Key points
Eurozone debt fears - more than just Greece: Greek debt concerns intensified during the past month, leaving the euro with a heightened risk premium. While an unsustainable Greek fiscal policy should not be a major concern for the eurozone as a whole (Greece only constitutes some 2-3% of total eurozone GDP) the situation has escalated to a point where it has become at least partly systemic. Market focus has turned to the other PIIGS countries (Portugal, Ireland, Italy, Greece and Spain), which since New Year have seen government bond spreads widen alongside already elevated Greek spreads (see chart). The result has been a broad-based euro sell-off leaving the single currency with a risk premium in excess of 4% (as estimated by our short-term financial model). This is more than we factored into our January forecasts.
Political determination expected to trump market doubts: The pressure on Greece eased somewhat last week as the European Community agreed to lend support, but the euro remains stressed as the agreement lacked details and fiscal commitments. A clear inconsistency thus remains between market pricing and the fundamental political premise of the eurozone: the market currently prices a risk of a Greek default or devaluation (euro exit), while the political premise states that the eurozone system will be held together no matter what (i.e. no member state being interested in allowing a sovereign version of the Lehman default). This is, in our view, a natural consequence of the EMU's Achilles heel - that monetary policy has been centralised, while fiscal policy remains decentralised - highlighting the need for a political response. Given the alternatives, we remain optimistic about the prospects of a political solution, whether that be coordinated or bilateral and currently we do not factor eurozone member defaults, euro exits, or IMF packages into our forecast. Hence, we expect the risk premium on the euro to be reduced on the three- to six-month horizon, but also that the euro will remain under pressure until a credible political solution is found and Greece prove that it will adhere to spending cuts.
Risks that EUR selling could be more structural: Given that the current situation has proven to bear many of the classical symptoms of a currency crisis, and as the euro has gained negative momentum, it is hardly a surprise that speculative investors have been large sellers of the euro: data show that non-commercial short euro positions are at the highest level since the Lehman default in 2008. However, there are also indications that the euro sell-off has been driven by more than just 'hot money': recently published GDP data confirmed that Euroland is underperforming not least the US, fuelling fears that Euroland could be decoupled from the global economic recovery. Together with rising debt concerns, this is likely to postpone ECB tightening. Our economists are now forecasting ECB and Fed tightening to happen simultaneously in Q4, thereby removing a more pre-emptive ECB as an argument for EUR/USD to move higher (see Research Euroland: ECB doesn't dare lift its foot from the gas-pedal).
As a consequence, we have opted to lower our EUR/USD forecast profile, while retaining some dollar weakness (euro support) on the six- to 12-month horizon, reflecting our view that the risk premium on the euro is likely to be reduced. We look for EUR/USD to reach 1.35 (1.46) in 3M, 1.38 (1.43) in 6M, and 1.40 (1.40) in 12M (old forecast in brackets).
Risky assets posted strong start to 2010, but a few weeks into January the champagne turned sour - despite a continued stream of decent economic data and strong Q4 earnings reports. Global equities have shed close to 10% from the peak, bond yields have headed lower and pro-cyclical currencies have come under pressure. Several factors contributed to markets getting spooked, including concerns over monetary tightening (e.g. in China), increased financial regulation, and concerns that global growth is losing momentum. Looking ahead, our equity strategists fear that the stock market correction has further to go as earnings expectations remain high and the ISM new orders index should peak soon. Although the sustainability of the economic recovery is expected to drive stocks over the year, bear factors are emerging and 2010 is likely to present a challenging environment for risky assets. Particularly in the short term, risks are skewed to the downside and our equity strategists expect the S&P500 index to test levels below 1,000. Although we look for the close link between equity and FX markets to gradually fade, the bearish outlook could erode some short-term support for pro-cyclical currencies.
Asian monetary policy in focus: In the past month, the People's Bank of China has introduced larger reserve requirements and sought to guide interest rates higher. In isolation, a tightening of credit conditions will of course weigh on risk sentiment and some sort of “China scare” cannot be ruled out in the near term as PBoC looks set to deliver actual rate hikes in Q2. But, tighter lending standards come on the back of very impressive economic activity, and our economists still look for the Chinese economy to grow above trend this year. Also, crucially, China is not the sole driver of Asian activity with India, for example, experiencing very sturdy industrial activity recently. More broadly, this highlights the ongoing structural shifts within the world economy with demand growth now deriving predominantly from non-OECD countries. Going forward, this could make the FX market increasingly sensitive to shifts in Asian monetary policy.
Further Scandi potential, but the road is likely to be bumpy: The Scandis have performed strongly this year, as the focus on the unsustainable debt growth in many Euroland countries have put the strong balances of Sweden and Norway in a very favourable light. But the Scandi performance is not just about euro-weakness: the Riksbank last week sent out a clear message that rates will rise earlier than previously expected and while Norges Bank did not hike in February there is little doubt that rates will continue to rise in the course of 2010. We therefore keep our bullish view on both NOK and SEK for the rest of 2010, expecting EUR/NOK and EUR/SEK to reach 7.80 and 9.60, respectively. However, the road will likely be bumpy: the Riksbank might not hike quite as early as the market currently expects, and Norges Bank is likely to try to talk down the NOK.
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