The 'twin deficits' problem (current account and fiscal deficits) has put USD's status as the reserve currency at risks and triggered investors to dump the currency. Worries about the dollar's future as well as increase in risk appetite as global economic outlook recovered later in 2009 brought the greenback to extremely low levels.
Undervaluation: According Fed's measure, the trade-weighted USD index plummeted -13% against major currencies after making 2.5-year high in March. On annual basis, the gauge dropped -8%, the biggest loss since 2003. Despite modest recovery in December 2009, the dollar index continued hovering at historic lows.
ICE's US dollar index also showed a similar pattern. The valuation is about 1.5 standard deviations below its long-term average. From the viewpoint of mean-reversion, the dollar is poised for a strong rebound.
On a PPP basis, the dollar also looked undervalued when compared with major currencies. The table below shows the PPP values of 8 currencies which were used by Fed in composing the USD Major Currencies Index. Using closing price as of December 2009, USD is undervalued when compared with all 'major currencies'.
However, being cheap is not sufficient to make USD higher. The US needs to show promising economic growth to attract buying.
Economic growth in the US: Massive monetary and fiscal policies have helped reboot the growth engine as US data have turned more positive.
US growth is expected to outpace its counterparts in the advanced economy: Labor productivity grew +4% in 3Q09, compared with decline in Germany and the UK, suggested faster recovery in the employment market in the US. In fact, appreciation in the euro and the yen in 2009 was a barrier for economic growth in the Eurozone and Japan.
Economic expansion in Japan remained slow and deflationary risk continued to linger despite the government's expansionary measures. As urged by the Prime Minister, the central bank called for an urgent meeting in mid-December but the BOJ Governor Masaaki Shirakawa and his colleagues refrained from announcing more policy actions but sticking to a rate of 0.1% and a 10 trillion yen ($111 billion) lending program adopted in the previous meeting. It's widely anticipated that the BOJ will implement more expansionary policies to boost growth.
In the UK, further QE cannot be ruled out if growth remained subdued. Current account deficit widened +10% mom to -$108B in 3Q09. As a share of GDP, the deficit increased to 3% from 2.8%. Despite this, we see the trend of shrinking deficit as a % of GDP since the peak in 4Q2005.
Fiscal deficit in the US remains high. The chart below shows that the 'twin deficits' as a % of GDP reached 12.3% in 3Q09. Although it recovered modestly from a record of 15.6% in 1Q09, the double-digit reading is still worrisome.
Nonetheless, we believe fiscal deficit in the US is near the trough whileIn recent elections, Japanese and German governments promised to increase government spending and reduce taxes while the US will likely focus on narrowing deficits next year.
fiscal situations in Europe and Japan may worsen.
A critical issue to offsetting the deficits is capital flow which is yet to improve. It's too early to say it will rise in the near-term but as the balance sheet in the US starts to improve, investors will flee to US asset, particularly when USD is trading at historic lows.
Gradual Exit from QE (End of the Asset Purchase Program): The Fed funds futures factored in 50-60% chance that the Fed will increase the policy rate by at least +25 bps by June.
However, analysts in the street are more conservative and the consensus is that the first rate hike will not take place earlier than 4Q10. Although the Fed may not raise interest rates in the near futures, the end of the asset purchase program can effectively withdraw liquidity from the market and indirectly tighten monetary policies.
According to the accompanying statement of December's FOMC meeting, most of the Fed's special liquidity facilities (including the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, the Commercial Paper Funding Facility, the Primary Dealer Credit Facility, and the Term Securities Lending Facility) will expire on February 1, 2010, consistent with the Fed's announcement of June 25, 2009.
The amounts provided under the TAF will continue to be scaled back in early 2010. The anticipated expiration dates for the TALF remain set at June 30, 2010, for loans backed by new-issue commercial mortgage-backed securities and March 31, 2010, for loans backed by all other types of collateral.
To provide support to mortgage lending and housing markets and to improve overall conditions in private credit markets, the Fed announced purchases of $1.25 trillion of agency MBS and about $175 billion of agency debt. While the program remains in progress, the Fed is gradually slowing the pace and these transactions will be executed by the end of the first quarter of 2010.
As the asset buying program ends by the first quarter, abundant Treasury supply will no longer be absorbed by the Fed and this will add upward pressures to long-term interest rates. Credit Suisse forecasts Treasury 10-year note yields will rise to about 4.25% this quarter. Many investors view the end of the program as an end of the Fed's pledge to keep long-term interest rate low. In this case, market will react as if the Fed is tightening.
To conclude,
we expect the dollar to strengthen in 2010 as it was dumped to extremely low level in 2009.Moreover, recovery in economic condition and removal of excessive liquidity in the market should attract foreign investments. While it's not likely for a broad-based rally against all currencies, we believe long positions in USDYEN will yield good returns as the Fed's gradual exit from QE and the BOJ's re-entrance of QE should push the US-Japan yield in favor of the dollar.
2010 Currency Outlook: EUR
In the near-term, we see further upside for the euro against the dollar:
- as strong global economic recovery and a broad-based low interest rate environment continues to favor 'higher-yield' assets,
- disappointing US non-farm payrolls in December evaporated much speculation about an early Fed tightening,
- renewed weakness in USD, after a strong recovery in late-2009, should persist for a few months before favorable data emerge again.
ECB monetary policy. Although the ECB has been trying to separate withdrawal of liquidity from monetary policy so as not give the market a sense that the ECB is tightening (which would bring the euro higher), what it has been doing is effectively tightening.
In December's meeting, the ECB announced that the rate in the last 12-month longer-term refinancing operation (allotted on 16 December 2009) would be fixed at the average minimum bid rate of the MROs over the life of this operation. This decision increased the uncertainty of the cost of funds in the December repo as it would be determined by the strip of ECB repo rates over the next year. As a result, many banks may seek funding in the market instead of the ECB. Moreover, the 6-month longer-term refinancing operation on 31 March 2010 will be the last one.
The unprecedented supply of liquidity had tremendous impact of money market rates. Therefore, a withdrawal of which should also be influential. The upside effect on money market rates should be more significantly felt in the second half of the year.
In order not to spur excessive appreciation in the euro, the ECB sent some 'dovish' message.
For instance, it said that the main refinancing operations as fixed rate tender procedures with full allotment for as long as is needed - and at least until the third maintenance period of 2010 ends on 13 April. Moreover, President Trichet stressed that the move isn't a signal the ECB has decided to raise its main rate which is 'appropriate'.
We believe the ECB's liquidity withdrawal process should accelerate in 2Q09 when it put an end to full allotment and this should be positive for the euro. However, economic recovery and sovereign debt risk may more than offset the supports offered by the withdrawal plans.
Economic outlook. The Eurozone exited recession in 3Q09 with a GDP growth of +0.4% qoq after contraction since 2Q09. While encouraging expansions were seen in Germany and France, economies remained weak in most countries: GDP contracted -0.3% qoq and -4% in yoy terms.
As supported by the government, the manufacturing sector has been recovering in an impressive pace. Manufacturing PMI returned to 'expansionary territory' (above 50) in November. In December, the reading surged to 51.6, the highest level since March 2008, as driven by output growth and robust investment. We expect further output expansion in the 2010 but overall growth should be tame with consumer spending and unemployment remaining the biggest headache.
According the OECD, the Eurozone economy is projected to growth by +0.9% in 2010, followed by +1.7% in 2011. Corresponding growths in the US will be +2.5% and +2.8%.
Although the easing monetary and fiscal policies have helped improve financial conditions and stabilize export demand, consumer spending remained weak in the 16-nation region. There is a viscous cycle between consumer spending and the job market.
Consumers curb spending as they lose jobs and/or feel pessimistic about the job market. Companies continue to lay-off as a way of cost-cutting in order to survive but this pushes the employment rate higher. It is very difficult to break this loop. Unemployment rate in the Eurozone rose to 10% in November from an upwardly revised 9.9% in the prior month. That's the highest level since August 1998.
Strength in the euro is a curse for economic recovery. ECB's data showed that the nominal effective exchange rate of euro (trade-weighted against 21 main trading partners' currencies) surged +8.6% yoy in November. Although rebound in USD erased part of the euro's gain in December, the index still rise +2.6% yoy in 2009. As an economy heavily reliant on exports, net trade is expected to have contributed -1% to the 16-nation region's GDP growth in 2009 given euro's appreciation. If the single currency strengthens further in 2010, this should continue to restrain economic recovery.
Sovereign Debt Risks. On December 8, Fitch Ratings cut Greece's rating to BBB+, the 3rd lowest investment grade, on concerns over the country's medium-term outlook for public finances given the weak credibility of its fiscal institutions and the policy framework. The lack of substantive structural policy measures reduced confidence that medium-term consolidation efforts will be aggressive enough to ensure public debt ratios are stabilized and then reduced over the next three to five years.
Less than 2 weeks later, on December 17, S&P also downgraded Greece to BBB+ from A- after placing its long-term rating on Credit Watch for a week as 'the measures the Greek authorities have recently announced to reduce the high fiscal deficit are unlikely, on their own, to lead to a sustainable reduction in the public debt burden'.
The Greek government has planned to use one-time taxes, a crackdown on tax evasion and cuts in civil servant bonuses to cut its deficit, hoping to reduce to 8.7% of GDP this year from 12.7% in 2009 and push it below the 3% limit (the Maastricht criteria) by 2012. However, most analysts and industry experts doubt the effectiveness of these measures.
The CDS spread on 5-year Greek government debt rose to 210.6 bps on December 8 after Fitch's downgrade and surged further to 267.9 bps on December 17 after S&P's downgrade. The spread has been trading above 250 bps since then. Increase in funding costs only makes the debt situation worse. Moreover, the euro will be at risk as investors worry about monetization of debts.
The financial situation in Greece can affect the Eurozone as a whole despite its small size. If it turns out a bailout is needed, it may suggest other economies such as Spain and Ireland, which also have huge debt burdens, may need bailouts. This will by all means affect the credibility of the euro.
Status as the Principal Reserve Currency: One of the themes triggering euro's rally against the dollar was the issue of reserve currency. The 'twin deficits' problem (current account and fiscal deficits) has put USD's status as the reserve currency at risk and triggered investors to dump the greenback. Speculations arose that the euro may be replacing the dollar to be principal reserve currency as it's the second largest currency in terms of total reserve holdings. Holdings of the euro have risen to 28.8% in 3Q09 from less than 20% in 2001.
However, we do not feel USD's status will be replaced that easily. Although the percentage of total reserves held in USD has reduced, it remained above 60%. Moreover, most investors, (official, institutional and retail included) should still find US Treasury securities which worth around $ 7 trillion the most liquid and secure. We believe speculations about replacing USD by other currencies will fade in 2010 as the US government begins draining liquidity and the US economy improves.
Although the euro may strengthen further in the first quarter of the year as 'risk appetite' trades dominate in the market, country-specific fundamentals and unwinding of monetary policies should be in play later in the year.
The measures announced by the ECB in December indicated the beginning of monetary policy tightening. This should drive the euro higher as the Fed reiterated the low policy rate should stay low for an extended period. However, economic recovery in the Eurozone is expected to be weaker than the US in 2010 and 2011. Together with sovereign debt risk, the longer-term outlook in the euro is not that promising. (so, up or down, strength or weaken?)
2010 Currency Outlook: GBP
Since January 2007, the pound has dropped -23.5% against its major trading partners with the decline against the euro slightly more than that against the dollar. Although the pound managed to gained against most of these partners in 2009, much of the return was erased in the second half of the year as BOE committed to adopt extremely loose monetary policies and economic contraction was more serious than previously anticipated.
In 2010, we expect the pound will remain weak in the first quarter as there are still uncertainties in how the nation's economy will develop and whether the central bank will expand or unwind stimulus policies. However, things may be clearer towards the second half of the year.
More rapid economic growth (compared both with 2009 and with other OECDs) and improvement in fiscal conditions may help lift the pound. That said, 2010 will be a year full of variables in the UK. Election, exit of monetary policies, return of VAT to 17.5%... are all important issues for British economy this year and their impacts on economic development and currency are yet to tell.
Economic outlook: Economy should have grown slightly in 4Q09 after contracting almost -6% in the first 3 quarters. Forward-looking indicators have been improving and net trades have been boosted by weakness in the pound (against a basket of currencies, sterling has dropped more than -20% since 2007 and -4.4% since July 2009).
In 2010, recovery is expected to continue although the path should be gradual and bumpy - a situation similar to most advanced economies. The OECD forecast UK's GDP will expand +1.2% in 2010 and +2.2% in 2011, after tumbling -4.7% in 2009.
These are compared with corresponding growths of +0.9% and +0.9% in the Eurozone and +2.5% and +2.8% in the US.
The UK inflation jumped +2.9% yoy in December, +1% higher than the increase in November, as oil price rallied while reduction in sales tax in 2008 was not repeated. This is the first time since May that inflation has exceeded BOE's target of 2% and we forecast the rise may speed up in coming months as VAT has returned to 17.5%, from 15% last year, since January 2010.
However, this is premature to predict an early tightening by the central bank. In fact, the MPC expected a spike in CPI. At November's inflation report, the BOE said that inflation will accelerate and then dip below the 2% target and the rate will not return to the target until 2012.
Labor market in the UK has been resilient. The -15.2K decline in claimant count in December was the biggest drop since early 2007. Moreover, the decline in ILO unemployment rate to 7.8% in the September-November period from 7.9% in the August-October period also evidenced that the job market has performed better than expected since the beginning of the recession.
Monetary Policy: Same as its counterparts in the advanced economy, the UK implemented a series of conventional and unconventional measures to stimulate growth. The BOE cut its policy rate to from 5% to 0.5% in the 5-month period from October 2008 to March 2009. The interest rates are expected to stay unprecedentedly low until at least late-2010.
Moreover, policymakers also started buying assets in March 2009 and the size was increased from 75B pound in the beginning to 125B pound in May, 175B in August and then 200B pound in November.
It's a difficult task to forecast the BOE's policy as it surprises the market very often! In July, the market had expected the BOE would extend the asset buying program by 25B pound because it would be ending at the end of July, before the August meeting. Therefore, in order to avoid discontinuity, it's tactical for the central bank to extend the plan to 150B pound which was the total amount authorized by the Chancellor at that time. However, the outcome was that the MPC members decided to stick to 125B pound (May's decision).
After the meeting, the market widely anticipated the BOE would slow down the pace of purchases so that the whole program would extend beyond the meeting on August 6-until policymakers could acquired more information, from the Quarterly Inflation Report in August, on the impact of the existing monetary and quantitative easing policies.
While the market had expected the BOE would put everything on hold in August, it extended the asset purchase program by 50B pounds to 175B pound as 'the recession appears to have been deeper than previously thought. GDP fell further in the second quarter of 2009. But the pace of contraction has moderated and business surveys suggest that the trough in output is close at hand. Underlying broad money growth has picked up since the end of last year but remains weak. And though there are signs that credit conditions may have started to ease, lending to business has fallen and spreads on bank loans remain elevated'.
Another move was seen in November when the BOE raised the size of the program by another 25B pound to 200B pound, probably because the unexpected economic contraction in 3Q09 suggested dismal outlook in the country.
The next move will be in February when the Quarterly Inflation Report will be released. We and the market expect policymakers will announce a pause in QE at the meeting.
A 'pause' in QE has good and bad implications. The good thing is that the BOE may think that there's evidence that economy in the UK has shown signs of improvement and previous easing programs are sufficient to drive growth. Moreover, putting an end to liquidity provision should be supportive for sterling which was being dumped in the second half of 2009 due to BOE's aggressive QE. On the other hand, if the BOE announces it a 'pause', it means there's possibility for further extension of the program should the economy deteriorate. While both the ECB and the FED have shown signs of unwinding their liquidity programs, potential expansions of QE by the BOE is really negative.
The BOE's monetary policy will even be harder to gauge this year as fiscal and political issues are playing important roles in the monetary outlook. In short, substantial fiscal tightening will prolong the accommodative monetary situation while how aggressively the government will work to cut the budget deficits greatly depends on which party wins the General Election which must occur by June 3, 2010.
Fiscal Policy and Election: The UK is running at huge deficits and the government said in the Pre-Budget Report public sector net borrowing (PSNB) will increase to 12.6% of GDP in 2009/10 while public sector net debt (PSND) will rise to 55.6% of GDP during the period. While the former should be more than halved by 2013/14, the latter will probably surge to 77.7% by 2014/15. IMF forecast in October that UK's net debt will rise to 75% of GDP in 2010 before 2010.
Credit agencies have warned that the nation's deficit problem is hurting its credit rating. While Moody's said on December 8 that the UK may test the 'Aaa boundaries', S&P lowered the outlook on the country's AAA rating 'negative' from 'stable' in May.
The 3 political parties in the UK have pledged to tighten fiscal policy as economic recovers but the Conservative party appears to be the most aggressive one regarding the issue. The opposition party said the current Labor government's plan to halve the deficit in 4 years is not enough and the cut needs to start immediately. Last week, the shadow Chancellor of Exchequer George Osborne said he will target programs that 'represent poor value for money' including spending on advertising and consultants. Tax credits for people earning more than 50 000 pounds and tax-free child trust funds for “better off families” will be cut' during the financial year. Currently, opinion polls show that the Conservatives are 10% ahead of the Labors in opinion polls.
The pound should be lifted with a hope of narrowing fiscal deficit. Therefore, it's possible for GBP to rebound after weakening in the first quarter, as election gets closer. However, the rise should not be too strong as fiscal tightening may hinder economic recovery and prolong the low-rate monetary policy.
If the election result replicates the polls, a lead of around 9-10% should produce a Conservative majority. However, if that's not the case, a hung parliament, with no party with an outright majority, could cause sterling to fall as well as increase the difficulty in coming up with an agreed approach to tighten fiscal policies.
2010 Currency Outlook: NZD
New Zealand dollar surged in tandem with Australian dollar and commodity prices in 2009. Trade-weighted NZD gained +16% last year after falling sharply, by +20%, in 2008. Compared with AUD, strength in NZD was less prominent. In fact, AUD has outperformed NZD over the past 4 years, reflecting weakness in New Zealand's underlying fundamentals.
In 2010, we expect slow economic growth should weigh on NZD, Moreover, gains in NZD amid speculations on early tightening be pared and the market pushes back the timing and magnitude of the first rate hike.
Economic Development: Recovery in New Zealand is not as strong as many had expected. According to RBNZ Alan Bollard, economy remains fragile domestically. Although the economy surprisingly exited recession in 2Q09 with modest growth of +0.23% qoq, expansion slowed down in 3Q09. Job market remains dismal. The country's unemployment rate has been in an uptrend since 2008 and the latest reading of 7.3% (4Q09) represented the highest level since 2Q99.
Consumer spending stalled as dismal employment situation affected sentiment. Led by sales in department stores and appliance outlets, retail sales were flat from a month ago in December. Inflation contracted -0.18% qoq in 4Q09 although reading on annual basis stayed within the central bank's range of 1-3%.
Housing market in New Zealand is recovering but the pace has been moderate so far. In fact, recent data have revealed slowdown in housing market improvement. Building permits declined -2.4% mom in December, following a modest growth of +0.1% in the previous month. According to Real Estate Institute, median house prices dropped -2.8% mom in January from December. Given the high correlation between house prices and Kiwi, we worry NZD will weaken further against USD.
Pressure from Twin Deficits: Released in late-January, New Zealand's cash budget deficit totaled NZD 5.28B during five months to November 30, larger than the market expectation of NZD5.12B, as tax receipts were NZD485M less than forecast during the period. At the same time, the operating deficit was at NZD1.4B, compared with consensus of NZD2.48B. New Zealand's budget recorded a cash deficit for the first time in 9 years in the 12 months through June and the government has projected 5 years of deficits as debt increases. Last year, the government rolled out tax subsidies and welfare programs so as to combat recession, thus reducing the government's income.
Although the annual currency account balance improved to 3.1% of GDP in 3Q09 from the peak of 8.7% of GDP last year, rolling of tax windfall should worsen the situation again later in the year.
The market will be watching closing how the government boosts economic growth while reducing budget deficits this year.
Impacts from China's Cooling Measures: Similar to Australia, albeit to a lesser extent, New Zealand benefits from rapid expansion of Chinese economy. As stated in the January RBNZ meeting statement, 'global activity continues to recover, helping push New Zealand's export commodity prices higher. Economic growth is most apparent in China, Australia, and emerging Asia. However, sustained growth throughout our trading partners is not assured, with many still facing impaired financial sectors and overall activity still reliant on policy support'. Therefore, recent stimulus-unwinding measures in Chinese are negative for New Zealand.
People's Bank of China (PBOC) required banks to increase reserve ratio by +50 bps effective February 25, as stated in its Website last week. This was the second time this year the central bank raised banks' reserve ratios as a means to curb lending. On January 12, PBOC increased banks' reserve ratio for the first time since June 2008 as new loans reached a record of RMB 9.59 trillion in 2009. Concerns that growth in china will be slowed down as the government pushes out more tightening measures should exert additional pressures on NZD.
Despite its lower exposure to Chinese economy than Australia, performance of New Zealand dollar was actually worse than Australian dollar after China announced its cooling measures. The chart below shows than AUD strengthened against NZD on both January 12 and February 12, the day when China raised the required reserve ratio. This indicates underlying weakness in the Kiwi.
Monetary Policy: The RBNZ reduced its OCR by -575 bps to 2.5% during the period of June 2008 and April 2009. At the same time, the central bank also facilitated liquidity through measures including Term Auction Facility, which enabled banks to borrow funds using bills, bonds and mortgage-backed securities as collateral.
Since April 2009, the RBNZ has mentioned in the post-meeting statement that there's no urgency to begin withdrawing monetary policy stimulus, and 'we expect to keep the OCR at the current level until the second half of 2010'. However, the tone has turned less dovish since December and the RBNZ stated that 'if the economy continues to recover, conditions may support beginning to remove monetary stimulus around the middle of 2010'.
However, economic data released since January's meeting might have damped the central bank's outlook. In fact, after release of higher-than-expected unemployment rate in early February, the market pushed back the timing of the first rate hike to June from April. NZ-US 3-year swap dropped below 300 bps in February, the first time since September 2009. Narrowing in yield differential is negative for NZD.
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