Global PMI decline will not save the dollar

April 17 2011 by Milla Schmidt in Forex Release |No Comments

The dominating theme on the currency market remains relative monetary policy – with the most visible implication being the depreciation of the dollar and not least against the euro. However, the clear trends seen over recent quarters are at risk of coming across bumps in the road. We look at three themes that are likely to affect the currency market: the expected decline in global PMIs, the heightened risks to global growth from rising commodity prices, and the possibility of peaks in relative rates for several key G10 currency pairs.The decline in global PMIs during the spring and summer of 2010 led to increased concern of a global double-dip and triggered a bigger sell-off in the market. Fundamentals are stronger now, however, and we do not expect a sustained period of deteriorating risk sentiment. This should secure relative monetary policy outlook as a more dominating driver than risk sentiment and imply sustained support to the euro and sustained depreciation pressure on the dollar over the coming quarters.

Main forecast changes

Given the current high oil price and the outlook for a summer ECB rate hike, we have lifted our three-month EUR/USD forecast to 1.50 (from 1.46), while maintaining our six-month forecast of 1.50. On the 12-month horizon, however, relative rates are likely to rotate from being a euro-supportive factor to being more of a dollar-supportive factor, as a first Fed hike should be pending. We forecast EUR/USD at 1.40 in 12 months.The simple relationship between EUR/GBP and the two-year swap spread suggests that the pound should weaken further against the euro. So far, the pound has held up, supported by market expectations of imminent rate hikes and decent data. But as it becomes clearer that the Bank of England is in no rush to lift rates, the pound could depreciate even more. As a result, we have opted to raise our three-month forecast to 0.92. As it probably is a temporary weakening, which should not be interpreted as a new equilibrium, we keep our six- and 12-month forecasts at 0.89 and 0.86, respectively.We still look for a lower EUR/SEK based on relative yields and fundamentals, but risks have grown more balanced as the Swedish krona is no longer cheap versus longer-term measures, and since the ECB will be more proactive than previously anticipated. As a result, we now forecast the six-month trough in EUR/SEK at around 8.70 (from 8.50).Swiss economic data remains very strong and suggests that the output gap is closing – with the labour market recovery already having matured. At the same time, inflation has surprised on the upside, leaving greater potential for monetary tightening this year. As a result, we have opted to lower our 12-month EUR/CHF forecast to 1.35, reflecting the increased probability that the Swiss franc will continue to trade in overvalued territory.

Theme 1: Global PMIs peaking

Global leading indicators are currently setting new cyclical highs in most economies, but the outlook is less rosy. In the US, the ISM manufacturing index is expected to decline towards 57-58 over the coming quarters; in Europe, PMIs should be expected to fall back as well; and in Asia, the Chinese PMI peaked late last year and has been edging lower ever since. A key question for the near term is: how will the decline in leading indicators affect financial markets?In spring 2010, when global PMIs last corrected lower – also then led by the Chinese PMI, which had begun falling during Q1 – the reaction on financial markets was fierce. Double-dip was the new buzzword (with Google searches increasing more than threefold) and investors positioned accordingly. The MSCI world equity market lost nearly 15% from peak to trough, volatility rose, government bond yields plummeted and the dollar, yen and Swiss franc rallied. Today, however, we are faced with a very different market situation and we do not look for a similar sell-off.In 2010 the correction in risky assets was magnified by the European debt crisis, which acted to inflate market uncertainty. The lack of an institutional framework to address the funding crisis in Greece is probably the key reason why the sell-off in the euro became as strong as it did – eventually even seeing EUR/USD test levels below 1.20.Today, an institutional framework exists, and though important details still need to be worked out, the result has been a significant reduction in the euro risk premium. Not even the spike in Portuguese funding costs, the resignation of the prime minister, or the request of a bail-out have triggered euro weakness – in fact, Italian and Spanish government bond spreads appear to have decoupled, indicating that the market is now pricing a much higher probability of the funding crisis being contained to Greece, Ireland and Portugal. As a result, the euro should be more resilient now to a drop in global leading indicators.Also the stock market is likely to have become more resilient. Indeed, our equity strategists argue that the improved credit situation and maturing recovery on the labour market implies that the equity market should be able to stay afloat even in a situation of declining global PMIs. So even as downside risks to carry strategies and carry currencies (e.g. AUD and CAD) are likely to increase as growth slows, we do not expect a 2010-style correction. One should note, however, that volatility on the currency market has become more counter-cyclical in recent years, which means that the downward trend in option market volatility seen so far in 2011 (only temporarily interrupted by situations in the MENA region and Japan) could slow or even reverse. Table 1 shows the average change in equity and currency market option volatility and the average carry return during quarters of a falling and rising global PMI.

Theme 2: Higher risk of global demand destruction

Fears of absent demand have largely been replaced by fears of demand destruction. The period of falling PMIs in 2010, described above, acted to increase fears of a double-dip in global growth, as the inventory cycle matured and fiscal stimulus was turned into fiscal contraction. Today, double-dip fears appear more related to the adverse affects from higher commodity prices (see Presentation from Economic Research).The combination of supply shocks (e.g. in the MENA region) and a strong recovery in demand has driven a strong rally in commodity prices – now up close to 100% from their 2008 trough according to the CRB index. Fears are that this will leave a cost on consumers so high that it will kill the recovery in global demand. One should note, however, that oil consumption as a share of total consumption has generally fallen in the advanced economies and that wage indexation has become much less used. This suggests that demand today is more resilient to rising commodity prices than say during the oil crisis of the 1970s.As the IMF points out in the recent World Economic Outlook, however, the emerging markets are more vulnerable to rising commodity prices. In particular, food accounts for a much larger share of the consumption basket, which in turn has led to a surge in overall inflation. In China, more than two-thirds of the rise in consumer inflation to 5% can be attributed to food prices. The higher beta of emerging market inflation to commodity prices is important for the currency market. Higher inflation means more pressure on the central banks to tighten monetary conditions, which in turn risks triggering large capital inflows (hot money) and eventually lead to a stronger currency. This has been the case not least in Emerging Asia and has helped catalyse the general trend of currency appreciation of that region. We still look for the Chinese renminbi to appreciate by close to 5% against the dollar in 12 months.We do not view the negative demand effects from rising commodity prices as a significant risk to our case of sustained dollar weakness over the coming quarters, or to our general positive view on carry in the short to medium term. As long as commodity price increases remain mostly demand driven, the commodity currencies such as the AUD, CAD and NOK should benefit via improvements on the terms of trade. We forecast AUD/USD at 1.05 in, USD/CAD at 0.95 and EUR/NOK at 7.70 in three months.

Theme 3: Relative rates peaking

The past quarters have seen clear trends in relative interest rates between several key economies and hence clear trends on the currency market. Most notably, and since May 2010 at the time of the Greek financial bail-out, the spread between two-year swap rates in the eurozone and the US have widened from about 0bp to 150bp – a fairly big move. In the same period, EUR/USD has risen from 1.20 to 1.45. In Scandinavia, both Swedish and Norwegian rates have widened significantly against the eurozone, and in general commodity exporters have seen rate spreads widen against the US. These trends are likely to be broken over the coming year, however.Markets are currently pricing expected peak relative rates for currency pairs such as EUR/USD, EUR/GBP and EUR/SEK, and a peak in two-year swap spreads have already materialised for AUD/USD and NZD/USD. Should market pricing prove correct, how would this affect the currency market?Considering the Australian dollar and the New Zealand dollar, the narrowing yield spread to the US appears to have had little effect so far. In fact, both currencies have appreciated strongly this year – the Australian dollar even reaching a new record high. This probably reflects the rise in commodity prices and the fact that carry remains large on both currencies. However, when evaluating past currency performance around the peak in relative interest rates for a collection of traditional ‘carry target’ currencies, we do find evidence of increased risks. Not only does a peak in relative rates often coincide with a peak in the currency (though potentially with a delay), but more importantly does the risk of a bigger depreciation tend to rise (i.e. a rising ‘crash risk’). This suggests that currencies such as the AUD, NZD and CAD are likely to be more vulnerable to a shift in market risk and/or a collapse in commodity prices now than was the case a year ago.We do not expect a significant narrowing of the two-year swap between the eurozone and the US over the coming year. Rather, we expect the yield spread to remain around 150bp and for the short-end spreads to widen as the ECB hikes and money markets are eventually normalised. This suggests sustained support to EUR/USD from relative monetary policy over the coming quarters, but also highlights the downside risks to the pair from relative rates going into 2012. This is reflected in our 12-month 1.40 EUR/USD forecast.

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