FX Outlook For 2009

In contrast to other asset classes, foreign exchange markets have demonstrated relative immunity from harm in both bear and bull markets. Here’s a look at what is in store for these markets in 2009.  

by
Ray Farris, Head of the Global Foreign Exchange Research Group, Credit Suisse
Daniel Katzive, Senior FX Strategist, North America, Credit Suisse
Sean Shepley, Head of the Global Foreign Exchange Research Group and of European Interest Rate Strategy, Credit Suisse

Amidst the worst global economy since the 1930s, the foreign exchange (FX) market exhibited high volatility in 2008. We expect FX to continue to exhibit large swings and significant opportunities in 2009. In a climate of decreasing interest rates and rising government deficits, we see the following dominant themes:

• Interest rate convergence. As central bankers around the world cut rates in an attempt to restart their countries’ economies, interest rates in the major economic blocs are converging as they head to near zero. Within the Group of 10 countries (G10), the obvious beneficiaries are those currencies that already had near-zero rates and run large external surpluses, such as the Japanese yen and the Swiss franc.

• Financing stress. For the commodity currencies, such as the Australian, Canadian and New Zealand dollars as well as the South African rand, the economic cycle has been so disastrously weak that some form of “dead-cat bounce” seems inevitable when the efforts to cut inventory overshoot. This would mean less downward pressure on the commodity currencies, but at the same time, deficits are likely to be more difficult
to finance.

• Alternative policy tools. Without traditional interest rate policy, what happens next? There are two answers: quantitative easing and fiscal stimulus. Traditionally, fiscal stimulus is supportive for a currency because interest rates rise. However, the combination of fiscal and monetary stimulus is potentially dangerous for debtor currencies. Later in 2009, we think monetization will be the bigger risk, with the dollar particularly exposed.

• Emerging markets. As emerging countries’ interest rates follow core yields lower, will the carry trade strategy of buying high-interest currencies and selling low-interest ones end? Or, will it just pause quietly for a while? Instead of ending the strategy, we expect investors to confront the broader question of how much emerging market risk should be in their portfolios. Our view is that investors will gradually return to emerging market currencies, buying a combination of deep value and what we might call “safe” carry.

A THEMATIC APPROACH

A key starting point for thinking about these themes is to note the dollar’s vulnerability as it entered 2009. The deleveraging process that has supported the dollar has unwound many of the valuation excesses of early 2008, leaving most G10 currencies trading close to fair value (see charts below). This implies a more symmetrical distribution of risk around most G10 currencies. The U.S. dollar, the euro, and the Japanese yen are the standouts that are expensive. Reflecting the cheapness of most emerging market exchange rates are Asia, Mexico and South Africa in particular, but conspicuously, not Eastern Europe, which remains very expensive in our model.

Thus, the thinking is that the greenback should re-weaken in the absence of deleveraging driven forced buying of U.S. dollars. We see several arguments in favor of this view. First, supporting the idea that the U.S. dollar’s rally is both anomalous and temporary, its performance in this banking sector crisis has deviated

sharply from its experience in the 1987-1995 bear market, despite the United States’ larger current account deficit and deeper downturn in domestic demand, as shown in the graph (right). 

Year-end 2008 may well have represented a watershed turn in the dollar deleveraging process. Many non-U.S. banks probably did not want to carry into 2009 the net short dollar positions that funded collateralized debt obligations and other, now distressed, dollar assets. Also, some indicators show that the most aggressive phase of deleveraging has passed. Oil prices seem to be forming a bottom, volatility in emerging market currencies is softening, and Asian currencies have begun to rally.

However, we also see the following reasons to be cautious about betting that deleveraging is already complete: 

• Major hedge funds suspended redemptions in fourth quarter and may need to delever further in the first quarter of 2009. This overhang of positions would need to be sold into any risky asset recovery.

• Emerging market debt markets remain closed. This implies the potential for emerging markets to have to repay $39 billion in maturing medium- or long-term debt in the first part of 2009. In the worst case, up to $311 billion of short-term debt could fail to roll over, with more than 80 percent of it in dollars. This would keep demand for dollars high.

• Financial stress in Eastern Europe remains high. 

The last of these factors is perhaps the most important, as it is bearish for the euro. With European banks having lent more than $800 billion to Eastern Europe – $223 billion to Russia alone – we think markets will want to become comfortable that asset quality in Eastern Europe is stabilizing before they decisively re-embrace the euro as a store of value. Another way of putting this is to recognize that to sell the dollar, you really have to like the euro. Credit Suisse economists’ recent downgrade to their euro zone forecasts, combined with the policy discord in Europe, leave us skeptical about how attractive the euro will be in the first half of 2009.

What’s the bottom line? We think the evidence is mixed for the end to deleveraging. This leads us to enter 2009 neutral on euro-dollar in favor of more evidence that forced dollar demand is abating. In the meantime, we are focused on the prospects for further Japanese yen strength and weakness in the British pound, Australian dollar and New Zealand dollar.

As the global foreign exchange (FX) market has become increasingly sophisticated and attracted new market participants, the use of derivatives – particularly FX options – has grown. Regardless of your outlook on the U.S. dollar, euro or Japanese yen, this is a trend that is likely to continue. According to the 2008 Bank for International Settlement’s Triennial Survey, average daily turnover in over-the-counter (OTC) FX options stood at $212 billion a day, representing an 81 percent increase from the last survey, and accounted for 9 percent of the total FX segment.

At CME Group, the options growth trend has been equally strong. Average daily volume for FX options in 2008 was 22,109 contracts a day, with a notional value of $3.4 billion. This represents 29 percent volume growth and 43 percent notional value expansion from the prior year.
An important factor driving options demand is that traders entering the FX market are increasingly knowledgeable about derivatives and feel comfortable executing their strategies using FX options. Accuracy also is fueling growth, says David Poole, chief operating officer at London-based ClientKnowledge. “Traders are concerned about minimizing their risks – counterparty, liquidity and operational – while maximizing the accuracy of the hedge,” observes Poole. “Options allow you to do both.” He adds that the FX markets’ quest for simplicity and transparency has weighted the options market toward plain vanilla products, versus exotic instruments.
Electronic trading is another trend that has had a positive impact on the FX options market at CME Group, where, at the end of 2008, an impressive 63 percent of that volume was traded on the CME Globex electronic trading platform. CME Group customers who are active electronic options traders in other CME Group markets, such as equity indexes, have begun to trade the FX products as well. According to Poole, the OTC options market has been slower to warm to electronic trading, with the percentage of volume trading electronically comparable to where the spot market was 10 years ago.

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