Forex Investment and Currency Trading

Extreme uncertainty in global financial markets and the poor outlook for the global economy continue to drive volatility in currency markets. Deleveraging is also having a major impact as so-called carry trades are unwound. since this process has further to run and, as such, do not expect a quick reversal of recent currency moves.

The Japanese yen (JPY) has appreciated very sharply against high interest rate currencies over the past month, such as the euro (EUR) and the Australian dollar (AUD), as deleveraging intensified. Meanwhile, the yen’s appreciation against the US dollar (USD) has been much more modest. This combination will probably persist in coming quarters and the USD/JPY is expected to stay around 100 until the middle of 2009. As the outlook for the U.S. economy improves late next year, a shift of Japanese household portfolios into foreign currency denominated assets will probably generate modest JPY depreciation.

The EUR has continued its sharp deterioration against the USD, at a time when the outlook for the U.S. economy deteriorated substantially. This suggests that the market continues to downgrade its outlook for the euro area economy and ECB rates. Market forecasts a further gradual weakening of the EUR against the USD, to 1.25 by mid-2009 and 1.20 at the end of next year.

Sterling is also likely to remain weak, as the United Kingdom slides into a fairly severe recession. Domestic demand is expected to shrink sharply in 2009, similar to the worst declines of the past 50 years. Under these conditions, further currency weakness — unless precipitous — will not stop the MPC from cutting interest rates further. Political uncertainties and worries about the United Kingdom’s soaring fiscal deficit in the run-up to the next election also are likely to weigh on the pound.

With the Swiss economy deteriorating in line with Western Europe, the economic outlook will not do much for the Swiss franc (CHF). In the current situation, the primary driver is the financial market turmoil, two-sided risk is seen in terms of the CHF. However, moderately rising risk appetite tends to disfavor the CHF — that is, gradually depreciating profile versus the EUR in coming quarters.

Almost every Asian currency depreciated against the USD during the past month in response to deleveraging and weakening economic prospects. The biggest declines were in Korea, India, Indonesia, and the Philippines. The medium- to long-term outlook for Asian currencies remains upbeat, but these currencies are likely to stay weak for now, at least until the global financial crisis eases substantially. Among them, the Korean won, Indonesian rupiah, Vietnamese dong, Indian rupee, and Philippine peso could be at greater risk of weakening. Meanwhile, China’s currency is among the most resilient in the region.

The AUD continues to trade in a very volatile range, with significant deleveraging of the “carry trade,” lower commodity prices, and aggressive policy responses to the outlook for slower global growth. Any signs of financial market stability are likely to be supportive for the AUD because Australia is expected to be one of the few OECD nations that does not fall into recession. But, for now, the risks remain to the downside. The New Zealand dollar (NZD) has also been under pressure, with the economy already in recession and the central bank easing policy.

The Canadian dollar (CAD) is expected to continue to depreciate in the face of reduced terms of trade, recessionary conditions, and the strong likelihood of additional policy easing. Given the negative view on most key factors currently driving the Nordic currencies, the EUR/SEK and the EUR/NOK are likely to stay weak in coming months.

Currency vulnerabilities in CEEMEA are becoming more apparent: The South African rand, Hungarian forint, and Turkish lira have all depreciated by more than 20% against the USD in the past month. These countries have a set of external vulnerabilities in common — current account deficits and large refinancing needs — which seem difficult to sustain in a world of limited risk appetite. Meanwhile, risks to pegged currencies — in Ukraine and the Baltics for example — are being reflected in sharp rises in sovereign CDS spreads. For the most vulnerable countries, one key issue in the near term is the extent to which IMF lending can stabilize the balance of payments. The IMF has loanable funds of just more than US$250 billion, and the market is expecting financing packages to be announced soon for at least Hungary, Ukraine, and Pakistan.

Russian financial stability has been threatened by the high dependence of Russian banks on wholesale funding: Russia’s banks had net currency liabilities of some US$150 billion at the end of 2007, the product of a loan/deposit ratio of 150%. Financial risks could mount with further downside pressure on energy prices, leaving Russia with a choice of selling reserves, allowing the currency to depreciate, or imposing restrictions on outflows.

Our forecasts imply a stronger path for most Latin American currencies than those implied by forward markets. However, downside risks are significant and we generally do not favor long positions in Latin currencies at this time. We anticipate slowing economic activity to dominate central bank discussions in coming months, rather than inflation fears of pass-through from weaker currencies. Therefore, we generally expect central banks to postpone hikes or remove them from the horizon entirely, adding downside risk to local currencies.