lunedì 25 gennaio 2010

Will the Fed strengthen the US Dollar?

An excerpt from out weekly Top Down Outlook

Over the last week the Euro exchange rate declined versus the major international currency : the Euro fell by 1.66% versus the US Dollar, by 0.53% versus the UK Sterling and by 2.61% versus the Japanese Yen. More limited was the fall against the so-called commodity currencies (Australian Dollar, Canadian Dollar, New Zealand Dollar and Norwegian Krone), as they felt the negative effect of lower commodity prices due to both the uptrend in the US Dollar and the tightening of monetary policy in China.

The Euro’s fall was mainly triggered by the negative pieces of news coming from Greece. Last week, the country’s Government Bond yields hit their highest since the adoption of the Euro: the two-year note jumped to 4.23% and the 10-year bond to 6.17%. The spread between the Greek and German Bund widened to almost 300bp and the credit default swap rose to 345bp. Investors drove higher Greek Government Bond yields amid fears that the Greek Government might struggle to sell its debt to fund the deficit – the biggest within the European Union – and questioned the country’s ability to implement the deficit-reduction plan presented to the European Commission on 15 January.

Under the plan, Greece will slash spending and raise revenue by about €10bn this year, bringing the deficit/GDP ratio down to 8.7% by year-end. The deficit/GDP ratio is seen falling to 3% by 2012. According to the plan, the Greek Government should sell more than EUR53bn in debt this year (16bn in Q2).

Further uncertainty over the Greek economic outlook is also provided by the numerous statements made by many European authorities, according to which the European Union will not bail out Greece (Finance Minister Papaconstantinou said during the past week that a rescue package won’t be needed), hence suggesting that the European Union is likely to adopt a tough stance towards Greece not to encourage moral hazard among other European countries with ballooning national debt (i.e. Spain, Portugal and Ireland). A we have pointed out in the 11 January Global strategy weekly (“A good start for 2010”), although we believe that there is little chance that Greece will default in the next few years and that the European Union will not take action to help derail a default, we believe that the country’s negative outlook will continue to weigh on the Euro going forward.

However, other factors are penalising the Euro. The economic data published in early 2010 confirmed our view that the pace of the recovery will be more moderate in the Euro zone than in the US. The 2009 German real GDP figure published on Wednesday 13 provides a clear example: GDP contracted by 5% in 2009 against consensus estimates of -4.8%. This indicates that Q4 GDP may have been much weaker than previously expected, with a flat GDP that seems the most likely outcome in Q4. The Zew index, published last week, declined for the fourth consecutive month in January, showing that economic growth may soften sharply in the coming quarters. Next week, attention will focus on the German IFO index for January, due for publication on Tuesday 26. Although the business confidence index is expected to edge up, the increase is likely to be slim, confirming that economic recovery is losing momentum due to the imminent ending of the fiscal measures that have sustained the economy in the last few months. The latest economic data released in US, particularly in the real estate sector, offered evidence that also the US economic upturn is clouded in uncertainty. However, as we have suggested in last week’s Global Strategy Weekly (“What is the yield spread telling us?”), all leading economic indicators show that the economic recovery continue into the months ahead.

Next week, the FOMC monetary policy meeting will take centre stage. Although we do not expect major surprises on the interest rate outlook, we believe that the Federal Reserve might slightly upgrade its economic estimates, albeit confirming that the economic activity will stay sluggish for some time. Though confirming that the Federal Reserve will not hike rates any time soon (at least not until H2 ’10), an upgrade in economic outlook by the Fed will likely bring investors to increasingly discount the possibility that the Fed and not the ECB will be the first Central Bank to tighten in 2010.
Overall, we reiterate our view that the Euro might continue to trend downward against the US Dollar: we stick to our recommendation to sell the EUR/USD with a medium/long term target of 1.17, in line with the fair value of the EUR/USD exchange rate based on the PPP calculated by the OECD.

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