The world's so-called G3 currencies, the triumvirate of the US dollar, the euro and the Japanese yen, have all been rather weak in recent weeks as investors are increasingly abandoning these countries and their assets and looking elsewhere for opportunity. How long will this trend continue?
The G3 currencies are weak due to a sorry combination of low growth prospects, burdensome fiscal worries, and inferior yields on public debt. The euro has weakened sharply since late last year because investors are less willing to hold European assets due to the desperate fiscal situation of Greece and the potential for other countries at the euro zone periphery to fall into the same dire straits. For example, Portugal may be next in the firing line as its debt was downgraded by one of the bond rating agencies. The recent EU summit did provide a framework for emergency backing of Greece from the EU and the International Monetary Fund, but the specifics of the plan aren't really very compelling and it will be interesting to see how they would play out in reality were Greece or another weak euro zone country on the verge of – or in the actual throes of – default.
The yen and the dollar
The Japanese yen has been extremely weak of late as Japanese interest rates are consistently lower than the rest of the world's, and when interest rates are rising all along the yield curve in the rest of the world as they have been lately, the disadvantage of holding Japanese assets becomes more and more pronounced. In the US dollar's case, although the US economy has shown signs of reviving, the benchmark interest rate remains very low and the US Federal Reserve seems to be in no rush to push the interest rate higher while other central banks around the world are already beginning to tighten rates and from a higher starting point.
One currency's weakness is at least one other currency's strength, since a currency can only be measured versus its peers elsewhere. In the current market, the strongest currencies are in those countries where growth has the best prospects if the global recovery continues and where interest rates are already on the move higher. The most popular major currencies since the equity and other risk markets bottomed in March of last year are the so-called commodity currencies like the Canadian dollar and Australian dollar, which have been bid up to remarkable heights by the beginning of the second quarter of this year. Emerging market currencies like the South African rand and the Brazilian real (both of which have important commodity angles) are also doing well as a class as investors chase higher returns.
Where do we go from here?
For currency markets, the most important factors over the next 12 months are the trajectory of interest rates and the trajectory of risk appetite, both of which will search for clues from the real economy and from governments' handling of their debt burdens, which have become excruciatingly heavy in places. It is our assumption that this latest move ever higher in risk appetite and belief in a continued strong recovery could begin to fade out by the second half of this year. If that were to come to pass, this could cause a significant reversal in already very aggressive "anti G-3" positions and a large scale correction to the weak side in the commodity and emerging market currencies. Timing such a move could be difficult, and we're highly unsure of what the trigger could be for such a scenario to come to pass. Will interest rates continue to march higher until the market crashes on the feared effects of this tightening, or will end demand simply prove insufficient to keep growth from improving satisfactorily and result in a renewed risk of deflation as the feared hyperinflation from government spending profligacy never materialises? These are tough questions indeed for the coming year.
So 12 months from now, our forecast for EUR-USD is that it will be trading in the 1.15 to 1.20 range, and that USD-YEN will be trading in the 106-108 range, but more interestingly, we could see AUD-USD trading 20 per cent lower if the world begins to lose faith in the recovery and especially if China's commodity buying frenzy dries up on possible Chinese growing pains from its increasingly fearsome real estate bubble and desperate overcapacity in the face of insufficient demand. So the big swings will be in the G3 currencies versus the rest of the world's higher beta pro-growth currencies. The G3 may look ugly now, but they could yet have their day in the coming year.
- The author is Saxo Bank's FX Analyst. The views expressed are his own.