2009 Dollar Outlook
December 15, 2008
By
Stephen Jen & Spyros Andreopoulos | London
Summary and Conclusions
In 2009, assuming that the global economy does find a trough by summer, we see the dollar rallying further into the trough, but underperforming most other currencies as the world recovers in 2H. The swings in the global business cycle will likely be the dominant driver for the dollar. (For the ‘Dollar Smile’, the horizontal axis is the US growth premium over the rest of the G7. This means that the world surges higher on the left side of the Dollar Smile only if the US economy underperforms the G7. As the rest of the world catches up to the flattering US economy, however, the world drifts back down into the ‘gutter’ of the Dollar Smile, eroding the safe-haven bid for the dollar. Only successive downward adjustments in US growth could propel the dollar higher.) Other factors such as US government debt sustainability and the US inflation outlook associated with the Fed’s QE (quantitative easing) operations will likely be secondary considerations, mainly because we believe that US Treasuries will likely remain well-supported while a flare-up in inflation is not a probable risk.
There is no official change to our forecast, and we continue to look for EUR/USD to dip to 1.10 by 2Q, before recovering to 1.20 by end-2009.
USD/JPY will likely exhibit a similar U-shaped trajectory, dropping to 85 by 2Q before rising to 100 by end-2009. Most EM currencies will likely experience intense depreciation pressures vis-à-vis the USD in 1H. Differentiation at the EM country level will likely be unproductive in the sell-off phase. But in the recovery phase, country-specific factors will likely drive a wedge between the currencies of the ‘good’ from the ‘bad’ economies.
Resurrecting our ‘Four Seasons’ Framework
In thinking about how currencies might be affected by large swings in the global business cycle, it is important to consider both the real side (the real economy) and the financial side (the buoyancy of the global equity markets) factors. In other words, exchange rates are not only functions of the relative economic growth rate, but are also sensitive to general levels of risk appetite, which, in our view, are correlated with the buoyancy of the world’s equity markets. We illustrate a simple framework we have been using for some time (see
Currency Implications of a Slowdown in the US, September 6, 2007).
On the horizontal axis, we show the relative strength of the global economy. To the right, the global economy is strong. To the left, we have slow global growth. On the vertical axis, we show the buoyancy of global equity markets. Since financial markets tend to be ‘forward-looking’ and anticipatory, when the world plunges into a recession, earnings forecasts are cut and risk-taking curtailed, and equity prices would be likely to fall as a result, ahead of the actual contraction in economic activities.
Thus, we have traced out the path A-B-C to convey the notion that equity markets will fall before the global economy reaches its trough. (As the stock market moves faster than the economy, we move along path A-B-C rather than directly from A-C.) Following on from this, as the global economy climbs out of a recession, equity markets could anticipate this outcome and path C-D-A would then be likely. We call this framework the Economic and Financial Life Cycle, or the ‘Four Seasons’ framework for currencies.
Through the Economic and Financial Business Cycle, we should see four ‘seasons’ – summer, fall, winter and spring – corresponding to the four quadrants as indicated. Since equities have already declined substantially, yet a synchronous global recession has just begun (in light of the fact that Asian export growth began to falter only in September 2008), we mark where the world is in this stylised chart. We expect to reach point C by 2Q09, with the global equity markets poised to anticipate an economic recovery.
To help us think about the implications for currencies, we first calculated the historical correlations between various currencies (vis-à-vis the dollar) relative to economic growth and the equity markets. Different currencies tended to perform best in different ‘seasons’, or ‘comfort zones’. We suggested that high-beta currencies such as many of the AXJ currencies should belong to the top-right (‘summer’) or the top-left (‘spring’) quadrant, while the currencies of large capital-surplus countries, such as JPY and CHF, should be in ‘winter’ or ‘fall’. By and large, simple correlations of exchange rate performances relative to global growth and global financial market buoyancy are consistent with these broad prejudices. (Please see Appendix 1 for more detail on these calculations and how these relationships have changed over time.) The distance of these currency cells away from the origin denotes the size of the elasticities.
Several modifications will need to be made to this chart. First, we believe that EUR and CHF should underperform the dollar as we enter the ‘winter’ quadrant, due to European and Swiss banks’ exposure to EE. JPY, on the other hand, could be supported by acute repatriation flows as we head into ‘winter’.
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Call 1. The dollar to strengthen first, and weaken later. At the turn of each year, there is a temptation for analysts like ourselves to make one call on the dollar for the entire calendar year (i.e., a strong or weak dollar ‘year’). However, more often than not, currencies don’t change trends on January 1 of each year. 2008 is a good example: the dollar did not begin to show strength until May against AXJ currencies and July against the EUR; in the first few months of 2008, the dollar was extraordinarily weak. For 2009, we see the opposite trends: dollar strength in the first months, followed by possible dollar weakness in 2H. We see the world toggling through ‘winter’ and ‘spring’ in 2009, with a risk that ‘winter’ may last longer than 1H, and ‘summer’ may come in 2010 or later. Thus, the point is that we will be buying dollars and JPY into 1H, but with a view to flip our positions some time in 2Q, in anticipation of an economic recovery in the world.
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Call 2. EM currencies will be stressed in 1H. The global EM currency ‘moment’ is not over, in our view. In fact, the process is roughly halfway complete. We see weaker Latam currencies in 1H09. Pressures on AXJ currencies will likely persist, as these countries’ exports collapse and their central banks cut interest rates. We believe that even the CNY will be allowed to weaken against the dollar in the coming months (see
Changing My Call on the Chinese RMB, December 2, 2008). Finally, EE currencies may come under intense BoP pressures (see
The RUB – Eastern Europe – EMU Nexus, November 13, 2008 and
EM Currencies: Sell into the Rally, October 30, 2008). While the situation in Russia especially deserves investors’ full attention, the familiar structural fragilities of EE will expose the broad region to possible discrete changes in the RUB, in our view. When the global economy bottoms, we would be keen to buy back KRW, BRL and MXN. Our view on the commodity currencies (AUD, NZD, CAD) is broadly similar to that on the EM currencies.
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Call 3. We remain bearish on the EUR in 1H. Though the EUR is no longer over-valued, it is still over-rated and over-owned, in our view. The sell-off from 1.60 to the high-1.20s merely puts EUR/USD closer to its fair value: EUR/USD was massively over-valued at 1.60. The EUR is no longer expensive, but it is not cheap, either. Further, the only reason why the dollar could have rallied so sharply since July was its hegemonic reserve currency status. The fragmentation of the European sovereign bond markets helps preserve the superior reserve currency status of the dollar, in our view. Finally, the negative feedback from possible fractures in EE could cause material damage to the EMU, and weigh on EUR.
Two Main Risks to our Dollar View
The two key risks to the dollar are inflation and an unsustainable federal debt profile. The Fed’s QE operations need an exit strategy. The latest talk of the Fed issuing its own debt may be one way the Fed could unwind its balance sheet in time to stabilise inflation expectations. The dollar’s performance will be driven by inflation expectations, in our view (see
The Fed’s QE Operations and the Dollar, November 26, 2008). Similarly, the super-sized US fiscal deficits will be a risk for the dollar, though our central case view is that US Treasuries are more likely to be a preferred safe-haven asset in a global recession, marginalising other sovereign debt (see
US Fiscal Deficits and the Dollar, December 4, 2008).
Bottom Line
We continue to manage our currency call centred on the ‘Dollar Smile’ and believe that the dollar should head higher in the 1H09, before giving back some of its gains in 2H, assuming that the global economy bottoms next summer. Our ‘Four Seasons’ currency concept may be a useful framework for thinking about the dollar.
http://www.morganstanley.com/views/gef/index.html#anchor7287
Just ask Mr. Paulson. :suspicious:
