From the April 2013 issue of Futures Magazine • Subscribe!

The new “new normal” in FX

To paraphrase Jerry Garcia, it has been a long, strange trip for markets, particularly foreign exchange markets, in recent years. But traders and analysts believe 2012 was somewhat of a watershed with the Eurozone getting a handle on, if not solving, its sovereign debt issues, the yen coming back down to earth and the U.S. economy growing, albeit slowly. 

What this has meant for foreign exchange is a move toward the market following more normal fundamentals instead of simply being whipsawed by the risk-on/risk-off trade that has been the driver of choppy markets for much of 2010, 2011 and the first half of 2012. “Currencies are following more normal fundamentals after spending the last two years flipping from risk-on to risk-off,” says Paul Chappell, chief investment officer of U.K.-based C-View Ltd.

Mikkel Thorup, principal of Capricorn Currency Management, agrees. “I do see the markets as being a little more fundamentally driven and less political, which is a good sign.” 

But what does normal mean at this point? Well, first, it probably doesn’t mean the euro will be able to sustain its strong move from the second half of 2012 and early part of this year (see “A good run,” below). Although most of our experts agree a major catalyst for forex moving toward more normal fundamentals was the Eurozone getting its house in order in the summer of 2012, that move has gone as far as it could go. While the Eurozone appears more stable, it certainly is not in line for strong growth. 

Chappell says there is more stability in the Eurozone, but it is not out of the woods. “There will be bumps along the way and worries about the [Eurozone] sovereign crisis and U.S. fiscal cliff.”

Although the Eurozone sovereign debt crisis has been in abeyance since mid-2012, it is not necessarily over. “A large amount of debt still exists. There is a way to go; we don’t think it is going to be a smooth ride,” Chappell says. 

He sees the mid-February level around 1.33-1.34 in the euro as fair value but says it could sell off to the mid-1.20s and he sees 1.40 as the top of the range for 2013. 

Andrew Wilkinson, chief economic strategist at Miller Tabak & Co., says the European Central Bank (ECB) prevented a potential contagion but growth will be slow. “The measures the ECB [have] drawn up widely are perceived to be sufficiently strong to snuff out any contagion. So we have seen rising government bond yields and the flow of credit. That in itself is a big factor in creating [an] economic [recovery] in the Eurozone,” he says. “Now the recovery is going to be very slow, we should probably expect no growth in the [first half]. In the second half of the year, it seems reasonable for the German economy to grow, and it will flow through, albeit slowly, to the peripheral areas of the Eurozone.”

Wilkinson adds, “We now have seen some independent currency movement, which is great because you no longer can predict volatility. So currency trading has come full circle, back to trying to predict which economy is going to outperform the next.” 

In terms of performance, Wilkinson sees a widening growth differential between the U.S. and Eurozone to keep the euro down most of the year, targeting the 1.24 range. “It has more to do with dollar strength than euro weakness. Euro weakness is isolated to outperformance of the U.S. economy and growing expectations that the Fed at some point will alter its official policy stance,” he adds. 

Thorup says the euro is too high at current (1.33-1.334) levels. He targets 1.25 for the euro by mid-2013. “Right now it is seeing some technical momentum. It was very risk driven,” he adds. 

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