FX Outlook for 2009

Since this past summer, USD has rebounded forcefully from a seven-year bear cycle that started in Q1 2002. The global financial crisis has created massive demand for the USD that propelled the currency to stage a dramatic comeback. Since mid-July, the USD index has gained 24 percent. Against the EUR and GBP, the USD has surged 23 and 27 percent respectively.

The initial driver for the strong USD came from the liquidity crisis among financial institutions triggered by the collapse of Lehman Brothers. The lack of USD liquidity drove banks around the world to buy USD in the foreign exchange (FX) markets to meet their funding needs. But as central banks took steps to inject liquidity into the system, the tension in the short-term money market was somewhat eased and so did the demand for USD. However, the USD strength did not retrace, saved by the burst of repatriation demand from U.S. investors.

Capital Preservation and De-leveraging
Sharp declines in the global equity markets have greatly reduced investors' risk appetites, resulting in mass liquidation of overseas investments and repatriation of trillions of USD of foreign assets. The contagious subprime crisis had caused stock markets in both major and emerging countries falling roughly 50 percent year-to-date. U.S. investors, who have put around $1 trillion into foreign assets over the past three years, began to liquidate their foreign holdings and bring the money home.

The financial crisis also led to the unwinding of structural positions established over the course of the past few years. Typically, investors have sold short of USD and JPY and bought high-yielding currencies such as EUR, GBP, AUD and NZD. De-leveraging from these carry-trade positions has resulted in exodus from these high yielding currencies into USD and JPY. Together with JPY, the USD becomes a safe-haven currency in times of financial stress.

USD Remains Buoyant
The USD will remain well supported at least through out H1 2009, though the uptrend might be choppy. As global economies are entering or have already entered recessions, USD will benefit as foreigners seek safety in U.S. Treasuries while U.S. investors sell foreign assets and repatriate.

The fate of the USD has essentially tied to the intensity of the global financial turmoil. As long as the outlook remains depressing and investors remain risk-averse, billions of USD will potentially be channeled back to the U.S. in the coming months, albeit at a slower pace. In addition to the bleak outlook for the U.S. economy, markets expect economies outside the U.S. to be equally gloomy and the responsiveness of policymakers in these countries to be restrained and somewhat behind the curve. Other central banks, particularly the ECB, will have more room in cutting interest rates, to catch up with the Fed. This expectation will reduce the attractiveness of carry trades to next year, keeping the USD in demand.

Fears about the lingering credit crunch and global slowdown will keep demand for liquid, safe-haven assets such as the USD, as evidenced by the record low yield in U.S. Treasuries. This means further repatriation of overseas assets by U.S. investors will continue to support the USD.

Once the world economy recovers, perhaps during second half of 2009, risk appetite will return and U.S. investors will probably seek higher returns overseas which will reduce support for the USD. But given the financial markets are not yet clear of any meltdown danger and the global economic outlook still has plenty of room to be revised lower, the prospect for this USD negative factor is highly uncertain. Also, historic data suggests that investors are slow to return to risky investments after substantial market setbacks, which argues for a prolonged period of USD strength.

EUR at $1.15?
EUR will remain pressured by the risk aversion and repatriation flows mentioned above. The large long EUR position built up against the USD and JPY over the past five to seven years will continue to haunt on EUR as investors continue to reverse their positions. In addition, central banks of emerging countries have been buying EUR in the past few years as their reserves grew. Now that their reserve balances are shrinking, they need to rebalance by selling EUR.

The bigger issue for EUR is that the Euro economy is in a very tough state with the Eurozone GDP shrinking in both Q2 and Q3. Ironically, the ECB was still hiking rates in July, citing inflation concerns at that time.

The EUR got temporary relief after the aggressive 75 bps rate cut by the ECB on the December 4 meeting. Expectation is for the ECB to be more aggressive in quantitative easing going forward. However, rate cuts will eventually undermine its currency, especially with deterioration of the underlying Euro economy, posing substantial downside risk to the single currency. With a buoyant USD going into 2009 as mentioned above, it is possible for EUR/USD to fall further towards 1.15, albeit in a choppier mode after the big drop experienced this year.

GBP Faces Severe Challenges
GBP has been hurt by weak UK fundamentals and de-leveraging so far. The UK economy, given its reliance on the banking sector and the slumping housing market, has been the worst hit by the financial crisis so far. Recent data points to a bleak economic outlook and a sharper contraction in Q4 2008 and Q1 2009, prompting expectation of a further interest rate cut by the Bank of England. The outlook remains vulnerable going into 2009 and will continue to exert pressure on GBP/USD towards 1.40.

JPY with Hidden Strength
JPY has been well supported throughout 2008 by the de-leveraging flows. The deteriorating fundamental picture in Japan continues to be ignored in a highly risk averse environment. Global financial uncertainties will leave JPY well supported as a safe haven currency going into 2009.

Japan's deteriorating economy will potentially be adding to the demand for JPY. With exports falling and recent government warning that fiscal stimulus might not help, risk aversion among Japanese investors will rise. As Japanese investors are still sitting on sizeable foreign investment with huge paper losses, the deteriorating Japanese economy might prompt these investors to liquidate these foreign investments to stop future losses. The resulting repatriation flows could lead to further JPY appreciation.

The strong JPY placed an extra burden on the already weakening Japanese economy and could trigger BOJ intervention. However, JPY strengthening so far has been orderly without the gaping price action seen in EUR and GBP. As long as this trading pattern continues, it will be difficult for the BOJ to prevent the USD/JPY from gradually grinding towards 85.

Asian EM Currencies Depressed by Capital Outflows
Over the past few years, significant foreign capital portfolios have been built up among Asian Emerging Market (EM) countries. But the global financial crisis and sharp slowdown in global growth have finally impacted these growing economies. Investors have started to unwind investments in these countries and have depressed local asset markets which will likely compromise future economic growth. Thus, Asia economies are not immune from the global slowdown as evidenced by the declining trend in their exports. Policymakers have been intervening and may move to use less conventional measures such as capital controls should de-leveraging flows continue.

With the USD in demand as foreign capital flees, Asian EM currencies - KRW, INR, TWD, THB, MYR, SGD, IDR and PHP - have come under considerable pressure this year with the INR and KRW both falling at least 20 percent. Over the next 12 to 18 months reduced de-leveraging may allow for small retracement for these currencies. But downside risk against the USD dominates into H1 2009.

Those EM currencies, including INR, KRW, PHP and CNY, that manage to rely on domestic demand, are in a better position to rebound first should their domestic demand recover some time next year. By contrast, currencies with high dependency on external demand such as SGD, MYR, THB, TWD and VND might underperform.

In the near term, focus is on the fear of the devaluation of the Chinese CNY. Chinese authorities have allowed consecutive higher fixing in USD/CNY, up to the limit of 0.5 percent away from the central parity fixing, resulting in the largest CNY devaluation since its revaluation in 2005. Back in October, after a slew of weak data, China had stepped up its initiatives to boost export growth, including higher export tax rebates for thousands of products. Fears are increasing that China will favor competitive devaluation in the currency to boost growth, a favored tactic used by Asian nations in the past. Further CNY devaluation could depress other Asian countries as well.