Foreign Exchange Forecast: A Look Forward to 2012

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

Now that 2012 is here, it is time to reflect on the past year’s many memorable events.  How would we have survived without the drama of the Kardashians or the antics of Charlie Sheen?  Does Donald Trump really have a chance to be the next President of the United States? 

On a more serious note, how could we forget the images of the earthquakes and tsunamis in Japan, or Hurricane Irene slamming into the East Coast?  The Middle East brought us the Arab Spring, the death of Osama Bin Laden, and the overthrow of Libya’s Moammar Gadhafi.  Most U.S. combat troops are now out of Iraq.  And for the finale of the year, North Korea’s Kim Jung Il died and it appears as if his youngest son, Kim Jon Un will take over, backed by the military.

Meanwhile, the financial markets have been gripped by struggling economies, high unemployment, low interest rates and the unresolved European sovereign debt issues.  In the foreign exchange market, 2011 may have not been the most volatile year, but there was plenty of news and speculation to keep us on our toes.

Global Trends 

 The question is what will 2012 bring? I am not smart enough to speculate whether Kim Kardashian will find a new beau; however, I will try to formulate some predictions in the world of foreign exchange. I suspect the themes that were popular in 2011 will remain the same for 2012.  I expect the dollar to remain strong with some chance to appreciate more, given the lack of carry trade incentive against all other currencies and the prospect that yield spreads will only narrow.  The Federal Reserve has pledged to keep rates unchanged until at least the middle of 2013. Economists surveyed by Bloomberg, predict the European Central Bank will likely need to reduce interest rates next quarter, while the Bank of England, the Swiss National Bank and the Bank of Japan will stay on hold through 2012. Tight interest rate spreads and elevated financial volatility have historically led to safe-haven flows into safe haven low-yield currencies, which since early 2007 has included the U.S .dollar, the Swiss franc  and the Japanese yen.

 EUR Weakness 

The first trading day of 2012, the EUR has remained below the 1.3000 threshold, reaching a 15-month low against the USD.  The 2011 peak for the EUR was 1.49 in May.  It appears the euro zone stresses remain very much intact. Most sentiment indicators continue to look weak and some have already reached recession levels. Many companies and consumers remain unsettled by the sovereign debt crisis in the euro zone. The first negative data for 2012 was the January 2 euro purchasing manager index (PMI). It printed at below 50, indicating manufacturing continued to shrink as 2011 came to an end. 

These and other sentiments continue to evolve in a way that is clearly proving problematic for the EUR.  The euro is also vulnerable to the decline of business confidence surveys around the world, which creates downside risks to the projected interest rates for the ECB over the medium term.  Of course, the 800 pound gorilla is how European leaders will struggle to find ways to curb the region’s growing debt crisis, which has seen bailouts of Greece, Ireland, and Portugal and now threatens to engulf Italy and Spain. Many believe any hope for immediate solutions to this crisis is likely nonexistent.

 JPY Strength 

The JPY is likely to continue to benefit in 2012 from interest rate convergence and risk aversion. With most central banks likely to be in or close to a policy easing mode, pressure on rate differentials to converge towards Japan-like levels (near zero) is likely to persist. Faced with continued uncertainty in the global financial markets and an unattractive array of developed economy yields, Japan’s current account is likely to remain insufficient and there may be persistent repatriation pressure of foreign investments. Foreign currency intervention from the Bank of Japan remains an important limit on significant JPY appreciation, particularly with Japan now running a trade deficit.  Japanese exporters are sure to continue to struggle with the yen trading below 80 per 1 USD. However, the Bank of Japan will have a difficult time establishing a definitive floor in USD/JPY.

 GBP Weakness 

The GBP-specific story is one of continued sluggish growth and negative real policy rates. The sterling has been an indirect beneficiary of EUR strain, as investors have stepped up their diversification into sterling during periods of elevated EUR concerns. The shortage of AAA reserve currency alternatives to the EUR implies that the GBP may continue to see some demand in the near term.  However, more deterioration in the euro area would likely stall any UK recovery and prompt further easing from the Bank of England.

 CAD Strength 

The Canadian economy is primed for further expansion in 2012 amid continued domestic growth and a sluggish recovery in the U.S.  Canada’s dollar may turn into a haven for foreign-exchange investors shunning European turmoil and seeking the safety of the U.S. without the budget deficits or political gridlock. As the U.S. struggles with a $1.4+trillion budget shortfall, AAA-rated Canada may use rising commodity revenue and spending cuts to balance the budget. Canada’s economy is growing at 3 percent, twice the average pace of Group of Seven and euro-area nations. Bank of Canada will likely be the only central bank in the Group of 10 countries that may raise interest rates next year.  Inflation has exceeded the bank’s 2 percent target for the last 11 months as the economy grows.

AUD Bearish 

he outlook for a reduced risk environment and global interest rate convergence argues that carry trade currencies may lose their luster. While domestic data have stabilized somewhat over the past quarter and second half 2011, GDP is likely to print strong, driven by mining investment. The lower inflation outlook has allowed the Reserve Bank of Australia (RBA) to start cutting rates. This is reducing AUD's yield spread advantage, and in a case of a more of a more serious global downturn, the RBA has the scope, as in the past, to cut rates more aggressively. In addition, the AUD is particularly vulnerable due to its reliance on elevated commodity prices and steady global growth.  The median estimate of economists from a Bloomberg survey indicates China’s economy, the world’s second largest, may slow to 8.5 percent next year, from 9.2 percent GDP growth percent in 2011. China accounts for 25 percent of Australia’s exports, with Asia taking more than 70 percent, according to the Reserve Bank of Australia.

Remember, there is plenty of uncertainty in today's global economy.  Hedging is one way to help reduce some of the unwanted risk.

Good Luck and Happy New Year!