Currency Views: November 2008 - OCBC Wealth Management

Greenback could strengthen further

28 October 2008

The recent carnage in the credit and equity markets has benefited the greenback in a big way. Investors scurried for cover, taking their funds out of equities and moving them into Treasury Bills, for want of a better place. The widening credit spreads also helped to boost the U.S. dollar, as institutional buyers headed to the currency market to buy U.S. dollars outright. Banks were leery about lending to each other, and nobody wanted to be caught short. We thus saw the greenback appreciate steeply, especially against higher-yielding currencies such as the Aussie and Kiwi.

With the benefit of hindsight, the positive U.S. dollar sentiment was clearly not driven by fundamentals as the U.S. economy is weak and could slip into a recession.

If the U.S. dollar weakens, it will be for two reasons:

First, credit markets are easing up. The joint action by central banks to inject liquidity into the system has given markets some comfort, and this can be seen in London inter-bank offer rates (i.e. Libor) which have eased. With banks slowly starting to lend to each other again, there is less of a need for institutions to hold on to U.S. dollars, which they are likely to sell off in favour of higher yielding foreign currency denominated assets.

Second, the U.S. Presidential election will take place in early November, and with it comes some degree of uncertainty. The Democrats are perceived by the markets as being stronger on the economy, and Barack Obama is ahead in the polls. However, the election is by no means a foregone conclusion, and we expect to see some investors pull out of the greenback in the weeks preceding the election - a phenomenon that we observed during the last election in 2004. If this happens, the major beneficiaries should be the Euro and Swiss Franc.

While fundamentals will eventually catch up with the greenback and cause it to weaken, it could still strengthen further in the next couple of months as international investors seek opportunities among undervalued U.S. stocks and Treasuries - which are perceived to be safer bets at this juncture. Repatriations to the U.S. to meet mutual and hedge fund redemptions have also contributed to the greenback's strength. The weakness in commodity prices also augurs well for the greenback as they tend to move in opposite directions.

Euro

The Euro continued slipping in October and there are concerns about further downside pressure on the currency. The ECB has been notoriously slow at adjusting interest rates, until its hand was forced in a coordinated move amongst central banks in mid-October. If this tardiness continues, the Euro may stay supported on yield differentials.

British Pound

The Pound has followed most G10 currencies down vis-à-vis the Greenback, on fears that Europe will be the next continent to feel the brunt of the global economic slowdown. The United Kingdom, with its housing industry on the ropes, certainly fits the bill as the next economic whipping boy.

We expect to see continued outflows for the Sterling going forward, as the BOE will likely embark on a series of rate cuts to stimulate the economy, given that inflation is not in focus at this point. We see the currency weakening against the Euro, and being flat to bearish against the U.S. dollar.

Australian dollar

We said last month that the Aussie was prone to two factors: risk-aversion and monetary policy easing. We got both in large doses in October. Bank failures and a credit market seizure prompted investors to dump high yielding assets for the relative safety of U.S. Treasuries. Around the same time, the RBA decided to over-compensate and slash its benchmark rate by a full percentage point. Faced with the prospects of higher risk and lower yield, carry traders scrambled to unwind their positions, which led to a massive fall in the Australian dollar.

The prospects for the Aussie do not look good in the short- to medium-term. Commodities demand is tapering off as global growth continues to slow. Yield expectations are also coming down, with analysts expecting the RBA to bring its benchmark interest rate to as low as 4.5 per cent. While the Aussie may see a short-term rebound, we see this as an opportunity to sell the currency as the rebound may not be sustainable.

New Zealand dollar

The weak economy and prospects for lower interest rates will clearly weigh on the currency. The Kiwi dollar is likely to weakening in November, particularly against the Yen, Aussie dollar and Euro.

Japanese Yen

The fundamentals for the Japanese economy remain fairly weak, as evidenced by the latest Tankan surveys. The economy is largely export-driven, making it very susceptible to the fortunes of the global economy.

Nevertheless, we've seen the Yen strengthen broadly against most of the other G10 currencies, on the back of widespread carry-trade unwinding..

While the Yen remains the funding currency for carry trades, we do not expect a return to the kind of activity seen in the past couple of years. Risk aversion remains relatively high and we think that any return to risk will be slow and tentative. As such, the Yen is unlikely to weaken significantly against the U.S. dollar in the short-term even though there are expectations that the Bank of Japan will intervene as the strong Japanese currency is hurting the economy.

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