Forex Investment and Currency Trading

While the EUR remains well below its record highs versus the USD and JPY, it has soared versus the GBP. Not only has EUR/GBP reached a new high since the introduction of the EUR, but the GBP has fallen this week to an all-time low versus the DEM (2.0476). As a result, the trade-weighted EUR is now extremely close to its July 11 peak, suggesting a low probability for EUR/USD to surge back toward 1.60, even in the near term period of USD weakness.

EUR/GBP, which continues to follow interest rate differentials closely, does face the possibility of a near-term retracement with most of the negative economic developments already being “priced in” for GBP, whereas market expectations for a rate trough in the Eurozone (currently at 1.50%) face the risk of some downward revision. However, the potential for quantitative easing to be implemented in the UK, and the
resultant decline in real interest rates, does not bode well for the currency. Indeed, in a world of scarce capital the external financing needs of the UK will likely prove increasingly difficult to meet. The relatively favourable external position of the Eurozone should therefore continue to apply upside pressure to EUR/GBP throughout 2009.

In contrast, the outlook is more favourable for the CHF. The CHF has demonstrated a strong tendency to out-perform during periods of global economic slow-down as its use as a funding currency is offset by risk aversion. In this context, Switzerland’s large current account surplus, which stood at 10.1% of GDP as of 2Q 2008, should apply upward pressure on its currency in the year ahead.

Brighter times also likely lie ahead for the Scandinavian currencies. The relatively illiquid currencies of the small Nordic countries have historically experienced significant depreciation during periods of global financial turmoil, especially SEK, as investors seek the safety of more liquid markets. However, this phenomenon, known as a currency substitution effect, is likely to be reversed in 2009 as turmoil in the financial markets eases to a greater extent, leaving NOK and SEK as strong out-performers throughout the course of the new year.

After lagging the initial surge in risk aversion in late September, the trade-weighted JPY benefited significantly during the period of heightened risk aversion. However, in recent weeks the JPY TWI has held near recent highs despite a sharp retracement in the VIX index of equity volatility.

Moreover, fundamental support for the JPY at 13-year highs versus the USD is lacking. The Japanese recession could bring a modest form of quantitative easing in Japan, reducing downside pressure on USD/JPY. As the US 2H 2009 recovery allows the Fed to withdraw excess liquidity, USD/JPY is likely to creep back above 100. In the interim, political pressure will likely keep the MOF from intervening unless USD/JPY falls sharply below 85.

Among the dollar bloc/commodity currencies, the price of a basket of commodities most relevant to Australia’s export mix has held up considerably better than those of Canada and New Zealand. The Australian commodity price index will fall further in the months ahead but is unlikely to fully reverse the huge jump in the first three quarters of 2008.