Foreign Exchange Outlook September 2012

Scotiabank – September 2012

 

Collective stimulus and liquidity injections by major central banks, decelerating growth in emerging-market economies, speculative moves in selected commodities and persistent Europe-centred financial stress currently dominate investor sentiment in foreign exchange markets.

The EUR will remain weak against all major currencies. The CHF value will be anchored versus the EUR by policy and the GBP outlook is bright.

Market Tone & Fundamental Focus

Central bank intervention, growth stimulus in China and Brazil, persistently strong European financial market stress, speculative trading dynamics in commodity markets and uneven directional shifts in emerging-market assets are some of the primary factors swaying capital flows in foreign exchange markets.

The US dollar (USD) has been under pressure following three consecutive months of gains versus other major currencies, with the exception of the Japanese yen (JPY). The US economy continues to struggle to address prolonged weakness in employment conditions, despite timid improvement in leading job-market indicators over the past few months. Recent data on jobless claims and still high unemployment levels indicate a relatively fragile outlook for consumption activity.

 

The USD may be on the defensive as monetary authorities remain committed to maintaining a near-zero short-term interest rate environment and to its large-scale asset (US Treasury and Mortgage based securities) purchase program aimed at depressing long-term funding costs for both the government and mortgage borrowers. Currency markets will be impacted materially by the mid-September Federal Reserve decision on further asset purchases (so-called QE3). The US fiscal outlook is complicated by the November election; however, market participants will demand clarity on key government policies before year-end.

The European economic landscape remains in a constant state of convulsion. Despite a temporary relief in the selloff spree, the underlying structural weakness of the peripheral economies, coupled with the governance challenges facing German and French leaders, should keep the euro (EUR) on the defensive for a prolonged period. The growing uncertainty about the future shape of the European currency union has triggered another round of credit rating revisions last month: Moody’s downgraded the rating outlook of Germany, the Netherlands and Luxembourg to “negative”.

This bearish outlook for EUR is tempered by the negative USD fundamentals noted above. Meanwhile, the Swiss authorities remain committed to defending the policy-mandated ceiling of 1.20 francs (CHF) per EUR as a means of defending the country’s export sector against damaging currency appreciation. The outlook for the other European currencies is brighter; however the recent strength in the Swedish krona (SEK) seems to have overshot.

 

The bullish outlook for the British pound (GBP) is temporarily damped as the UK struggles to meet its austerity plan and to address the economic contraction. The Bank of England maintains aggressive policy as the UK finds itself highly exposed to the European crisis; however, on a relative basis the GBP should fare better than EUR and rally against the USD in 2013.

 

United States – Monetary Policy Commentary

Scotiabank continues to expect that the Federal Reserve (Fed) will undertake quantitative easing

during H2 2012 with high odds that it will commence its purchasing program at its September 13 meeting. We expect further easing to come in the form of open-ended rolling purchases of a mix of treasury securities and MBS. The Fed’s rationale for undertaking further quantitative easing is slow economic growth (2% q/q in Q1, 1.7% q/q in Q2) and stubbornly high unemployment (8.3% in July, 8.3% in January).

Minutes from the August 1 FOMC meeting said that “Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery” – we do not see any change in the economic data that would reverse that view.

 

EURO ZONE – Currency Outlook

Event risk in the Eurozone looms and has skewed the risk return profile of EUR. Sentiment has improved but remains bearish with both risk reversals and CFTC positioning suggesting there has been significant short covering. Historically, September has proven the most volatile month of the year, averaging an absolute return of 4%.

Fundamentally, the outlook is weak; however it is also a challenge to build in a sustainably stronger USD profile. Accordingly, we do not expect EUR to collapse, but instead for it to trend lower, closing year-end at 1.23.

 

UNITED KINGDOM – Currency Outlook  

The domestic fundamentals continue to deteriorate as the UK struggles to meet its austerity plan, growth falters and the Bank of England turns to increasingly aggressive policy. The economy is exposed and vulnerable to the European crisis. To date, GBP has been supported by its triple-A rating, which could come under threat.

 

Technicals suggest GBP is ranging, while the option market has positioned itself increasingly for GBP upside. Sentiment has improved, but the net position is only modestly long. We hold a Q412 forecast of 1.59.

 

UNITED KINGDOM – Fundamental Commentary

 

Despite nagging concerns on the fiscal, economic, and inflation fronts, the pound sterling strengthened through August as markets were buoyed by expectations of imminent action by global central banks.

 

Notwithstanding the mild upward revision to the second quarter GDP estimate at the second reading (to -0.5% q/q from -0.7%) and the anticipated boost from a successful Olympic games, the fundamental growth story in the UK remains weak.

The PMIs drifted lower again in July, with the manufacturing and services indexes reaching their lowest levels since May 2009 and December 2010, respectively. The nation’s public finances have also deteriorated; four months into this fiscal year, government borrowing is GBP 9.3 billion higher than the same period last year, on track to exceed the official full-year target by a notable margin.

With the nation’s triple-A credit rating under close scrutiny, authorities are now under pressure to either tighten spending, or loosen the fiscal plan so as to support growth, and increase

borrowing even further. Meanwhile, rising food and energy costs have revived near-term inflationary concerns. The chances for additional policy easing by the Bank of England have receded, though we consider the door still open for expanded asset purchases.

In stark contrast to the headline GDP data, the labour market appears remarkably resilient. In the three months to June, 201,000 jobs were added, the most in two years. This trend should continue in July given the 5,900 drop in jobless claims that month.