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Currencies Economics – Markets – Strategy Fed Funds Rate forecast, eop Latest Prev Close 2.00 3.00 2Q08 2.00 2.25 3Q08 2.00 2.25 4Q08 2.50 2.25 1Q09 3.25 2.75 2Q09 4.00 3.25 3Q09 4.50 4.00 4Q09 4.50 4.50 Latest close on Jun 11 Prev close on Mar 12 US dollar – weakness becomes an inflation problem The USD is likely to have completed its second phase of adjustment that started in Nov 2005. Unlike the first phase between 2002 and 2004, USD depreciation was not led by major currencies this time around. Instead, the burden was shared more evenly spread between major and Asian currencies. We reckon the third phase will be led by Asian currencies, where those with strong fundamentals are likely to appreciate not just against the USD, but also against the EUR and other G7 currencies. Before we enter into Phase III, the USD is likely to recover some lost ground from now into mid-2009, similar to 2005 when the US hiked rates. DBS is looking for Fed Funds Rate to rise from 2.00% to 4.25%, starting in 4Q08 into 3Q09. The most significant development in 2Q08 was growing belief amongst policymakers around the world that the “Weak USD” has become an inflation risk. For example, China blamed the deep US interest rate cuts for creating inflation in emerging markets. Increasingly, there is belief that the increased liquidity to stabilize financial markets during the US mortgage/credit crisis facilitated speculation in commodity markets. The US rate cuts were seen responsible for weakening the US dollar, which in turn, implied stronger Asian currencies or increased purchasing power from Asia for commodities. On Jun 3, Fed Chairman Bernanke highlighted that the “weak dollar”, in shaping inflationary expectations, is now a threat to its dual mandate to keep inflation stable and to create jobs. Bernanke’s comments affirmed the view that the Fed will no longer be looking to cut rates. Unlike past episodes, this should increase the USD’s resilience to renewed financial stress going forward. US Treasury Secretary Henry Paulson also visited the Middle East to reassure Gulf countries that the US was committed to the USD as a reserve currency. His goal was obviously to ensure that Gulf countries do not hurt the USD’s credibility by abandoning their USD pegs. For the first time in a long time, Paulson did not rule out intervention to stabilize the USD. That said, G7 nations have not abandoned their long-time call for USD adjustment to address global imbalances. Except that the stance has narrowed to the Chinese yuan and other Asian currencies with large current account surpluses to bear the adjustment burden. At its meeting in April, G7 nations warned that sharp fluctuations in (specifically) major currencies could threaten economic and financial stability at its April meeting. In short, G7 nations want these Asian currencies to appreciate on a trade-weighted basis. Before this can happen, Asian currencies will need to deal with inflation first. Rise in oil prices are more aggressive compared to previous USD fall in 2002-04 140 120 100 80 60 40 20 0 DXY index (rhs) Oil prices ($/barrel, lhs) 01 02 03 04 05 06 07 08 130 120 110 100 90 80 70 60 Market is coming to our view for higher US rates % pa 4.50 4.25 4.00 3.75 3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 DBS forecast for Fed Funds Rate Fed Funds Futures as at Jun 9 Fed Funds Futures as at Apr 30 (last cut) Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 28
Economics – Markets – Strategy Currencies Euro – relinquishing its anti-USD role The high of 1.6018 achieved by EUR/USD on Apr 22 is likely to be the peak for the next 6-12 months. Looking ahead, the EUR is set to lose its anti-USD role on expectations for the EU-US interest rate differentials to narrow, as well as a policy shift in G7’s exchange rate stance towards discouraging USD weakness. In our opinion, the EUR/USD’s rally during the US mortgage/credit crisis from Jul 2007 to Apr 2008 did not reflect a strong EUR view, but a weak USD view driven by aggressive US rate cuts amidst steady EU rates. Between Sep 2007 and Apr 2008, the Fed Funds Rate (FFR) fell from 5.25% to 2.00%, or half the ECB’s 4.00% refi rate. Looking ahead, we expect EU-US interest rate differentials to narrow, as they always do after Eurozone loses its GDP growth advantage to the US. The Fed should start taking back rate cuts in 4Q08, initially as an exercise to normalize interest rates. The FFR is expected to rise to 4.50% by 3Q09 and reclaim its positive carry against the EUR. This is not an unreasonable prospect considering that US real interest rates, whether measured against headline CPI or core inflation, are significantly lower than their EU counterparts. There was also a major shift in the G7’s stance on exchange rates in 2Q08. At its meeting in April, G7 nations warned that sharp fluctuations in major currencies could threaten economic and financial stability. After EUR/USD rose above 1.50, Eurozone officials persisently complained about the EUR’s overvaluation and the USD’s undervaluation. Lending support here is the US-EU trade deficit, which is set to narrow for the third straight year in 2008 to below USD100bn for the first time since 2003. Eurozone also reported a current account deficit of EUR17.8bn in 1Q08, its worst level since 2Q01. If this persist, it will be the first since 2001 that Eurozone posted a current account deficit. EUR/USD forecast, eop Latest Prev Close 1.56 1.55 2Q08 1.55 1.48 3Q08 1.52 1.50 4Q08 1.49 1.54 1Q09 1.46 1.50 2Q09 1.43 1.49 3Q09 1.45 1.48 4Q09 1.46 1.48 ECB refi rate forecast, eop Latest Prev Close 4.00 4.00 2Q08 4.00 4.00 3Q08 4.25 4.00 4Q08 4.25 4.00 1Q09 4.25 4.00 2Q09 4.25 4.00 3Q09 4.25 4.00 4Q09 4.25 4.00 Latest close on Jun 11 Prev close on Mar 12 These initial currency complaints by EU officials initially fell on deaf ears, that is until the US Treasury and the Fed acknowledged in June that the weak USD was responsible for fueling inflationary expectations by boosting commodity prices, especially food and energy prices. Given that EUR accounts for 57.6% of the weight in the the DXY (USD) index, this implies that the firmer USD sought by G7 to rein in commodity prices will inadvertently imply a weaker EUR. During the US rate hike cycle in 2005, EUR/USD returned close to 40% of its three-year rally from 2002 to 2004. If history repeats itself in the coming US tightening cycle, EUR/USD has potential to fall back towards 1.43 by mid-2009. EU-US policy rate spread to fall with GDP spread 2 1 0 -1 -2 -3 EU-US GDP growth spread, % YoY EU-US policy rate spread, % pa 96 97 98 99 00 01 02 03 04 05 06 07 08 G7 seeks a firmer USD (or weaker EUR) should pull down commodity prices 440 420 400 380 360 340 320 300 280 260 CRB index (lhs) Jan-07 Jul-07 Jan-08 EUR/USD (rhs) 1.65 1.60 1.55 1.50 1.45 1.40 1.35 1.30 1.25 29
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