Forex markets: Important developments on the forex markets.

The past week has been packed with events bearing on the forex markets, the most significant of which vis-à-vis the effects that will they continue to have on exchange rates include: (1) Trichet’s remarks at the end of the ECB meeting, (2) Bernanke’s speech yesterday evening, (3) Obama’s USD 447Bn fiscal stimulus plan, and (4) action by the Swiss National Bank to weaken CHF. In light of these events we have made some changes to the forex projections, more in respect of levels than directionality (see table). This week’s events seem to lend weight to the view that the trends we have recently had some intimation of are materialising.

DOLLAR – The first indication should be positive for USD. Bernanke and Obama conveyed the message that from in monetary and fiscal policy terms everything will be done to stimulate/support the economy given the recent increase in the downside risks. Bernanke mentioned policy tools the Fed will consider at this month’s meeting (21 September). The downtrend in USD, penalised by a virtually zero rates policy, should thus be petering out. This does not mean an immediate trend reversal, but the start of a sideways consolidation movement. USD should be helped by the improved growth outlook in 2H11 thanks to growthsupporting economic policies.

EURO – The comparison of the growth outlook between United States and Euro area couldn’t be starker. Trichet admitted the downside risks to growth had increased and the inflation risks were no longer to the upside but balanced, and yet he gave no indication the ECB would act to foster the recovery. On the fiscal policy front developments have moved in a tightening direction in order to avert default (notably Greece). After August’s FOMC, despite the resurgence of the debt crisis, EUR appreciated from 1.40 to 1.45 EUR/USD, although this was due entirely to USD weakening following the Fed’s commitment to keep rates almost at zero out to 2013. The violent downward reaction in EUR – which in the last two days has fallen from 1.41 to just below 1.3700 – on the remarks from Trichet and Bernanke seems to endorse this interpretation. Accordingly, we have revised our EUR/USD projections (see table) and signal that the risks are to the downside, i.e. a further downward acceleration sooner than expected.

SWISS FRANC – On Tuesday the SNB stepped in to weaken CHF, when EUR/CHF returned to 1.10 for the third straight day – but most importantly it set a level (1.20 EUR/CHF) and pledged to protect it by preventing CHF appreciating vs. EUR and driving EUR/CHF below 1.20. To this avail, it said it is “prepared to buy foreign currency in unlimited quantities”. The SNB also added that at EUR/CHF 1.20 the franc is still strong and should weaken over time, as “the current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy, and carries the risk of a deflationary development”.
In our view, the move was appropriate, and should prove effective. The timing was also very good: a couple of days ahead of the ECB meeting, and just over a week before the SNB meeting (Thursday 15 September) and the review of Greece in view of implementation of the rescue plan. Unlike Japan’s situation (see dedicated section below), the evolution of the franc has been dramatically unfavourable compared to the fundamentals of the domestic economy, and realistically poses a threat to the country’s economic prospects. The franc not only hit historical highs against the dollar and the euro, but is also at its highest in terms of nominal effective exchange rate, and its real effective exchange rate is almost 20% higher than the 1995-2007 average. The unstoppable surge began at the outbreak of the first Greek crisis, early in 2010, when the divergence with the euro in terms of nominal effective exchange rate began, in itself enough to outline the excessively strong trend of the franc. What’s more, the fact that such a strong trend, and the achievement of such high levels, was fuelled solely by strong risk aversion generated by the sovereign debt crisis in the euro area, and not also by other factors, allows us to say that the situation which had come to rise was characterised by a serious imbalance. An imbalance all the more worrying when considering the potential traumatic repercussions on the domestic economy, and the total lack of any collateral benefits outside the Swiss borders. In light of the SNB’s intervention, our projections are for a gradual weakening of the Swiss franc with respect to the euro (see table). On the whole, the “indirect” effect of the SNB’s move on the EUR/USD exchange rate should be moderately skewed to the downside.

YEN – Contrary to the SNB, on conclusion of its monetary policy meeting the BoJ left all conditions unchanged, confirming the expansive measures put in place at the previous. Therefore, no new action was taken, nor was anything said or done to weaken the yen. In our view, there are two main explanations for this behaviour. First of all, contrary to the situation in Switzerland, Japanese growth is set to pick up soon, driven by post-earthquake reconstruction, also considering that most of the problems on the offer side have been resolved. Secondly, in terms of its real effective exchange rate, the yen is not particularly strong: in fact, it is around 7% lower than the 1995-2007 average. Therefore, at the present stage it does not (yet) represent a dangerous threat for the recovery of the economy. This is one of the main reasons for which we believe the BoJ will not follow suit the SNB’s course of action. In terms of real effective exchange rate, the franc, on the other hand, is hugely overvalued, higher than the 1995-2007 average by around 20%. However, it cannot be ruled out that the BoJ may resort to one or more traditional interventions, selling yens to weaken the local currency, should the exchange rate attempt to drop below USD/JPY 76-75. In the meantime however the reaction post-ECB and post-Bernanke was a fall of the yen, albeit by precious little. We think this response is symptomatic of the main drivers of JPY at this time, namely global/US growth prospects. In light of the considerations made above on the United States’ new – and possibly better – growth prospects, we confirm our expectations for a depreciation of the yen, although we expect the movement to prove a little more gradual, and smaller, than previously forecast. Therefore, the prospected path has changed from USD/JPY 81-84-88-92- 100 to USD/JPY 80-84-86-90-95.

STERLING – As unanimously expected, the Bank of England – for the thirtieth consecutive month – left the bank rate unchanged at 0.50%. The APF was also left untouched. Contrary to our expectations sterling reacted to the announcement by strengthening, probably following some speculation on the market that the APF may have been extended. It then strengthened further in the wake of Mr. Trichet’s speech, both against the dollar and the euro, but it turned back – only versus the dollar, from GBP/USD 1.60 to 1.58 – soon after Bernanke’s speech. As remarked above for the euro, future growth prospects are being more strongly supported through the use of monetary and fiscal policies in the United States than in the United Kingdom. There’s smaller scope for economic policy in the United Kingdom than in the US and it mainly lies in monetary policy, in the shape of potential – if any – increase in the APF program. Any rate cut is instead unlikely. Therefore, we confirm our expectations for a decline of the pound towards GBP/USD 1.55/1.54 against the dollar: of the projections presented in our table, we have only changed our 1m forecast from GBP/USD 1.60 to 1.57.