“Locked in” US interest rates to help growth also help the dollar. Near term summits on the European debt crisis are crucial for the euro. BoE resumes QE. Sterling however is being conditioned also by developments in the euro area. Yen “locked in” until market conditions stay “locked in” (interest rates at close-to-zero and risk aversion)….…
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The third quarter saw signs of a trend emerging, which could develop more clearly during the last quarter of the year.
As regards 2012, the greenback could again be hit for some time by the level of Fed funds, not only because they are exceptionally low, but, most importantly, because they are “time-locked”.
A widespread and protracted downward trend, hitting troughs even lower than those recently recorded, should however be avoided, perhaps aided partly by the countdown to the US presidential elections in the autumn. One development that should be in the dollar’s favour, however, will be when the market starts to factor in the beginning of a cycle of rate hikes by the Fed some time after the “deadline” of mid-2013, which could happen at the end of next year.
This is likely to have a significant and broad effect but not necessarily a long-lasting one.
(1) the worsening of the sovereign debt crisis, and
(2) the ECB’s “pre-announcement” of a change in direction or, at the very least, the announcement that rates would not go up any more.
(1) In the short term, the currency could react quite differently depending on how the sovereign debt crisis unfolds. Assuming that the euro does not “implode”, and that a positive solution to the crisis is eventually found, there could be two different scenarios, depending on whether:
(a) a solution is reached slowly without too many obstacles, or
(b) a solution is found straightaway (e.g. at the European Council meeting on 23 October or at the EU summit to be held within 26 October).
(a) If the crisis were to drag on, with further obstacles and delays, expectations – created in the first two weeks of October – of a rapid solution to the crisis, which caused the euro to bounce back to almost EUR/USD 1.40, would be disappointed, and plausibly, the currency could correct
again, sliding towards EUR/USD 1.30-1.28. In this case, the risk of a further decline towards EUR/USD 1.25-1.20 could not be ruled out, although it would likely only be a temporary foray into this territory.
(b) If, however, an immediate solution to the crisis were to be found, the euro could strengthen further, rising towards EUR/USD 1.40-1.45. It could, however, be a more modest and/or shortlived rise (perhaps just a “knee-jerk” reaction). Indeed the market has already priced in a rapid positive solution, with the currency’s rebound in early October. Furthermore, once a solution has been found, attention should return to “normal” macro fundamentals, i.e. growth and interest rates. With a central scenario, therefore, of one or two ECB rate cuts totalling 50 bps, and a refi rate falling from 1.50% to 1.00% by the turn of the year, together with the widening of the divergence between Euro zone and US growth due to the European slowdown, the currency is likely to retreat again to the region of EUR/USD 1.35-1.30.
(1) In the medium term, i.e. over the next year, if we maintain our assumption that the crisis will be resolved, regardless of the time taken to find a solution, two phases are likely to emerge. (i) Initially, following the ECB cuts, the euro could rise again moderately, also on account of the widening of the interest rate spread, given that the Fed is committed to keeping rates on hold until mid-2013. (ii) Subsequently, however, in the absence of any improvement in growth relative to the US, and with the risk of new problems arising on the sovereign debt front (not necessarily as serious as those seen recently), the euro could again beat a retreat. The trend in both the first and second phases could however be less marked than in the last two years, with an overall fluctuation band broadly similar to this year’s.
To obtain an approximate measure of the euro’s future trend in relation to fundamentals, we turn to the model proposed in the last Quarterly Macroeconomic Outlook report. This uses twoyear yields in the Euro zone and the US as the explanatory variables for the EUR/USD exchange rate, and the cointegration estimates reveal the long-term fundamental relationship between exchange rates and yields. We project the model on three alternative scenarios, varying our assumptions about the ECB’s actions:
(1) central scenario: a total cut of 50 bps in the refi rate from 1.50% to 1.00%;
(2) alternative scenario A: a total cut of 100 bps in the refi rate from 1.50% to 0.50%;
(3) alternative scenario B: no cut in ECB rates, i.e. leaving the refi rate unchanged at 1.50%.
As shown in Fig 3, the exchange rate
(1) in the central scenario, falls in the short term from its current levels and rises moderately next year;
(2) in scenario A, falls further and for longer, and then rises in the second half of next year;
(3) in scenario B, in the absence of rate cuts by the ECB, starts to rise immediately.
The lower the overall cut in the refi rate, the higher the currency will climb. The monthly data are calculated as an average of the daily figures. The fact that the trend is broadly unidirectional in 2012 and does not ease back at all in the second half of next year (as we assumed above, paragraph 1-ii) can be explained in two ways: (i) when rates fall to even lower levels, also hitting record lows in the Euro zone, while they are already close to zero in the US, yields are not completely representative of the level of economic growth or of a change in monetary policy, and (ii) there are no variables in the model that enable it to take account of developments in the debt crisis. We can however obtain an approximate measure of what could be called the “crisis effect”, by calculating the average deviation between estimated values and the actual monthly values (fitting) of the currency at the height of the crisis in 2010 (see “hatched area” in Fig. 3).
As can be seen, the estimated values for that period are much higher than the actual values, as the model was unable to capture the tumble by the euro when the crisis first broke out in early 2010. The average deviation was around five figures, but it is reasonable to assume that the crisis will have less of an effect over time, and that it will have the greatest effect only when an event occurs that is directly linked to the crisis. If, for example, we were to assess any short-term strengthening of the currency in the event of a rapid solution to the crisis being found, we could estimate it in around five figures, but this would represent its broadest scope, in line with the considerations discussed above in point (b) in relation to the “knee-jerk” reaction.
Sterling experienced mixed fortunes in the third quarter: it fell against the dollar (-1.3% on average qoq), rose against the euro (+0.6%) and then remained broadly stable in terms of the nominal effective exchange rate (-0.3%). The trend would have been more linear and understandable if it had been in line with the data flow from the UK economy, which clearly became progressively worse, indicating a slowdown in growth and hinting at the adoption of a more accommodative monetary policy. Overall, sterling should have been on a clearer, downward underlying trend.
Numerically this dependency translates into a high correlation between sterling and euro versus the dollar, i.e. between GBP/USD and EUR/USD (see Fig. 4a). Economically, this is explained by the fact that the Euro zone is the main destination for UK exports. This dependency has increased significantly in the last two years, since both economies are in crisis, but their cycles are not perfectly in line (see Fig. 4b). There are three main differences that have proved crucial to determining the exchange rate: (1) in the post-crisis expansive monetary policy phase in 2008, the BoE cut rates to 0.50% while the ECB stopped earlier, at 1.00%; (2) this year the ECB has twice raised rates, in April and July; (3) the sovereign debt crisis in the Euro zone, which broke out in 2010, reappeared in a more serious form in 2011, arousing concern in the UK too.
As can be seen in Fig. 5a, UK yields started falling in February. However, sterling continued to rise against the dollar, following Euro zone yields rather than those of the UK (see Fig. 5b). In the Euro zone, on the back of an improvement in the economy, the ECB raised interest rates (the first rise was in April). The same situation occurred with the second ECB hike in July.
Sterling did not go into free fall against the dollar until the second half of August. The publication of the inflation report in August struck the first blow to the GBP/USD exchange rate, followed by the minutes of the BoE’s meeting in the same month, which preannounced a reversal in monetary policy. But sterling’s downward slide (GBP/USD) came a little later, when the euro (EUR/USD) started to trend downwards as the Euro zone plunged into the sovereign debt crisis. The strong positive correlation between GBP/USD and EUR/USD explains the part of sterling’s behaviour that cannot be explained by the UK economy’s “own” factors.
With a central scenario that envisages (1) further quantitative easing by the BoE and a bank rate stable at 0.50%; (2) one or two interest rate cuts by the ECB totalling 50 bps with a reduction in the refi rate from 1.50% to 1.00%; and (3) acceleration of UK growth in 2012 compared with 2011 against a slowdown in the Euro zone, sterling (GBP/USD) should ride out its weakest period in the fourth quarter of this year and stage a “moderate” recovery next year (likely to be in 2H).
In order to obtain a measure that would give us an initial approximation of the potential movements of sterling (GBP/USD) on the back of the above-mentioned developments, and in light of the considerations discussed, we use a simple regression on the period 2010-2011 to estimate the relationship between GBP/USD and two-year UK and euro yields. The use of euro and UK yields as explanatory variables allows the divergent phase of sterling to be separated from purely domestic developments: the resilience/strengthening of the GBP/USD exchange rate between February and June 2011, i.e. after the downtrend of UK yields and in tandem with the ECB’s interest rate rises.
Using projections of these estimates, we set out three different scenarios for the explanatory variables: (1) central scenario, with further QE by the BoE, an unchanged bank rate, and a reduction in the ECB refi rate from 1.50% to 1.00%; (2) alternative scenario A, which assumes a bigger cut, from 1.50% to 0.50%; (3) alternative scenario B, which assumes the refi rate remains unchanged at 1.50%. As can be seen in Fig 6, in the central scenario, sterling is at its weakest in the fourth quarter, and will recover the following year – more markedly so in the second half. In alternative scenario A, however, sterling weakens further, a trend that will continue until the ECB concludes its cycle of rate cuts. After that, sterling will begin to rise on the back of the expected benefits from a return to Euro zone growth (and therefore UK growth) with a more expansive ECB monetary policy. Lastly, in alternative scenario B, sterling will start to strengthen immediately, as the absence of cuts to ECB interest rates can be interpreted to mean that resorting to a more accommodative monetary policy is not necessary given hypothetically better-than-expected growth.
The exercise shows that in all three scenarios, the exchange rate will stay broadly within the same range as it did from summer 2010 until today (approximately 1.50-1.65 GBP/USD. The fact that even in the worst-case scenario projected, GBP/USD would not hit new lows could be interpreted as another indication of the inherent resistance to the downside of the UK currency since the global crisis of 2008, given that it is the currency that together with the dollar has depreciated the most overall. In total, sterling has lost 19% (in nominal effective exchange rate terms) since its pre-crisis levels, almost double the fall of 11% recorded by the euro.
YEN
As the BoJ explains in its Monthly Report of 12 October (p. 14) this is “due in part to anxiety over a possible foreign exchange intervention”. The other part of the explanation, in our opinion, lies with market conditions: (1) BoJ and Fed rates at near-zero, (2) BoJ and Fed both willing to further expand the quantitative stimulus already in place, and (3) the return of high levels of risk aversion internationally (in August and September) (see Figs. 7a-7b).
Assuming that current conditions remain as they are in the short term, a projection of this model gives the following results: (1) if risk aversion were to ease very slowly and normalise only at the end of the year, the yen would continue to oppose resistance to the downside in broad terms and would weaken very slightly and gradually, whereas (2) if risk aversion were to drop immediately, the yen would correct immediately. The correction shown is, however, limited as rates are close to zero both in Japan and in the US.
The implications that can be drawn from the exercise are still valid, though: once a positive solution is found to the sovereign debt crisis in the Euro zone, for example, this could lay the foundations for the start of a downward reversal for the yen. However, even in this case, given that the Fed is committed to keeping rates at close to zero until mid-2013 and it is well-nigh impossible that the BoJ will raise them before then, a protracted period of such low rates could make the expected depreciation of the yen during 2012 slower and/or not as great as expected.
The risk to our scenario, which sees the yen returning to around 90 by the end of 2012, is therefore that the end point for the exchange rate in this time period will be lower and/or that this level will not be reached until later.
Appendix
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