2009 Dollar Outlook

In 2009, assuming that the global economy finds 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. 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 remain well-supported and 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 economy and the financial side (the buoyancy of global equity markets). In other words, exchange rates are not only functions of relative economic growth, but are also sensitive to general levels of risk appetite, which are correlated with the buoyancy of world equity markets. Since financial markets tend to be ‘forward-looking’ and anticipatory, when the world plunges into a recession, earnings forecasts are cut, risk-taking curtailed, and equity prices decline ahead of the actual contraction in economic activities.

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 tend to perform best in different ‘seasons’, or ‘comfort zones.’ We suggest that high-beta currencies such as many of the AXJ currencies belong to summer or the spring quadrants, 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 performance relative to global growth and global financial market buoyancy are consistent with these broad prejudices. The distance of these currency cells from the origin denotes the size of the elasticities.

We believe that EUR and CHF should underperform the dollar as we enter the ‘winter’ quadrant, due to European and Swiss banks’ exposure to Eastern Europe. JPY, on the other hand, could be supported by acute repatriation flows as we head into ‘winter’.

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. 2008 is a good example: The dollar did not begin to show strength until May against AXJ currencies and until 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, we will be buying dollars and JPY into 1H, but with a view to flip our positions some time in 2Q in anticipation of a global economic recovery.

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 coming months. Eastern European currencies may come under intense balance of payments pressures. While 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.

Call 3 — We remain bearish on the EUR in 1H. Though the EUR is no longer overvalued, 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 overvalued at 1.60. The EUR is no longer expensive, but it is not cheap. 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 status of the dollar. 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. 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 relative to other sovereign debt..

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