FX Forecast Update: Euro Sold in May, But Dollar...

Key points

• EUR/USD expected to rise again and is likely to peak around 1.48
• A gradual increase in US rates should help lift USD/JPY
• GBP will stay weak, as the BoE will postpone rate hikes
• CHF will stay overvalued as the Swiss economy looks strong
• Relative rates continue to favour SEK and NOK
• The commodity currencies are expected to peak in three months' time

The euro has been the worst-performing G10 currency over the past month as European sovereign debt concerns have resurfaced as a market theme. Also, the massive correction on commodity markets, the fact that money-market pricing of the ECB proved too aggressive and stretched long euro positioning ahead of the ECB meeting have added to the selling pressure on the euro.

Looking ahead, however, we expect relative interest rates to resume their role as the dominant driver of the currency markets. Our economists' main scenario remains that an early Greek debt restructuring will not find political support within the EU, which should leave the debt crisis contained for now and limit the spill-over to overall risk appetite.

Furthermore, in our main scenario Greek funding problems render the ECB's hiking path unchanged. As the Fed stays dovish, dollar weakness is here to stay, in our view. Relative rates should also play a pivotal role in driving EUR/SEK and EUR/NOK lower, as both the Riksbank and Norges Bank are continuing their hiking cycles this year. While we look for overall market sentiment to remain intact, the support to the pro-cyclical currencies from risk appetite is likely fading, as our equity strategists look for equities to stay range-bound for the remainder of 2011. Also, it seems like we are nearing a peak in the commodity currencies, as we do not expect a repetition of the past year's large gains in commodity prices.

Main forecast changes

Lingering concerns about a Greek debt restructuring have left the euro trading with an elevated risk premium. While fears of contagion and a disorderly Greek default have returned to the forefront, our euro economists expect a loan package be extended, easing fears of a debt restructuring being imminent. Given the prospects of the ECB signalling in four weeks that the hiking cycle will continue in July, we therefore maintain our call for EUR/USD to trade higher. However, we have opted to revise our three-month forecast lower to 1.48 (from 1.50), reflecting the elevated risk premium on the euro, as well as the outlook for equities and commodities to range-trade in the coming months. Towards yearend, relative rates should become less of a USD-negative, as the Fed moves towards ending its current loose monetary policy regime. Thus, as time is passing, we have revised lower our six- and 12-month forecasts to 1.46 and 1.38 respectively (previously 1.50 and 1.40).

The collapse in US rates since mid-April and the unwinding of short JPY positions have been key factors sending USD/JPY lower. We maintain our view for the pair to correct higher as our interest rate strategists see US fixed income markets as somewhat overbought and look for US yields to grind higher in the coming months as the end of QE2 approaches. However, with the Fed expected to stay put until well into 2012, the upside potential for US yields remains benign, capping the potential for a higher USD/JPY in the near term. We have revised our three-month forecast lower to 82 (previously 85).

Despite the hawkish BoE inflation report, the hawks in the MPC are facing headwinds: economic data is weak and inflation expectations are easing. We expect the BoE to remain on hold throughout 2011 (see details in UK Research: Ten good reasons why the Bank of England will keep rates unchanged in 2011), causing relative rates to move against GBP. We maintain our call for EUR/GBP to reach 0.92 in three months, 0.89 in six months and 0.86 in 12 months.

The Swiss franc has gained ground as worries over the Greek fiscal situation have intensified. However, it is not only European sovereign debt concerns that are keeping EUR/CHF low. The Swiss economy is favoured by a strong cyclical outlook which, coupled with low debt levels as well as healthy internal and external balances, is keeping CHF strong. The first SNB rate hike has been delayed due to the strong level of the currency and the low inflation rate, but a rate hike is likely to materialise towards yearend. Overall, we therefore expect CHF to remain at overvalued levels for longer than previously anticipated. We have revised our six- and 12-month forecasts to 1.27 (previously 1.33 and 1.35, respectively).

Our forecasts for the scandies are largely unchanged: we look for relative rates to continue to point to lower levels in EUR/SEK and EUR/NOK. Most recently, Norges Bank has hiked rates and signalled that further tightening may be in the pipeline. Also in Sweden, a more hawkish tone from the central bank could become a reality if inflation expectations depart further from the Riksbank's target. We therefore continue to see value in the scandies due to the continued support from higher Swedish and Norwegian interest rates, although we are likely getting closer to the bottom in EUR/SEK and EUR/NOK. SEK might have a bit more catching up to do, however.

We now look for the commodity currencies (CAD, AUD, NZD) to peak against the dollar on a 3M horizon and then decline to less overvalued levels. While all three are expected to see support from central banks likely delivering hikes in Q3, headwinds are mounting as the dollar is likely to stage a comeback during the autumn when Fed hikes draw closer. CAD should be able to sustain its current strong levels in the near term, on an improving economic outlook and still-elevated oil prices, which our commodity strategists see well supported at USD110 per barrel (Brent). Similarly, most factors remain bullish for AUD but a weakening growth outlook, not least in China, could soon start to take its toll on exports. The outlook for the New Zealand economy after the quake is still uncertain, but NZD should get some short-term support with the prospect of the RBNZ rolling back the February rate cuts soon.

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