The European debt crisis rocked the currency markets in the first half of 2010, sending the euro lower while investors fled to the safe haven of the U.S. dollar. Experts are split about whether the euro has hit bottom, with some predicting a comeback by the end of 2010 and others forecasting continued economic weakness in Europe that will drag the euro down further. With split opinions on the euro come split opinions on the direction of the dollar. And economic uncertainty will likely equal volatile currency markets for the rest of the year.
After the euro took a beating on the heels of severe economic weakness in the PIIG nations (Portugal, Italy, Ireland and Greece) in early 2010, Europe conducted stress tests on its largest banks in an attempt to make their balance sheets more transparent to investors and stabilize the behavior of the euro. The results, released on July 23, were positive, with only seven of 91 banks failing. This gave a boost to the currency, which had rebounded from its lows throughout July. However, among analysts, the jury is out on whether the euro has hit bottom.
Andrew Wilkinson, senior market analyst at Interactive Brokers, thinks the euro has hit bottom and that pessimism on the euro in the first half of 2010 was overdone. He adds that second quarter industrial production and manufacturing output in the Eurozone expanded, outpacing demand in the United States and playing a role in boosting the value of the euro against the dollar. He predicts the euro to be at 1.40 by yearend.
However, according to International Monetary Fund (IMF) forecasts, GDP in the Eurozone is expected to rebound in 2010 at a slower pace than other regions. The pace of economic recovery is key to where currency markets are headed (see "GDP jumping?" below).
"Eurozone fundamentals, in terms of economic data, will improve a bit and even though their growth in individual regions is going to be zero to negative for the rest of the year, in the near-term, you’re going to see prior weakness in the euro have an impact on the data, so that should help sustain 118.77 as the bottom," says Kathy Lien, director of currency research at GFT. She says the euro should be at 1.26 by yearend.
But some say the euro is headed lower. Budget deficits have plagued most of Europe, the UK and the United States over the last few years, weighing on currencies and the broader economic picture (see "At a deficit," below). Brian Dolan, chief currency strategist at Forex.com, says the euro is undergoing a correction and is likely to see further weakness in 2010 due in part to a slowing global recovery. "The catch-22 for the Eurozone is that their deficit reduction efforts need stronger economic growth than they’re going to achieve to remove and repair the debt crisis. Their austerity measures are likely to work against economic growth. They’re on the verge of a fiscal deficit spiral," he says, targeting the euro at 1.15 by yearend.
Dan Cook, senior market analyst at IG Markets, agrees, adding that there’s no sign austerity measures in the PIIGs are working or being implemented properly. "They had a lot of debt before and they’re issuing more backed by the European Central Bank [ECB], but how will they be able to sustain it later into the year, particularly if the ECB slows down on their measures? That’s my big concern over being too bullish on the euro," he says. "If the austerity measures start to work, which data hasn’t suggested, we could see the 130s. However, there’s still a lot of risk that could take us [down] to 1.15 or 1.10."
The pound took a nosedive in May and June and then had a major rebound throughout July. "The story for sterling is similar to the outlook for the euro," Dolan says. "Austerity measures [will] be kicking in in 2011, and the market’s going to be in the process of pricing those in, and that’s a negative for the sterling." He adds that the Eurozone and UK are at risk for seeing negative GDP in the quarters ahead, which means the Bank of England could keep interest rates on hold and weaken the pound further. Dolan predicts $1.40-$1.45 for the pound at the end of the year.
Others have a more positive outlook for the pound. "The UK [is] a more favorable growth story [than Europe]. While it has a huge budget deficit, the new coalition government has tackled it with a very stringent budget," Wilkinson says. He expects the pound to reach $1.60 by the end of the year.
Cook says the investment community is extremely optimistic about the pound. "It’ll [experience] steady growth, more of a range-bound trade between the pound and dollar, 1.48-1.58 or into the low 160s." However, he adds that if things blow up in Europe, the pound will be dragged down.
Dollar daze
The dollar enjoyed a major rebound in the first half of 2010 as it became the currency of last resort. Opinions on where the dollar is headed hinge on views on the direction of the U.S. economy. And in the eyes of the Federal Reserve, that view is getting more pessimistic. Markets headed lower on July 21 after Federal Reserve Chairman Ben Bernanke told Congress that financial conditions "have become less supportive of economic growth in recent months."
Lien says that where the dollar is concerned, the market has shifted its focus from risk to fundamentals. "We’ll probably see additional dollar weakness before strength," she says.
Wilkinson says the dollar’s recent rally has gone too far. "I see risk appetite returning in the second half and that would be detrimental to the dollar," he says.
Some say global economic recovery will be a slower process, and the dollar will therefore strengthen as it retains safe-haven status in the currency world. Cook expects the dollar index to gain heavily based on fears in Europe. "The dollar is going to remain a safe haven. We haven’t had any good data out of the U.S. in a long time, so that’s put some pressure on the dollar. We have fewer [debt] problems, and that will likely help the dollar," he says.
The dollar will end the year stronger because the U.S. economy will continue to weaken, says Joseph Trevisani, chief market analyst at FX Solutions. "Any time systemic risk factors come up, the dollar is still king. The fear background has not abated very much. I would look for a consolidation back and forth, and not a strong trend in either [the euro or the dollar]," he adds.
Dolan agrees. "The dollar’s likely to be relatively well supported because of the weakness in the global economic recovery and there’s going to be that safe-haven appeal," he says, adding that he expects the dollar index to be at 90-92 by yearend.
What’s happening in the U.S. economy will likely have an impact on the yen. "The yen is moving based on U.S. development. U.S. yields have fallen quite significantly. The further these yields fall, the more pressure there will be in dollar/yen," Lien says. She expects the yen to be at 85 by the end of the year.
"If risk appetite returns, the yen [should] weaken to 100 against the dollar. I find it hard to be bullish on the yen," Wilkinson says.
Dolan looks for 85-90 for the rest of the year in dollar-yen and says the upside in dollar-yen is limited by risk aversion. "I can’t rule out intervention [from the Bank of Japan] if we see below 85 in the dollar-yen for any length of time," he says.
Cook agrees. "Economically speaking, I don’t see too much of a shift that could strengthen the yen, but we could be in for some direct intervention where [the Bank of Japan] tries to bring it up to 95 or 98."
Hot commodity currencies
While the rest of the world has kept interest rate policies on hold, continuously delaying exit strategies, the commodity producer countries, Canada and Australia, have raised rates, with Australia hiking rates several times starting in October 2009. And for the most part, analysts expect the outlook for commodity currencies to be bullish.
"I’m looking for more gains in the Aussie and the loonie. [In July], Canada raised interest rates for the second time in a row [and] it’s really going to help the Canadian dollar in the long run," Lien says. She expects the Australian dollar to reach 90¢ by the end of the year and the Canadian dollar to hit 1.02.
Wilkinson says the Canadian dollar should reach parity with the U.S. dollar by the end of the year due to demand for minerals and resources from Canada. "The Canadian dollar will strengthen as the global economy gets back on its feet," he says. However, he says that the Canadian central bank signaled it’s not going to raise rates much more, which could be a counterargument against the loonie.
Dolan says the Canadian dollar could be between .98 and $1.08 at the end of the year, while the Australian dollar could run into some limits above 90¢.
Canada will continue to recover faster than the U.S., Cook says. However, he adds, "If things are bad in the U.S., that automatically slows Canada’s growth. The value of CAD is so linked with the profitability of oil that if we see demand start to slow in the U.S., that keeps the value of CAD in check. Parity is a possibility."
Both Wilkinson and Cook expect the Australian dollar to reach 94¢ by the end of 2010. "There are some concerns about how much China decides to tighten, as well as India. [For] commodity-related currencies, if there’s not demand from China, [there’s trouble]," Cook says.
In June, China announced it would revalue its yuan but there was no timetable attached with the announcement. "In terms of the yuan, there’s only one way it’s going: up. It’s just a matter of the speed in which it’s going up," Lien says.
Dolan says there’s potential for a more drastic slowdown in China. "That would seriously undermine the global recovery and [be] a negative for risk and a positive for the dollar," he says.
Higher commodity prices could happen as a result of yuan revaluation, Cook says. "We’ll see a very slow, very controlled, very tentative float," he says. "One of the big impacts on the dollar won’t be the yuan float but how much U.S. debt China is picking up at any given time. If things turn south in Europe, we’ll see China move to pick up more U.S.-denominated debt as a safe-haven play and then eventually get back to the euro buying. The world is hinging a lot on Europe right now."
Looking for direction
Central bank action could provide clues about where currencies are headed. "What central banks are and are not doing will determine which currencies outperform and underperform for the rest of the year. The ones that are being proactive in terms of normalizing their monetary policy will see their currencies strengthen and those that are being passive will see their currencies weaken," Lien says.
Dolan says traders should focus on the European and UK growth outlooks and the implementation of their deficit reduction measures and how the market is pricing in the impact of those spending cuts and tax increases. He also says that the U.S. elections could have an impact on the currency market (see "Trading the dollar on election results"). "If the elections can result in a gridlocked Congress, we might see more of a rebound through the end of the year. Major government initiatives would be less likely to materialize over the next two years and markets tend to like that."
The world has focused on Europe’s debt problems for the first half of 2010 and here in America we tend to shake our heads, but our reality is not that different. When the world’s markets turn their focus back to the dollar, things could change. There have been no strong currencies of late, only less weak ones. And once the world is able to accept risk, the dollar may be in the hot seat.
