Euro/US Dollar interest rate forecasts have become somewhat bearish, but recent FX market price action suggests the EURUSD will continue to trade off of risk sentiment in broader financial markets. Indeed, the historically strong correlation between interest rates and FX market price action faded quickly through the onset of the global financial crisis. Overnight Index Swaps predict that Euro and US Dollar interest rates will be roughly equal in 12 months’ time.
Such forecasts should be bearish for the Euro, which currently enjoys a 100 basis point yield advantage over its US counterpart. Yet we believe that these developments may have little impact on the Euro/US Dollar exchange rate. It will be far more important to monitor trends in the US S&P 500 and other key global risk sentiment indicators.
Euro / US Dollar Valuation Forecast
The Euro has pushed deeper into overvalued territory and is now 3135 pips above is “fair”, PPP-implied exchange rate as risky assets continued to advance, weighing on the safety-linked US Dollar. From a fundamental stand-point, the foundation behind Euro strength seems shaky: the IMF is forecasting that the Euro Zone will stand apart from other industrial economies in seeing GDP continue to shrink through 2010, which likely means the Fed will lead the ECB in starting to raise interest rates once economic recovery begins in earnest. In fact, a look at overnight index swaps (see above) seems to be pricing in just that. Further, deflation is beginning to set in while the banking sector is yet to come to terms with an estimated $1.1 trillion in unrealized sub-prime related losses (again courtesy of the IMF), a hit that could be compounded by losses from default or devaluation in some of the newly-minted central European EU member states. That said, the sharp rally in equity markets that has punished the Dollar since March continues to make new highs despite increasing chatter about the move being over-extended, so timing a reversal is a decidedly difficult endeavor. On balance, the bias remains bearish with further EURUSD gains to be taken as a welcome opportunity to exploit a larger disparity in valuation once the downturn does begin to materialize.
US Dollar Japanese Yen Exchange Rate Forecast
Interest rate traders forecast that the US Dollar yield advantage over the Japanese Yen will pick up significantly in the coming 12 months, but recently apathetic FX speculators have shown little interest in interest rate developments. The US Dollar/Japanese Yen exchange rate has instead moved off of shifts in global financial risk sentiment—especially as seen through key risk barometers such as the S&P 500 and Nikkei 225 indices. We predict this will continue to be the case through the foreseeable future.
Indeed, Overnight Index Swap differentials have supported a USDJPY rally since the pair traded near the 105 mark. Suffice it to say, such interest rate-based forecasts were far from accurate. It remains far more important to monitor general financial market risk sentiment.
US Dollar / Japanese Yen Valuation Forecast
The bottom line for the Japanese Yen is broadly unchanged for the fifth consecutive month with the currency still effectively at its “fair” value against the US Dollar. As before, both the yield outlook and comparative economic growth expectations are biased in favor of the greenback. Indeed, median estimates from a survey of economists conducted by Bloomberg suggest that US GDP growth will outpace that of Japan by an average of 2.4% through the end of 2010. The pair’s correlation to risk trends seems to have declined sharply recently, but these relationships can vary in prominence over time and there is certainly a possibility that any return to risk aversion would prompt carry trade liquidation and send the Yen higher across the board, weighing on USDJPY by association. On balance, current positioning does not offer an attractive mispricing to be exploited from a valuation standpoint; it seems prudent to remain flat for the time being until a cleaner disparity presents itself.
British Pound US Dollar Exchange Rate Forecast
The British Pound/US Dollar currency pair has shown relatively little sensitivity to interest rate developments through recent trading. FX markets have sent the GBPUSD to fresh peaks despite the fact that Overnight Index Swaps show little change in yield forecasts, and there is little reason to believe that markets will subsequently grow more sensitive to GBP/USD rate differentials.
It has been far more significant to monitor financial market sentiment as seen through the S&P 500 and other key risk barometers. The rolling medium-term correlation between the GBPUSD and the S&P remains near record highs, and we have many reasons to believe that this will continue to be the case through the foreseeable future.
British Pound / US Dollar Valuation Forecast
As with the Euro, the gap between British Pound spot and PPP-implied exchange rates has widened over recent months, catalyzed by the market’s seemingly insatiable appetite for risky assets. Indeed, the sterling’s relative superiority in value and yield has seen it outperforming other major European currencies against in the greenback. However, this also means that the UK unit is more vulnerable to a reversal of a current rally, an outcome that seems reasonable considering global shares look decidedly overvalued having finished July trading at the highest level relative to earnings since October 2003. After adjusting for inflation, the pace of global GDP growth registered at 2.7% that year having been accelerating since 2001, implying earnings that all but certainly expanded at a healthier rate than anything we are going to see this year. It seems only a matter of time before the stock markets experience a rude awakening and begin correcting sharply lower, dragging the Pound along for the ride. In the meantime, continued gains may be considered in the context of creating a more pronounced overvaluation, presenting an increasingly more attractive selling opportunity ahead.
US Dollar Swiss Franc Exchange Rate Forecast
Negligible US Dollar/Swiss Franc interest rate differentials have meant that the USDCHF remains largely removed from shifts in rate forecasts. Interest rate traders anticipate that the US Dollar will yield over 100 basis points more than the Swiss Franc in 12 months’ time—normally a positive sign for a given currency. Yet the USDCHF trades near important lows, and FX traders have shown little concern over yield developments. It may be far more significant to monitor another important fundamental theme: central bank intervention.
The Swiss National Bank has defended the important SFr 1.5000 mark on several different occasions, and open-market intervention may continue to sway the USDCHF as well. It remains critical to monitor SNB rhetoric and actions.
Swiss Franc / US Dollar Valuation Forecast
On balance, the outlook for the Swiss Franc is much the same as it was last month: the currency’s substantial overvaluation against the US Dollar bolsters other catalysts that are expected to eventually work in the greenback’s favor, most notably the SNB’s commitment to keep a lid on the currency’s appreciation as a bulwark against the onset of deflation. Switzerland’s dependency on external demand (particularly from the EU) as a key driver of economic growth is also of note, suggesting a recovery for the mountain nation is contingent on a return to growth in other countries and all but assuring that interest rates will be slower to rise there than in the States. The recent selloff in the Dollar has widened the disparity between spot and the PPP-implied exchange rate, offering bulls an increasingly attractive entry point once growth and yield considerations re-capture traders’ attention.
US Dollar Canadian Dollar Exchange Rate Forecast
The US Dollar/Canadian Dollar exchange rate has shown very little correlation to interest rate forecasts, and we have little reason to believe that said dynamic will change through the foreseeable future. Overnight index swaps currently predict that Bank of Canada and US Federal Reserve interest rates will be roughly equal in a year’s time. Barring any significant and/or unexpected shift, said predictions leave little interest rate bias for the USDCAD.
The exchange rate remains closely linked to global commodity prices, and the USDCAD-Crude Oil correlation trades near record-highs. It will subsequently be very important to monitor trends in raw materials prices, and their recent uptrend bodes well for the Canadian Dollar.
US Dollar / Canadian Dollar Valuation Forecast
The Canadian Dollar has outperformed the spectrum of major currencies in July as risky assets continued to push higher, with the currency able to find a catalyst beyond overall US Dollar weakness in the rebounding price of oil. Indeed, USDCAD now shows a whopping -89.9% inverted correlation with Nymex crude. As with most of the majors, however, the operative question going forward concerns the longevity of the current bout of risk-taking. An increasing number of observers are suggesting that oil is becoming decoupled from underlying fundamentals of demand, with recent buying driven by the desire for a tangible asset hedge against future inflation born of the aggressive monetary easing that has been put in place to check the onset of what looked like the next Great Depression. However, the IMF has forecast that consumer price growth will average less that 3% for the world at large and a mere 0.5% for advanced economies through 2010, figures that seems hardly indicative of a catastrophic spike in inflationary pressure. Indeed, infamous New York University professor Nouriel Roubini that has earned the nickname “Dr. Doom” for predicting the 2008 credit crisis and recession recently said that deflation, not inflation, is the biggest threat to a sustained rebound and chalked recent oil gains as being driven primarily by “speculation”. If this is indeed the case, the Canadian Dollar could tumble as quickly as it rallied when the underlying fundamentals of the global economy replace current euphoria as the catalyst for price action, offering USDCAD bulls a lucrative value gap to be exploited.
Australian Dollar US Dollar Exchange Rate Forecast
The Australian Dollar/US Dollar exchange rate is one of the few that remains sensitive to interest rate developments, and currently bullish forecasts for AUD yields points to further rallies for the AUDUSD. It is undeniable that high Reserve Bank of Australia interest rates bolstered demand for the domestic currency through recent years. Through the recent financial crisis, traders aggressively shed exposure to the Aussie as the forex carry trade collapsed. The more recent rally in global equity indices has clearly reversed said trend, and the Australian Dollar now trades at its highest levels since the Lehman Brothers bankruptcy. Absent a noteworthy correction in global risk sentiment, we expect the AUDUSD to continue trading off of bullish interest rate forecasts.
Australian Dollar / US Dollar Valuation Forecast
The Australian Dollar continued to advance last month as risk-seeking investors flocked to the high-yielding currency. As has been the case since March, the single indicator to be followed here remains the pace of the global stock rally. Indeed, AUDUSD is now shows a staggering 97.7% correlation with the MSCI World Stock Index. On balance, equity valuations look increasingly overdone having finished July at the highest level relative to earnings since October 2003 in a year when the global economy is expected to shrink for the first time in the Postwar era, suggesting an eventual correction lower will bring the Australian Dollar closer to its PPP-implied exchange rate. In fact, the higher the current push extends, the sharper the eventual downturn is likely to be. In the meantime, further gains may be seen as creating an increasingly attractive selling opportunity down the road.
New Zealand Dollar US Dollar Exchange Rate Forecast
The New Zealand Dollar/US Dollar currency pair likewise remains sensitive to interest rate differentials, and bearish forecasts for yields could have a negative effect on the NZDUSD. The New Zealand dollar currently enjoys a sizeable 225 basis point yield advantage over its US namesake, but interest rate traders anticipate that said spread will contract by 13 percent in a year’s time. We believe that interest rate-seeking speculators have bid the New Zealand dollar higher against the extremely low-yielding US Dollar. Any sign that the NZDUSD will no longer offer an impressive carry trade return could sink the Kiwi versus the US dollar. We have already seen the New Zealand dollar slip against its higher-yielding Australian counterpart.
New Zealand Dollar / US Dollar Valuation Forecast
In a similar fashion to its Australian counterpart, the New Zealand Dollar has captured outsized gains at the expense of the greenback, driven higher by a hefty 95.7% correlation with surging global equities (as measured by the MSCI World Stock Index). Meanwhile, the fundamentals of the economy are decidedly grim. Indeed, Fitch downgraded New Zealand’s long-term credit outlook, expressing concern over the country’s medium-term growth outlook given its “persistently large current account deficit and rising foreign indebtedness”. The ratings powerhouse added that the volatility of the New Zealand Dollar complicates the necessary adjustments to the economy, with the currency “more responsive to global financial conditions than to domestic economic fundamentals.” Although a host of officials from the head of the central bank to the prime minister have tried talking down the currency, we have argued that a rate cut is the next logical step to create lower yield expectations and thereby help to decouple NZD from trends in risky assets. It remains to be seen whether this or an actual reversal in risk sentiment will prove to be the Kiwi dollar’s undoing, but a bearish bias with an eye to (eventually) exploit the currency’s growing overvaluation seems warranted regardless.
Written by Joel Kruger, Technical Strategist; David Rodriguez, Quantitative Strategist; Ilya Spivak, Currency Analyst
Article Source - Monthly Forecasts for US Dollar - August
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