Ron Leven of Morgan Stanley has recently delivered a presentation under the auspice of ETF Securities Ltd. in which he outlined his expectations for the major currencies.
He argues that it was perhaps inevitable that we would be running into a rough patch in the economy in mid-year, when the Fed’s QE programme is due to stop. There is a fair amount of uncertainty about the implications for the US and the global economy of the ending of the liquidity injections. What is the source of the current softness?
Morgan Stanley believes that the current weakness in both the US and global economy is temporary and is currently stemming from the production disruptions in Japan along with unusually severe weather in the US in H1 2011. There is also some legitimate slowing in China as the inflation problem becomes significant. The slowdown is real but temporary; over the rest of the year Japan’s reconstruction efforts will be a source of strength, while the US economy is expected to regain traction in the second half of the year. Leven argues that the easy gains in productivity in the early part of the recovery cycle in the US are now over; Morgan Stanley is looking for a significant pick-up in capital investment over H2 and this is expected to generate US growth of approximately 4% on average over the second half-year. China, although struggling with inflation, is thought to be intent to maintain growth at 8-9%. Expect China to be able to underpin the economy through increased infrastructure investment, even as the government makes material efforts to reduce inflation.
Generally speaking, the dollar’s broad performance (using the Morgan Stanley G-10 index) is generally in line with trends in money growth; periods of relatively rapid growth in M1 usually coincide with dollar weakness and periods of relatively restrictive money growth are supportive. The financial crisis saw this relationship fail, but the outlook is more in keeping with normal historical trends. The Fed is not talking yet of tightening, but even supposing that M1 stays flat going forward, this will gradually decelerate the rate of growth, and gradually provide support for the dollar. The recovery in the dollar s not expected, however, for “quite a while”.
The Fed is expected to start tightening via the balance sheet well ahead of when it starts raising interest rates and this will bring forward the deceleration of US money growth. The bank is also of the view that inflationary risks will be pushed back into “well into the future” and, with unemployment high, the Fed will not have a clear-cut case for raising rates until the third quarter of next year. Once they do start raising rates, the pace is expected to be fairly aggressive and Leven is looking for a rise of 75 basis points in H2 2012 and then again in to 2013. In the interim, the lack of rate hikes will weigh on the dollar, and so the recovery that will be generated by the tightening in the balance sheet will take months to develop..
As far as the major exchange rates are concerned, the bank’s thinking is as follows:
Dollar:yen; if anything the QE2 / QE3 outlook is more important for the $:yen than any other, as this is the pairing that reacts most closely to relative growths in money supply. Conditions remain negative for the $ rate, but it will be “well into next year” before it becomes outright positive for the dollar. Periods of sustained $ strength against the yen historically needs an interest rate spread of at least 350 basis points and in the early stages of tightening phases the $ tends to make new lows against the yen and we should see a new low in 2012.
For $:€; the relative monetary growth is not as significant as it is for dollar:yen. In general, high US monetary growth is associated with a weaker dollar, but not always. The interest rate cycle is less relevant than with the yen, but there is a key threshold; generally a dollar recovery needs something of the order of >200 basis points to sustain an uptrend against European currencies and “we are a long way from that happening”. This creates an extended downward $ bias against Europe. The two-year rate spread is already discounting the expectation that the ECB will be more aggressive in its rate hikes than the Fed, implying that a $:€ at mid-to-high $1.40s is broadly appropriate on the basis of current interest rate expectations.
Morgan Stanley thinks that the curve may be pricing in too much by way of aggressive rate hikes in 2012, and there is some reason to expect the euro to peak out in the second half of this year and become vulnerable in H2 2011 and into 2012. In addition the euro’s linkage with sovereign debt is becoming tighter, notably the five year CDS rate in Spain and this also limits the euro’s upside potential.
Oil has also historically been an important driver for the euro and Morgan Stanley currently believes that the euro is overprices with respect to oil – although the bank is looking for a substantial rebound in oil and other commodity prices on the belief that global economic weakness in temporary. Combining these three factors suggest that the euro may be overvalued in the short term, and although the dollar may have its problems in the short term, Leven does not see a turn in the $:€ rate until the first half of next year; probably ahead of the turn in $:yen, but still “well off into the future”
Commodity currencies are expected to be relatively soft for the next couple of months, but the Aussie may then test new highs in the second half of the year. The Canadian dollar is also likely to slip slightly over the next few weeks, but the bank is also an aggressive rate hike stance from the Canadian government and the downside risk in the C$ is more limited than it is for the A$ in the near future.
And the key question driving the prospects for global recovery this year: Will the Chinese government get its policy mix right and be able to contain inflation while also being able to allow the economy to grow at 8% annualised rate? Leven believes the answer is yes. He argues that there is a clear link between China’s dollar / accumulation of reserves policy and local inflationary pressures, and believes that China will therefore have to slow the pace of reserve accumulation. This implies that the pace of the Yuan’s appreciation may therefore have to be allowed to accelerate, albeit gradually; perhaps at between 5-7% annualised.
This has broad-based implications for the US dollar, and reinforces Leven’s expectation of a broad weakness in the currencies, particularly against emerging market countries [this should reinforce central banks’ attitude towards accumulating gold] and also G10 currencies through towards the middle of next year.
Morgan Stanley’s Base Case is that the Fed will not look to implement QE3 at this point, although it is a possibility is the equity markets fall sharply or if there are continued signs of a slowing in US growth into the third quarter of this year. If unemployment rate rises, reducing consumer demand and pointing towards QE3, this would carry considerable downward risk for the dollar.