainty ahead and that global growth will come in somewhat weaker than expected, particularly in Asia. The outlook is extremely uncertain, as ever, with markets so vulnerable to and dependent on signals from policymakers and central banks.

The Scandies – NOK and SEK
NOK and SEK stand to outperform for the coming quarter and longer term as Norway and Sweden ought to be seen as safe havens in a world of sovereign debt worries. In past cycles, the two currencies have tended to be more pro-cyclical - weakening in an environment of risk aversion on fears that trade flows will be heavily disrupted by weak demand in export markets and due to the currencies’ relatively thin liquidity. But this time around, other considerations may prove paramount. Namely, these are open economies with spotless sovereign balance sheets. Yes, weak oil prices could cause headwinds for NOK for a time and weak export demand and an eventual unwinding of the housing bubble could act as headwinds for both of the Scandinavian economies, but these currencies are still attractive at close to their strongest levels in years against the Euro, and are especially attractive against the likes of the overvalued Aussie on a relative value basis. In more stressful EU scenarios going forward, their strength could even create discomfort for Norges Bank and the Riksbank and eventually threaten various forms of intervention.

The commodity dollars – AUD, NZD and CAD
The key question from here for the Aussie is whether it can maintain its newfound status in late Q2 as the currency that can both have its cake and eat it, too. Australia’s economy is easily the major economy most reliant on China, and as fears over China’s foundering economy have risen this year, the Aussie justifiably corrected a bit more than 5 percent against the rest of the G-10 currencies in the first months of this year from its very lofty peak. Going into Q3, it has taken back about half of lost ground. The apparent hope for Aussie buyers is that China is stabilising and that the money printing impulse of the major central banks will remain while the Reserve Bank of Australia (RBA) will easily steer clear of such excesses. Other Aussie positives include a low sovereign debt load and the supposed imminent return to a budget surplus. Still, there is reason to fear for Aussie weakness on a number of fronts, including plummeting expectations for the major Australian miners and a further unwinding of the domestic housing bubble as well as a domestic economy that is on the ropes. The Australian economy has arguably been a credit and housing bubble on top of a mining bubble – if so, there is a much larger hangover for the economy and its currency in quarters to come than the one we have seen thus far, particularly as the transition period for China is likely far from over.

Chart: AUD vs. rest of G-10
The chart shows the Aussie vs. an evenly weighted basket of the rest of the G-10 currencies, indexed to 2500 trading days before present. Adjusting significantly lower in early 2012 on worries over Chinese growth and a steep unwinding of the RBA cash target and future expectations thereof, the Aussie was surging again by the beginning of Q3 on expectations of new central bank stimulus in the pipeline, resurging risk appetite, and perhaps  Chinese safe haven flows. The standard fundamental inputs already suggest that the Aussie should be far weaker as the currency remains overvalued broadly.

New Zealand should fare less ‘bad’ than Australia in a weaker global environment, both because its excesses in the last cycle were less extreme and because its mix of key commodities exports is far less cyclical. AUDNZD downside could well finally become a theme in coming quarters after only fitful bursts of downside over the last 18 months. Still, the kiwi is at the very top of its long-term range against the rest of the G-10 currencies and is fairly thinly traded. Thus, it is generally at risk when the markets are buffeted by volatility and risk aversion as we saw late last year and during this year’s bout of weak risk asset and commodity prices.

CAD has seen an indifferent performance of late despite a resilient domestic economy. Still, the currency has done better than one would expect, given the massive swoon in oil prices that unfolded in Q2. Over the last few quarters, CAD has done better in the non-USD crosses when the USD is outperforming and has tended to be weaker in the crosses when the USD is weak – not a huge surprise given its satellite status to the US economy and the Bank of Canada’s need to not diverge too widely from Federal Reserve policy. Despite hawkish noises at times from the BoC, interest rates are likely to go nowhere in Canada and the currency is likely to remain an indifferent performer, though it has a long-term attractive valuation relative to the other commodity dollars.

JPY – growing headwinds
The JPY saw a new local peak in its strength in Q2 due to record low bond yields across the developed economies as the state of global bond yields remains a familiar theme for the JPY. The JPY rise impressively came despite the Bank of Japan’s (BoJ) declaration of a “war on deflation” at its February meeting and other follow-up measures. But bonds sold off heavily and the JPY weakened again in June. We enter Q3 with bond yields near critical resistance levels and thus with an uncertain outlook for the JPY. In the big picture, the strong JPY is sowing the seeds of its eventual weakening, as Japan’s competitiveness suffers under the yoke of JPY strength. As well, a rapidly aging Japanese demographic and massive growth in the population of retirees means that the nation has become a net spender after decades of impressive savings rates. This, combined with weakening current account fundamentals and a new steep doubling of the sales tax on the way are developments weighing against the JPY. Future bouts of JPY strength will be weaker than they have in the past as we slowly transition to a JPY bear market in the quarters to come.

GBP – easy does it for the BoE
The sterling had a bizarre flirt with strength in Q2 based on a brief impression that the Bank of England (BoE) stance was changing over inflation worries. This was quickly proven unfounded and the currency rushed lower against the USD, though it did maintain a persistent rally against the Euro for much of the quarter on the ongoing EU crisis. This kind of performance is likely to continue going forward – maintaining strength as a semi-credible safe haven from the Euro – only semi-credible because the country’s long-term twin deficit situation is alarming, though it does feature deep capital markets that make it a preferred destination for capital seeking safer harbours away from the continent. But the BoE’s easy stance and a weak UK economy will mean continued weakness or range-bound behaviour versus the USD.

CHF – will the peg slip?
The EURCHF peg has survived a rather major stress test this year, though not without serious heavy lifting by the Swiss National Bank (SNB), which has intervened massively to protect the peg to the tune, for example, of several per cent of GDP in currency reserve accumulation in a single month in May of this year. The question going forward is whether the EU situation improves and if not, if the SNB and Swiss government judge the peg too expensive to be worth maintaining. There is a non-trivial risk of the SNB being forced to drop the peg back to 1.10 or even parity in a more stressful scenario. The only other option in such conditions is the enactment of various forms of capital controls, a technique Switzerland has used in the past. The upside risk for EURCHF is minimal unless the EU starts to really deal with its problem. Ironically, longer term, the franc is severely overvalued, but will need to see prospects of a credible solution in Europe before its strength can be sustainably unwound.

See the entire Saxo Bank Q3 Outlook report in a PDF version below.

See previous Saxo Bank Quarterly Outlooks.